On Wednesday, the Federal Reserve announced the third interest rate hike since the onset of the global financial crisis.
The message is that the U.S. economy is healthy. Yes, GDP growth is less than ideal. (Real GDP expanded by 1.9% in 2016.) But job growth is strong. The unemployment rate is low, by historical standards. And now the Fed wants to normalize interest rates.
While this move is easy to understand, I think it’s going to spark a now unavoidable crash. I’ll explain.
How are low interest rates supposed to help the economy?
First, let’s briefly discuss why we use low interest rates in the first place. Here’s how the process is supposed to work:
- The Federal Reserve increases the money supply.
- A larger supply of dollars today means less demand to pull forward tomorrow’s dollars. In other words, an increasing money supply pushes down interest rates, which are a measure of today’s demand for tomorrow’s dollars.
- The cost of capital goes down. Businesses can borrow money more cheaply, making some projects profitable that were unprofitable before the drop in interest rates.
- The incentive for saving goes down. Lower interest rates mean smaller yields on savings. As a result, we have an incentive to consume more.
- More investment means more jobs, higher wages, more purchases of raw materials, et cetera. More consumption means more buyers of the goods and services provided by businesses. Economic activity on the whole increases.
That’s how you get to economic growth through monetary policy. Encourage businesses to invest, and potential customers to consume, in ways they otherwise wouldn’t.
What we’re really doing is helping borrowers at the expense of savers
If the government didn’t meddle with the money supply, collective behaviors around saving, consuming, and investing would dictate the demand for, and hence the price of, future dollars. The market would settle on a particular interest rate.
But by injecting more dollars into the economy, the government forces interest rates below the level the market would otherwise set. And as a result, savers collect a lower yield than they would otherwise collect.
Who’s the big winner? Borrowers. With artificially low interest rates, borrowing money is cheaper than it otherwise would be. And that’s the point. The whole idea is to encourage people and businesses to borrow more money, and in turn use that money to accelerate consumption and investment.
What’s the problem with prolonged low interest rates?
Here are three big problems we get when he hold interest rates low for extended periods of time:
- We rob from tomorrow to pay for today. The investments that would have become economical in the future are instead economical now. The consumption that would have occurred in the future, as a result of saving, occurs now, because of reduced borrowing costs. We pull activity forward from the future. While today is more pleasant, tomorrow is more painful.
- We create asset bubbles. Fixed income investments are less attractive with lower interest rates. In order for savers to find acceptable yields, they have to take on more risk. More dollars flow into stocks, for instance, which inflates stock prices. When interest rates inevitably rise, and borrowing costs rise with them, companies become less valuable. Stock prices fall. The bubble pops. Savers are punished all over again.
- We create inflation. The Fed keeps interest rates low by pumping money into the economy. The money supply grows more quickly than the volume of available goods and services, which sends prices upward. Rapid upward price movements punish employees that can’t frequently renegotiate their compensation. They also punish businesses that can’t frequently adjust their prices, say because they operate under long term contracts. Stable prices, on the other hand, don’t punish any particular group.
Why will we see a crash?
I believe we’re going to see a strong pullback in stock prices in the not too distant future. The Fed rate hikes will be the spark.
Why do I think there’s a stock bubble? Look at the chart below. It’s called the Schiller P/E ratio. We’re looking at the price to earnings ratio for the S&P 500. Specifically, we’re looking at price divided by average inflation-adjusted earnings over the previous 10 years. We use this measure to smooth out anomalous single year earnings.
You can see where we’re at. Only two times has this ratio been higher than it is today: right before the 1929 stock market crash, and right before the 2000 dot com crash. That’s not good company.
Why will interest rate hikes cause a crash? Because higher interest rates make fixed income securities relatively more attractive. Savings accounts will offer better rates. U.S. treasuries and corporate bonds will have better yields. Some fraction of savings dollars will move away from equity securities (e.g. stocks) and toward fixed income securities (e.g. bonds). And as the demand for stocks goes down, so do stock prices.
But it’s not just relatively weaker demand for stocks that will cause a problem. Rising interest rates reduce the present value of future cash flows. In other words, future dollars are worth less, relative to present dollars. As a result, corporate valuations will decline, because future corporate cash flows will be worth less. Declining corporate valuations manifest in lower stock prices.
Here’s one more headwind against stock prices. As interest rates go up, so do borrowing costs. The problem comes as large companies try to find enough cash to fuel their aggressive dividend and stock repurchase programs.
In many cases, large companies (like Chevron and Boeing, for instance) either take on more debt to fund their cash transfers to shareholders, or they cannibalize their cash balance to make these payments. In either case, you have to eventually borrow more money or scale back your dividend and buyback program.
When borrowing costs increase enough, some companies will have no other option but to slow down their cash transfers to shareholders. They simply won’t generate enough excess cash, without super cheap access to credit, to sustain these payments. And as these programs slow down, or go away, stock prices will decline.
Why is a stock market crash bad?
This one is kind of obvious, but let’s cover it quickly.
First, savers get demolished. Pension funds, for instance, are huge investors in the stock market. If the stock market moves backward, retirees won’t have the nest eggs they thought they had. Young adults won’t have the college funds they thought they had. And so on.
Second, employees get demolished. Do senior executives lose their jobs when the market crashes? Nope. Cuts are made along the front lines of the business. Stock price is the key metric driving corporate decision-making. How do you get the stock price up? Grow revenue, cut costs, or both. In a downturn, it’s easiest to cut costs. And employees are the biggest cost. Employees take it on the chin.
The effects radiate outward from there. But a stock market crash is an ungly event. And unfortunately, I fully expect one to materialize sooner rather than later.
What can we do?
At this point, not a whole lot. We laid the groundwork for this with nearly a decade at very low interest rates. The lesson is, after we take our next round of medicine via a crash, to not put ourselves in this position again.
Don’t distort the market so strongly for so long. Don’t distort the market at all, if you can avoid it. If you’re not going to let the market find its own interest rate, try to find one that best balances the considerations of both borrowers and savers.
It should be a wild ride from here. But we’ll survive. And hopefully we learn some important lessons along the way.