No Interest Rate Depression Is Coming To The United States


John M. Mason reports on a dire forecast by Martin Feldstein if interest rates spike.

Feldstein forecasts a depression to rival the 1930s.

Like many dire forecasts, that one is unsound historically.

John M. Mason reported here on Seeking Alpha that Martin Feldstein predicts a depression to rival the Great Depression of the 1930s if the interest rate on the 10-year Treasury spikes (to an unnamed number). Mr. Mason discusses what might happen to the interest rate on the 10-year Treasury and seems to accord credence to Feldstein’s Chicken Little surmise.

The core of Feldstein’s forecast, it appears from the Daily Telegraph article that reported it, is that “The next bear market risks causing a $10 trillion crash in the US housing market that could lead to a downturn to rival the Great Depression of the 1930s, according to Martin Feldstein, the president emeritus of the US National Bureau of Economic Research.” The Daily Telegraph loves to report sensational financial stuff like that, but for purposes of discussion, let’s take it at face value.

The yield on the 10-year Treasury could indeed go up significantly, not merely another percent or so, as Mr. Mason discusses. But data from past interest rate spikes do not suggest that even a 200 basis point surge from today’s rate would have a huge impact on the U.S. housing market. I discussed this issue in Instability, my 2017 book (pp. 65-69). There I discussed the work of several economists that suggest that for an increase of 100 basis points in interest rates, U.S. house prices decline between three and four percent. That kind of decline, even from a 200 basis point spike, would not wreak havoc on American homeowners’ balance sheets, especially since the vast majority of home loans now are long-term and do not have to be refinanced.

As part of my study of this subject, I created a somewhat complex graph that is based on FRED data.

Blue line—inflation in percent (source: World Bank consumer prices U.S.)

Red line—change in house prices in percent (source: Federal Housing Finance Agency)

Green line—30-year fixed rate mortgage rates in percent (source: Freddie Mac)

Purple line—change in total outstanding mortgages in percent (source: Federal Reserve)

This graph shows mortgage interest rates rising steeply in the late 1970s and early 1980s, then declining fairly steadily for the next 34 years. For the most part, mortgage interest rates appear to be unaffected by recessions. Mortgage volumes and house prices, on the other hand, appear to respond far more closely to general economic conditions, rising in most markets but usually declining in recessions. (If one focuses specifically on the late 1970s and early 1980s, one sees mortgage interest rates at an elevated level throughout the period—around 10% or higher—but home prices and mortgage volumes declining only after mortgage interest rates breached the 10% level and in the double-dip recession following the Volcker credit crunch. Both prices and mortgage volume resumed their upward march almost as soon as the double-dip recession was over, despite long-term mortgage interest rates remaining around 14% for another two years.)

Thus, although a 200 basis point or so spike might have a different impact next time it occurs, that would be an historical anomaly. With a total value of a little over $30 trillion, American houses would, it appears, lose less than $3 trillion of value even with a spike of over 200 basis points.

At the same time, the stock market might decline, as investors shifted from stocks into higher-yielding debt instruments. But history does not suggest that stock market declines cause deep recessions. Think about the Dotcom bust, for example. Many studies have shown that it did not have a very significant economic impact.

The big economic impacts come from homeowners who have used their homes as ATMs no longer being able to do so (the Great Recession) or debt default cascades where a decline in value of an asset triggers margin calls or writedowns that render major institutions insolvent (the accompanying Great Financial Crisis). I do not foresee a 200 basis point spike in the 10-year Treasury as causing a debt default cascade.

That is not to say that a spike in interest rates will not cause a recession. I think it is likely to do so. But I think it is unlikely to cause a financial crisis in the U.S., though it may do so elsewhere. See my discussion here a year ago. I continue to see the world about that way.

Mr. Mason also discussed the possibility that in some such circumstance, foreign owners of U.S. Treasury securities might sell or stop buying and that event could contribute to an emerging crisis. But I wonder where those people and governments are going to put their money. Where else is there a liquid market that has close to zero credit risk? And why would the world stop buying when interest rates have risen to make the asset more desirable? U.S. Treasury securities have remained desirable throughout the post-WWII period, regardless of what was going on. Periods of weakness have been short-lived. Some day that may change, but that will have to be a day when other economies are in stronger positions, so that they may appear as safe or safer than the U.S. Today there is no such economy and no such liquid market.

Over the last several years, pundits of all political stripes have been predicting the next financial crisis. And many of the hundreds of articles on the ten-year anniversary of the Lehman failure have complained that the world has not learned the lessons of the last crisis. Risk may have pushed out of the regulated banking system, they complain, but it is still there in various less regulated sectors.

It is true that risk has not been banished, and it is true that the lessons of the last crisis all have not been learned or acted upon. Nevertheless, the financial world in the U.S. is far sounder than it was. The biggest problem areas are now in government, not in the private sector. Government agencies Fannie, Freddie and the HFA continue to make loans at high LTVs. Student loans continue to default and will continue to default. And Treasury debt continues to grow apace. The saving grace of all that is that the U.S. borrows in a currency that it can print. Inflation may ensue and with it, interest rates may go back to historically dangerous levels. But American financial institutions today do not look like S&Ls that borrowed short to lend long—though the Fed is an exception in having short-term liabilities and long-term, interest-rate-sensitive assets.

My bottom line is that many countries might well experience financial crises over the next few years, but the U.S. is not likely to do so.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.