U.S. has dealt with Previous inflation storm. But nothing started in such an unprepared financial environment. Therefore, future effects are expected to be chaotic.
(See Inflation Message: Rudeness in 2021 and Wisdom in 1981 for the rationale for the upcoming rise in the inflation period.)
Preparations were lost due to the treatment of the Great Recession, which is extremely large and time consuming. These actions encourage inflation and need to be mitigated in the face of rising inflation. Otherwise, there are growing concerns about stagflation (declining economic growth as inflation rises) and hyperinflation (a virtuous cycle of rising inflation).
And it poses a fourth, and perhaps the greatest danger. Investors have the belief that we are living in a “new normal” era.
Easy funding, deficit spending and low interest rates over the last decade have given rise to a “new normal” view. It has been fully supported by economists (especially the Federal Reserve people), government leaders, and Wall Street. So, of course, many (most?) Investors consider these behaviors tolerable, necessary, and permanent. Investors react negatively when they change them.
How “New Normal” was created
Three important external forces were at work during and after the Great Recession.
- Huge US government deficit spending and debt levels
- Large-scale creation of fiat money supply through Federal Reserve purchases (“fiat money” means money that is not backed by or cannot be converted to something of value, such as gold)
- Long-term use of negative real interest rates by the Federal Reserve (“real” means after deducting inflation, that is, a decline in the purchasing power of the dollar)
The first two are prerequisites for an environment of rising inflation.
The third is the tactics that have created incentives and behavior for extraordinary borrowing, lending and investment. In other words, it is “new normal”.
How to find “true normality”
Much of US financial history is characterized by some external factor, such as boom, bust, wild optimism, horrific pessimism, and all the spots in between.
The search brings us back 25 years ago until 1996. Federal Reserve Chairman Alan Greenspan has returned to market-based interest rates after the collapse and recession of banks and S & L in 1990-91. He saw the rising stock market as showing “irrational vibrancy,” but he was three years early. The economy grew, the government focused on both expansion and deficit reduction, and the financial system was stable.
Following 1996, there were five overlapping episodes in which various external forces were working.
- Internet bubble formation and implosion / recession
- Housing bubble with subprime financial blunder and long-term fallout
- Great Recession and Rebound-Recovery
- Behavior caused by the ongoing Great Recession of the Federal Reserve with unusually low interest rates combined with the creation of an unusually large money supply
- U.S. Government’s unusually large deficit spending program, including the 2018 tax cut bill
View of normality in 1996
Below are the yields, price fluctuations and growth rates for the year. Note the “real” positive interest rate everytime It occurs in a normal environment. They are based on the basic truth of investing in the regular capitalist market. Investors demand returns commensurate with risk. This means interest rates above or near inflation (short-term US Treasuries), with rising interest rates and potential returns on higher risks (eg, long-term and / or weaker credit). there is.
1996 Annual Average and Growth Rate View:
- Total: 3.4%
- Less food and energy: 2.6%
US Government Yields-
- 90-day financial bill: 5.0%
- One-year financial bill: 5.2%
- US Treasury for 5 years: 6.2%
- 10-year US Treasury: 6.4%
Corporate Bond Yield-
- Moody’s AAA: 7.4%
- Moody’s BAA: 8.1%
Bank prime rate: 8.3%
Mortgage Interest Rate-
- 15 years: 7.3%
- 30 years: 7.8%
Rising house prices-
- S & P / Case-Shiller US National Housing Index: 2.5%
- Median new home sales: 4.5%
economic growth rate-
- GDP (Nominal-that is, no inflation adjustment): 6.2%
- Corporate profit (after tax): 7.4%
- Personal income: 6.2%
- Private consumption expenditure: 5.7%
economic growth rate-
- Commercial and industrial loans (all commercial banks): 7.9%
- Consumer loans (all commercial banks): 6.3%
- Federal Debt: 5.3%
- Overall: 5.4%
- 25-54 years old: 4.3%
Stock Market Profit-
Now, think about normalizing today’s environment plus Inflation rate is rising
Today we take a major 10-year Treasury yield of 1.66%. How high does the yield need to be to reach the normal position? Compared to other rates in 1996, the spread was a total spread of + 1.6% (for riskless vs CPI) and + 1.4% (for 10 years vs riskless) = 3.0%.
Savers and conservative income investors have quietly accepted a 2% inflation loss (loss of purchasing power) over the past decade or more, even though the cumulative loss is currently around 20%. If you increase the annual loss rate to 2.5%, 3%, or more, the noise will start.
In addition, professional investors will begin demanding higher yields again with long-term bond issuance. In the past, long-term yields were more independent of what the Federal Reserve was doing at short-term interest rates.
Conclusion-Many people do not consider the times to be extraordinary, increasing the risk of rising inflation.
The picture above is not a low risk. This is a high probability “normal” response to leaving an abnormal environment. Therefore, the interest rate gap is of particular concern.
Rising inflation will create pressure on higher yields, whether or not Federal Reserve Chair Powell tries to raise interest rates to “neutral” levels again. As inflation expectations rise from 2% to 2.5%, 3%, and-unknown-the 1.66% 10-year UST yield will inevitably jump to catch up. Where until?It depends on how quickly health returns to risk pricing.