This week, the monetary policy making arm of the Federal Reserve, the Federal Open Market Committee (FOMC), left the target overnight lending rate between member banks unchanged. The upper bound remains at 5.50%, and the lower end has at least another 6-weeks at 5.25%.
This was as expected.
Unfortunately to many, Fed Chairman Jay Powell left the door wide open for at least one more rate hike with his comments on Wednesday afternoon. The markets reacted as though he said he was bringing a box of snakes to a baby shower.
No, the markets didn’t completely freak out. It hasn’t been financial Armageddon since 1:30 pm CDT on Wednesday. It has just been a little bit of a bummer despite today’s (9/22/2023) little rally.
Higher rates for longer?
- That means downward pressure on financial assets, doesn’t it?
- It means continued sluggishness in borrowing and lending, and, therefore, the money supply, right?
- We will probably have a whole bunch of zombie banks when all is said and done, won’t we?
- How is the economy supposed to grow if banks aren’t lending money and consumer balance sheets are under duress?
Yuck. Am I right or am I right or am I right?
Let me get this out of the way: I get it. There is an inverse relationship between interest rates and bond prices. After all, you probably wouldn’t be willing to pay full price for a 5-year bond with a 3% coupon when rates are 6%. At least I hope you wouldn’t be.
Then, higher interest rates make bonds more attractive to stock investors.
After all, why deal with all of the volatility and headaches if you can get, say, that same 6% from a bond?
Combined, it makes for depressing portfolio returns, as we saw in 2022. While 2023 has been much better to date, what does the remainder of this year and next year hold in store for us? Higher for longer? That doesn’t seem to bode well, does it?
Maybe… but then again, maybe not.
A Quick Primer on Interest Rates
You see, interest rates are nothing more than the price of money in the economy. As you might have learned in Econ 101, prices will go up when demand outpaces supply. As such, higher interest rates, in a well-functioning economy, often suggest vibrant economic activity.
Who doesn’t like that?
On the flipside of the coin, are low interest rates always good for what ails us? Haven’t we learned artificially, and arguably arbitrarily, that setting interest rates below the rate of inflation can lead to the misallocation of capital? Asset bubbles? Underperforming asset classes?
The Facts
Then, you have to take a look at the cold, hard facts.
- Since the Federal Reserve started its shenanigans with quantitative easing, flooding the markets with liquidity and engendering negative real interest rates for an extended period of time, the economy has, drum roll please, underperformed.
- With the lone exception of the ‘bounce back’ year of 2021 after the worst of the pandemic lockdowns, the U.S. economy has not had Gross Domestic Product (GDP) growth of 3% or greater in any one calendar year since 2005.
That is the black and white, even if there are apologists out there who could argue this isn’t a fair argument. After all, it is harder to grow $30 trillion at 3% than $50,000 at 3% in absolute terms.
Perhaps, but the economy is little more than an amalgamation of a lot of entities making, say, $50,000, and they are all trying to generate more than 3%. When interest rates, the cost of money, is 1%, that makes generating that 3% that much harder.
Don’t get me wrong. I am not advocating for oppressive high interest rates in order to stimulate economic activity in the short-term. That would be kind of silly. Further, temporary (and artificially) low interest rates can ‘goose’ the economy by stimulating lending and borrowing. However, when they become permanent, the economy adjusts to the lower cost of money and behaves accordingly.
In essence, it responds rationally to irrational behavior. Human beings have a tendency of doing that.
The Long-Term Impact
So, what impact will higher interest rates for an extended period of time do for economic growth and investment returns? Intuitively, the short-term shock of higher rates will, or should, put a ceiling on activity and results. However, over time, the economy and investors will adjust to the new cost of money, and eventually expect greater outcomes.
You see, higher interest rates alone don’t swamp the economy and the markets.
- After all, the average target overnight rate from 12/31/1990 to 12/31/2000 was 4.96%.
- During that period, the S&P 500 had an annualized rate of return of 17.44%, and the economy grew at a 3.44% annual rate.
- In the 1980’s, the numbers were 9.35%, 13.91% and 3.32% respectively.
- What’s more, the month-end target overnight lending rate never went below 5.88% from 12/31/1980 to 12/31/1990. Not once. That is 0.38% higher than the 5.50% upper end of the overnight rate we have today.
No, high absolute rates of interest aren’t necessarily the problem. The issue is with ‘real’ rates of return. This is the spread between interest rates and inflation. Intuitively, the higher the positive spread, rates less inflation, the greater the outcome for the economy and the markets.
Think about it.
Assume, inflation is 10%. That stinks, doesn’t it? However, what if you are generating a rate of return of 15%. Are you better off or worse? Conversely, what if inflation is 4%, but you can only generate a return of 2%? Of the two, which is the better scenario? High inflation and positive real returns? Or low inflation and negative real returns?
If you are dubious about my logic, consider this:
- From 12/31/2000 through 6/30/2023, the month-end average overnight rate has been 1.62%. During this time, GDP has grown at a 1.93% annualized rate, and the S&P 500 has generated an annual average 7.59% total rate of return.
Fun with numbers here today, huh?
So what does all of this mean over the next couple of years, as the economy and the markets adjusts to the higher cost of money?
The Bottom Line
As the system flushes out some of the misallocation of resources which occurred when the Fed kept rates artificially low, it means continued slower than desired GDP growth. This could take a couple of years, maybe. Further, it probably means a so-called reversion to the mean, as investors warm to boring ‘old-economy’ stocks.
Once that’s mostly finished, accomplished, the economic activity and market returns could be quite exciting.
So, no, higher rates won’t kill the economy. They will just transform it.
Thank you for your continued support. As always, I hope this newsletter finds you and your family well. May your blessings outweigh your sorrows on this any every day. Also, please be sure to tune into our podcast, Trading Perspectives, which is available on every platform.
John Norris
Chief Economist
Please note, nothing in this newsletter should be considered or otherwise construed as an offer to buy or sell investment services or securities of any type. Any individual action you might take from reading this newsletter is at your own risk. My opinion, as those of our Investment Committee, is subject to change without notice. Finally, the opinions expressed herein are not necessarily those of the rest of the associates and/or shareholders of Oakworth Capital Bank or the official position of the company itself.