The fallacy of permanent cheap finance is over, and it has caught some of the most conservative investors offside.
Never say never; the widely held belief that we would never see high rates in our lifetime was wrong.
What many believed could not have happened has played out
Maxim of investing, better to expect the unexpected, the only certainties in life are taxation and death.
The blowout from the fallacy of permanent cheap finance has exposed fissures in the pillars of Western finance, treasury notes, and its destabilizing the banks.
There is chatter that the Fed might still not be done hiking rates as some of the FOMC Hawkes talks about raising rates towards six per cent.
Underlying inflation, based on things like processed foods, clothing, and restaurants, has not come down since the start of 2023. What has come down a lot is energy prices. So lower energy costs have pulled down headline inflation, which accounts for every good and service.
“Never say never; the widely held belief that we would never see high rates in our lifetime was wrong. ”
Core inflation, which excludes food and energy but includes services, remains red hot
So they try to bamboozle investors using various definitions of inflation, underlying, headline and core. If food and accommodation, the most important expense for households, were included in core inflation, the real inflation rate would be in double digits.
The fallacy of permanent cheap finance is over, Fed’s current rate is 5-5.25%, near the top of the range, and there is Fed talk about more rate hikes on top of that.
But there are not many people today working in finance who were decision-makers the last time the Fed raised rates near 6% under the pressure of red-hot inflation.
“The fallacy of permanent cheap finance is over”
Post-financial crisis, the great recession of 2008 period of easy money, low-interest rates were near zero per cent, and the consensus was that inflation would never raise its ugly head again.
Moreover, most believed that if the Fed were to hike rates again, it would do so only by a little and only briefly.
So investors learned this lesson eight years ago when the Fed hiked the Fed fund rates by 2.25% over three years from nearly 0% in 2015 to 2.5% in December 2018, only to pivot a month later.
By January 2020, before the pandemic, rates were back at 1.75% and by March 2020, they were back to near zero percent.
But working in finance today, those making investment decisions during the last rate previous rate cycle from June 2001 through to June 2006, when the Fed hiked rates by 4.25% from 1% in 2004 to 5.25% in June 2006, are now middle-aged and older.
“the fallacy of permanent cheap finance led to some malinvestments, which continue to wreak havoc on the markets” – Win Investing
So investors have experienced a mild version of rate hikes, particularly from 2004 to 2006
Investors discarded the reality of rate hikes when bought into the fallacy of permanent cheap finance.
The rate hiking cycle from 2004 to 2006 occurred during a period of lower inflation compared with today.
For example, core CPI peaked at 3%, in 2006, and the hiking cycle progressed more slowly than the current cycle.
But today, there is nobody with experience working in finance with the core inflation higher than it is today.
The consensus view was that inflation would never come back, and if it did it would only just a little, and the Fed could easily squash it.
Investors believed that the Fed’s interest rates would be near zero percent and would only rise slowly by a small amount to maybe 2.5%.
Furthermore, investors believed that even if the Fed tightened it would soon be forced to pivot, bearing in mind the S & P 500 dropped 20% in 2018 as a December rate hike triggered market turmoil.
So the fallacy of permanent cheap finance led to some malinvestments, which continue to wreak havoc on the markets.
The fallacy that interest rates would never rise again led to four major bank runs
Silver Gate Capital, Silicon Valley Bank, Signature Bank and First Republic.
Overnight Reverse Repo hit two trillion US dollars, in late May, and June, an unprecedented amount, worse than during the 2020 global lockdowns, suggesting the banking crisis is far from over.
These banks bought a bundle of pristine long-term maturity treasuries and government-guaranteed mortgage-backed securities.
These bond asset prices fluctuate when interest rises, which resulted in significant unrealised losses.
So as Fed fund rates rose, depositors demanded more interest, pulled their funds out and bought short-maturity treasuries. As investors discovered that banks were holding huge book-to-market losses on their treasuries, they also yanked their funds.
“Mortgage interest payments have doubled over the last 15 months” – Win Investing
The fallacy of permanent cheap finance could lead to a worse real estate crash
Mortgage interest payments have doubled over the last 15 months, and the already struggling income from the office towers and rental shopping malls can no longer pay interest payments that have doubled, at the same time, the market value of these properties has plunged below the mortgage debt on the property. Landlords walk away, and the lenders take huge losses.
Landlords can walk away because these are non-recourse loans. Real estate crash
Landlords have already walked away from numerous off properties, such as office towers in Manhattan, huge malls across the country and residential towers.
The consensus hallucination, fallacy of permanent cheap finance has come to an abrupt end. The full fallout has yet to play out in real estate and other leveraged assets has yet to play out.