The U.S. has dealt with inflationary tempests before. However, none started in such an unprepared financial environment. Therefore, expect coming effects to be chaotic.
(See “Inflation Messaging: 2021 Imprudence Versus 1981 Wisdom” for the rationale of a rising inflation period ahead)
Preparedness has been waylaid by the Great Recession curative actions being taken to extremes in both size and time. Because those actions feed inflation, they need to be tempered in the face of a rising inflationary environment. Not doing so would raise the specter of stagflation (poor economic growth amid rising inflation) or hyperinflation (the vicious cycle of ever-rising inflation).
And that brings in the fourth, and perhaps greatest, danger: Investor belief that we live in a “new normal” time.
The past 10+ years of easy money, deficit spending and low interest rates have created the “new normal” view. It has been fully supported by economists (particularly those at the Federal Reserve), government leaders and Wall Street. So, naturally, many (most?) investors see those actions as acceptable, necessary and permanent. Alter them, and investors will react negatively.
How the “new normal” was created
During and after the Great Recession, three significant external forces were at work:
- The U.S. Government’s immense deficit spending and debt level
- The Federal Reserve’s massive creation of fiat money supply through bond purchases (“fiat” means money not backed by or convertible into something of value, like gold)
- The Federal Reserve’s extended use of negative real interest rates (“real” meaning after subtracting out inflation – i.e., the decline in the dollar’s purchasing power)
The first two are pre-conditions to a rising inflation rate environment.
The third is the tactic that has produced abnormal borrowing, lending and investing incentives and actions – in other words, the “new normal”
How to find a “true normal”
Most of the U.S. financial history is marked by external forces of one type or another – booms, busts, wild optimism, fearful pessimism and all spots in between.
The hunt takes us back 25 years to 1996. Federal Reserve Chair Alan Greenspan had shifted back to market-based interest rates following the 1990-91 bank and S&L collapse and recession. Although he viewed the rising stock market as exhibiting “irrational exuberance,” he was three years premature. The economy was growing, the government was focused on both expanding and deficit reduction, and the financial system was stable.
Following 1996 were five overlapping episodes of various external forces at work:
- Internet bubble formation and implosion/recession
- Housing bubble with linked subprime financial fiasco and extended fallouts
- The Great Recession and rebound-recovery
- The Federal Reserve’s still-continuing Great Recession-induced actions of abnormally low interest rates combined with abnormally large money supply creation
- The U.S. Government’s abnormally large deficit-financed fiscal spending programs such as the 2018 tax-cut bill
The 1996 view of normality
Below are the yields, price changes and growth rates for the year. Note the “real” positive interest rates that always occur in normal environments. They are based on the basic truth of investing in normal capitalist markets: Investors require return to be commensurate with risk. That means a riskless (short-term U.S. Treasury) rate above or near the inflation rate with increased rates and potential returns for higher risks (e.g., longer-term and/or weaker credit).
The view of 1996 annual averages and growth rates:
- Total: 3.4%
- Less food & energy: 2.6%
U.S. Government yields –
- 90-day Treasury Bill: 5.0%
- 1-year Treasury Bill: 5.2%
- 5-year US Treasury: 6.2%
- 10-year US Treasury: 6.4%
Corporate bond yields –
- Moody’s AAA: 7.4%
- Moody’s BAA: 8.1%
Bank prime lending rate: 8.3%
Mortgage rates –
- 15-year: 7.3%
- 30-year: 7.8%
House price increases –
- S&P/Case Shiller US National Home Index: 2.5%
- Median new home sales: 4.5%
Economy growth rates –
- GDP (nominal – i.e., not adjusted for inflation): 6.2%
- Corporate profits (after tax): 7.4%
- Personal income: 6.2%
- Personal consumption expenditures: 5.7%
Financial growth rates –
- Commercial & industrial loans (all commercial banks): 7.9%
- Consumer loans (all commercial banks): 6.3%
- Federal debt: 5.3%
Unemployment rates –
- Overall: 5.4%
- Ages 25-54: 4.3%
Stock market gains –
Now, think about normalizing today’s environment plus having rising inflation rates
Take the key 10-year U.S. Treasury yield of 1.66% today. How far does that yield have to rise to have a normal position? Relative to other rates in 1996, the spreads were +1.6% (for riskless vs CPI) and +1.4% (for 10-year vs riskless) = 3.0% total spread.
Savers and conservative income investors have quietly accepted the loss from 2% inflation (lost purchasing power) over the past 10+ years, even though the cumulative loss is now about 20%. Push that annual loss rate up to 2.5%, 3% or higher and the noise will begin.
In addition, professional investors will begin requiring higher yields on longer-term bond issues once again. In the past, longer-term yields were more independent from whatever the Federal Reserve was doing with short-term rates.
The bottom line – Many don’t believe times are abnormal, raising the risks from a rising inflation environment
The above picture isn’t a low probability risk. It is a high probability, “normal” reaction to leaving an abnormal environment. That makes the interest rate disparities look especially worrisome.
Whether or not Federal Reserve Chair Powell tries again to raise rates to a “neutral” level, rising inflation rates will produce the pressure for higher yields. As inflation expectations rise from 2% to 2.5% to 3% to -unknown-, that 1.66% 10-year UST yield will necessarily jump to catch up. How far? That depends on how quickly normality returns to the pricing of risk