Are interest rates ever going to go up again? And if they do, will the stock market crash like it did in 2008?
The general belief for the past several years has been that all of the interventions by the U.S. Federal Reserve and Central Banks around the world will end by inflation running rapidly out of control causing a Bank-led increase in rates. However, this is not presently the most likely outcome.
If I use as my frame of reference as the late 1970s, the odds are that inflation would cause a Fed rate increase. However, the current economic problem is diametrically the opposite of the 1970s - it is low economic demand growth and deflationary price pressure, not low growth, high inflation. Price deflation pressures defined the Depression Era. So, it might be a good idea as an investor to get very familiar with how interest rate policy worked in that time period.
Since taking the Chairmanship at the Fed, Ben Bernanke has been lauded as a scholar of the Depression Era. Since 2008, Fed policies have drawn from policies during the Depression. The Great Depression Federal Reserve was an activist Keynesian policy-driven organization, pegging short-term interest rates at or near zero percent for the purpose of wealth re-distribution and reducing long-term rates. The one exception in the period was 1936-37, when Marriner Eccles, then Fed chair, raised reserve requirements on banks from 12.5% to 25% and interest rates were driven up. The result was a plunge in the stock market (DIA) (SPY)(VOO)(IVV) from 187 to 100, 47%. The decline was championed as a confirmation that a more activist government was required and rates needed to remain low for what would be termed today as an "extended period." Sound familiar?
The conditions that Marriner Eccles confronted in the Fed in 1937 seem oddly identical to the situation that Ben Bernanke lived through in 2008. When Ben Bernanke assumed the Fed Chairmanship in 2006, few people remember that his first decision was to increase the Fed Funds Rate three successive times from 4.5% to 5.25%. This was in effect using a "blunt" instrument at an inappropriate time - but as history will reflect - at a time when speculative market activity and leverage in the mortgage lending market was out of control. The resulting market decline two years later was historic, but by no means a collapse as colossal as the 1929 crash, which sent the Dow from peak to trough down 83%. The decline in 2008 was 48%, which was almost the identical magnitude drop in value, which the history books call a Fed mistake in 1937.
In the wake of the decline in 1937 Galbraith wrote "The 1937 action was the last error of the Federal Reserve for a long time. That was because it was the last action of any moment for 15 years." Our current Federal Reserve seems to be on a similar, and possibly even longer path from an interest rate policy standpoint.
A lot changed in the 15 years between 1937 and 1952. There was WWII of course, which the War on Terror in current history does not equal. Additionally, Social Security and Welfare programs were implemented, and the first checks to social security recipients began being mailed in 1941. We presently have the Affordable Care Act, which will go into full force in 2014, and many more entrenched social programs. And, the government went deep into debt. The U.S. debt grew to over 120% of GDP as WWII ended and the troops began to come home. Currently the U.S. debt to GDP ratio is 104%, up from 66% at the beginning of 2008. In 1946, interest rates were at period-level lows at all maturities and the stock market surged through the high set almost a decade before. Voila, very similar circumstances to where we find the U.S. financial market in 2013, at least from a market metrics standpoint.
What a perfect model framework for evaluating what happened to make the "extended period" of low interest rates end, as it did in the years following 1946, and how the stock bull market responded to the change.
The Interest Rate Term Structure - 1941 thru 1957
The graph below summarizes how interest rates changed over the time period from 1941-1957. Pay attention to two aspects of the rate structure: 1) In the early 1940s rates trended downward, with corporate rates falling the most; government debt during this time was rising from 49% to over 120% of GDP; 2) Even as inflation increased rapidly post WWII, interest rates only began to trend upward 18 months after the Truman balanced budgets went into effect in 1946, and then only at a very gradual pace.
- There is a perceptible rise after 1946 across the term structure from a point that would mark time-period lows of .375% on overnight to three-month money, 1% on five-year money, 2% on the 30-Year Treasury and 3% on Corporate bonds.
- The very short-end of yield curve - Fed Funds equivalent - was allowed to rise to 1.0% from .375% in mid 1947 as the Truman Budget was being implemented and after WWII wage and price controls were lifted. It was a year of very high inflation (18.1%).
- Treasury rates through the time period never dramatically moved higher, even when inflation spiked; rather they changed very gradually.
- It took 6 years for overnight funds to rise 2%; six years for five-year T-Bills to rise 1%, eight years for 30-year Treasury Bonds to rise 1% and 10 years for corporate investment grade BAA1 bonds to rise 1%.
Through the entire 1940s repressive interest rates were utilized as a government policy of Keynesian re-distribution. Repressive rates are a policy where the Treasury works in conjunction with the Federal Reserve and Member Banks to auction government debt at rates below the economic rate of inflation (aka fixing rates). Repressive rates are a government act of price control allowing the government to borrow and not pay high rates as it re-distributes wealth thru government programs. This is the same policy that has been in effect in the U.S. since the Presidential election of 2008.
How did the Stock Market perform in 1946 as Interest Rates Rose?
In the graph below I have overlaid the performance of the DOW to show the market reaction as the Federal Reserve slowly began to withdraw monetary stimulus programs in 1946 in conjunction with the Truman Balanced Budget implementation.
The cyclical rise in stocks induced by the wartime economy and the euphoric run-up at the end of the war came to an abrupt end in May of 1946. The sell-off was 22% peak to trough. Economic growth as measured by GDP was strong throughout the period (8% yearly average for 4 years), and there was both high inflation (4%) and real growth (4%). The headwinds of measured government spending and slow withdrawal of low interest rates kept stocks from returning to the May 1946 high again until early in 1950. However, the stock market also never broke below the base it formed after the May 1946 correction.
U.S. Treasury interest rates continued to be repressed below the rate of inflation through the entire period until 1951.
What Changed in 1951?
Eventually the Federal Reserve pushed back against the policy of "pegging" interest rates on new Treasury issues. The discontent reached a head and Truman called the Treasury and the Fed open market committee into his office for a meeting in early 1951. The Treasury, history says, left the meeting convinced that rates would continue to be fixed. However, the argument continued. Finally the conflict was resolved through a negotiated settlement known as the Treasury- Federal Reserve Accord of 1951. The settlement allowed for slightly more latitude for the Fed in setting rates, and a small tick up in rates, and also the increase in rate volatility is visible beginning in early 1951:
When Eisenhower was swept into office in 1952, more conservative views and a belief in sound money policies became shared between the Treasury and the Fed. It was at that point that the Fed had regained its independence from policy makers who wanted easy credit and low rates.1
Relating the 1940s to Current Financial Market Conditions
The No. 1 lesson from the last "extended period" of low interest rates is that the Fed is not going to leave the party very fast. A market crash like September 2008 will not happen again anytime soon due to interest rate increases by the Federal Reserve. However, QE has probably reached the end of its effectiveness in dropping interest rates and cannot continue indefinitely unless the Fed wants to start adding stocks to its balance sheet.
When the Fed withdraws QE3, there is likely to be a predictable stock market reaction - even assuming that it continues to hold the assets that have been purchased, which I expect. The graph below provides a forecast of this likely reaction:
The above forecast is based on the market reaction in the 1940s as budget tightening began and Fed stimulus lessened. However, we live in different circumstances politically and economically, and the expected outcome from the Federal Reserve policies, in my professional estimation, is going to be slightly different - primarily in the post-correction phase.
From a historical perspective, an extended period of low Treasury interest rates in the U.S. means indefinitely until there is a clear change politically and a clear improvement in the fiscal situation of the U.S. government. Weaning off of repressive rates, from a historical analysis, requires several conditions:
- First and foremost, the economy must be strong enough to continue growing in the face of both less federal government stimulus and fed induced low rates - the past four years of GDP grew from $14.1T to $15.8T, a total of 12%, starkly in contrast to the conditions in the 1940s.
- A dedicated government policy to slow the growth of counter-cyclical Keynesian stimulus programs and to allow the private market to drive cyclical job growth and investment. The government took small steps at the beginning of 2013, but we have not yet felt the impact of the Affordable Care Act so it appears the steps are only to make room for the new program. And there is a growing Obama-led instigated resistance within the government itself to any cuts in the spending.
- A government willing to return to a debt-to-GDP ratio of 50% to 75%, not continually driving the ratio higher - time will tell if a Grand Bargain can be reached, but don't expect it without an election.
- A clear line of demarcation, which disappeared at the beginning of 2009, between Treasury and the Federal Reserve.
At present, the U.S. continues in a period of low economic demand growth. Jobs were plentiful in the mid 1940s and the wartime spending was so large, history reflects, a substantial portion converted into real economic growth post-war. Because of the underlying economic strength in the mid-1940s, post-correction the stock market was able to eventually find a base and begin to rise again. In 2013, the missing ingredient is private sector investment and job growth against the headwinds of dependency on government programs. Fed QE and low interest rates cannot cure the real economy problem. At present, all of the intervention has flowed primarily into financial markets and inflated intangible asset prices, not real economy price levels. This track record is empirical proof that at best, the Fed can only buy time for a solution to materialize, not create the solution.
With the Fed boxed in, the most likely interest rate scenario post QE3 is a continuation of the "extended period" rate policy. However, in contrast to the 1940s, the U.S. is likely to experience a widening of the spread between risk-free Treasury bonds (AGG) (BND) and corporate bonds (LAG) (SCHZ) due to poor economic conditions. These conditions are a function of exported wage deflation pressures, supply dampening U.S. regulatory policies and European continued turmoil. The interest sensitive markets feeling the brunt of this price pressure will be low investment grade, junk credit (JNK), which has been "inflated" the most by Fed QE.
As a result, the Fed induced bull market is likely to suffer a severe 20% set-back at some point in late 2013 or in 2014, which is a technical signal of a recession. Other than maintaining U.S. Treasury interest rates at low levels, the Fed will have very little left that it can do to respond.
The Fed can pump the market up, but it cannot rehabilitate it.
(For a more detailed analysis of the economic differences between today and those of 1946 see my last article Investing in Equities Today Remember May 1946; For an analysis of the likely deflation driven impact of the April 4, 2013, Bank of Japan monetary policy announcement, see Will Japan Create Inflation or Just Export Deflation?) .
1 William Greinder, Secrets of the Temple - How the Federal Reserve Runs the Country (New York: Simon & Schuster, 1987), 328.