In my last post, I explained why a flattening yield curve in December 2018 is causing quite a stir in the investing world. If you haven’t seen it, recommend you to do so before continuing.
During the major crashes of the 2 decades, the yield curve has given a sort of an idea at what it takes to stop the markets from going on a free-fall — and it seems to be dependent on the baseline interest rates just before the curve inverts itself — signalling a loss of faith in short-term repayment capabilities.
Taking the yield curve inversions discussed in the last post, let’s take a look at the first inversion of August 2000 just before the crash that took the S&P 500 index from the 1500s to the 700s. What happened?
The dot.com bubble
In the years leading up to 2000, investors were on a leveraged buying spree of any company stock with a “.com” in their names. Driven by the media frenzy of dot-com CEOs with their shiny new Ferraris and Lambos founded from the Internet, the Fear Of Missing Out (FOMO) drove dot-com share prices through the roof.
It was a matter of time before these “investors” realized they had been buying up companies doing nothing of value other than using raised funds for parties and worthless self-promotion advertising such as those below:
When the bubble burst, exuberant masses turned fearful of debt and the crushing interests that came with it. Borrowing ground to a halt as everyone rushed to get whatever they have left out of the markets. Short-term interest rates fell together with the S&P 500 in an attempt to encourage borrowing to support the falling prices. It wasn’t until the S&P 500 bottomed out at 776.76 points, a crash of around 53% from its peak, before things stabilized.
Unknown or more likely ignored by the exuberant masses during the inflation of the bubble, the free market was actually reacting to the increased borrowing from greed-driven start-ups and investors, by steadily raising interest rates in the years leading up to 2000 — right up to the vote-of-no-confidence inversion of the yield curve.
What about 2007?
The sub-prime mortgage crisis
What happened in 2007 was by far, much worse than 2000 by many orders of magnitude. 2000 was the result of market speculators flying high on leveraged greed, but at least those nutcases still had some clue of the risks they were taking to chase their delusions.
The sub-prime mortgage crisis was driven by Wall Street greed. The victims were mostly financially-uneducated home owners who were lured by into taking on huge mortgage debts, sometimes more than they could ever afford to repay, on the promise that their homes as assets, would appreciate far more than the principal loans with interest.
In a way, the folks most directly involved in this bubble had no clue what they were being led into — while Wall Street profited from them along the way… and eventually made away with trillions of dollars from Federal Reserve bailouts, and a resulting flood of currency in our economy.
The following 11-minute video provides a simple but apt explanation of the events that unfolded.
Similar to the crash of 2000, short-term interest rates were tracking the increase of currency supply to the point of the yield curve inversion.
Rate went up for 5 years from 1.57% to its peak of 5.14%. The crash brought the rate down similarly to that of the bubble burst of 2000, however, this time it was different.
The big financial institutions owed trillions of dollars worth of debt that were at risk of default. Banks were so adverse towards issuing new debt that they simply refused to lend even at 1%. The toxic CDOs were sold to so many investors around the world, that if they were to go bankrupt, the world economy would collapse.
Therefore, the Federal Reserve, deeming that these institutions were “too big to fail”, unleashed the largest amount of credit ever created in the history of Man to bail these companies out to “save” the economy. Benchmark rates dipped further to 0.25% at the bottom of the S&P 500 in 2007, a decline of 4.89% from its peak. These low interest rates persisted for the next 7 years, artificially pegged by the Federal Reserve below 0.25%, at times even at 0.01%.
How does the Fed peg rates? If the government issues bonds at 0.01% interest, would you buy them? Well the Federal Reserve would, and that’s what they did. They bought up all those low interest government bonds that the free market wouldn’t, because they can write checks drawing from an account that has nothing in it.
Despite bringing the world economy to its knees and nearly to an end, Wall Street paid out big fat bonuses to their high-level executives a year after being bailed out.
The plan worked. The markets did not fall below the troughs touched in 2000… but at what cost?
What does history tell us?
To those that believe that the stock market is ever only going to go up because companies are more innovative and productive in the last decade, then let this be a wake up call — yes, they are, but the most prevalent reason why stocks are going up is due to the flood of easy credit in the system that has artificially suppressed interest rates since the crash of 2007. More debt spending means bigger revenues and higher valuations.
But how long can this last?
History has shown that cheap borrowing is the strongest driving force of share prices in the last 2 decades. What usually follows is fear during the downturn, which then requires a whole lot of incentives before the debt-driven economy will start borrowing again.
It looks like central banks are running out of incentives for the next crash.
During the bursting of the Dot-com bubble, short-term interest rates had fallen to 1.57%, from a high of 6.31%. The S&P fell by more than 740 points and a 4.74% reduction of baseline rates was needed before currency started flowing back into the markets and stopped further declines. Lenders had to settle with a short-term rate of 1.57%.
During the sub-prime crisis, baseline interest rates fell by 4.89% to nearly zero, but it wasn’t enough. The Fed had to fill up the gaping hole left by the reckless financial institutions with trillions of dollars before the support for the market could be found at 696.33 points. The net effect was trillions of dollars added to the economy. Rates had to be lowered to nearly zero during those years when those currencies were conjured out of thin air to prevent the new debt interests from further crushing the economy.
After pegging baseline interest rates at nearly 0 from 2009 to 2015, the Fed decided to start raising rates again. Why? Because they have a lot of catching up to do, even if it puts the entire economy which is already addicted to easy credit at risk.
During both crashes of 2000 and 2007, benchmark rates had to be lowered by at least 4.74% to prevent the markets from diving beyond 53%. But in 2007, because the financial institutions were not allowed to fail for fear of plunging the world into another depression, the Fed had to unleash the helicopter drop of credit.
Today in the era of cheap credit, the markets have already risen beyond the highest levels since the crisis. Now they are nearly 2 times higher than the peaks of 2007.
Since the Fed started raising benchmark rates in 2015, today, the rates are only at 2.45%… yet the yield curve is already flattening.
The Fed will need to raise baseline rates by another 2.3%, if history is to offer us a lesson, to prevent the markets from losing more than 53% of its value during the next crash. However, to raise rates any further is to cause the curve to invert, and we’ve seen what happens when it does.
The Fed has no more room to go.
If baseline rates do not get above 4% before the next crash, does that mean we could fall back to bottoms last seen in early 2009? If we are to go back to those levels, that’s more than a 1,800-point drop — or 2.5 times worse than any of the market crashes seen in the last 2 decades.
The crash of 2000 and 2007 saw the S&P 500 losing 700-800 points when short-term interest rates was above 4% prior to the crash. With so much fiat currency in the system, how do we maintain the faith of the masses in the next crash?
Will another helicopter drop of free credit do the trick?
In an economy running on currency backed by nothing, interest rates put some form of restraint on a system that is heavily dependent on faith. Faith of the majority using the currency. It also acts as a gauge on the expected returns for those who take on risks. When there is too much of the “good stuff” causing whatever that has been earned to lose its value, producers exchanging real resources, time and energy for a seemingly unlimited supply of currency will begin questioning the point of such an exchange. Think about it. Will you be willing to exchange your limited time on Earth, just to exchange for something that only a select few can create, and in such large quantities without effort — while others can borrow it for near zero cost — all of which can be exchanged for real production outputs, your toil and effort
In other words, it seems that faith might be running out soon.
If you think that this only applies to the United States, then you will need to be informed that the global economy is now more connected as one due to international trade. Have a look at the chart of the Singapore M2 “money” supply1M2 supply consists of the most liquid form of currency such as cash, checking accounts and deposits (M1) and any near “money”, or monetary equivalents that can be quickly converted to currency. This is the measurement of the most liquid currency supply in circulation. Reference: https://www.investopedia.com/terms/m/m2.asp and historical average overnight interest rates of Singapore… and you’ll see the shockingly similar circumstance we’re in.
And here’s our flattening yield curve.
Our interconnected global debt crisis is reaching boiling point and evidence of it is in news we hear everyday. Greece, Spain and Brexit are all over the media, but do you know they are all problems related to runaway debt?
How will we survive another crisis?
If we can’t, is there something that we can do to protect ourselves?
Footnotes [ + ]
|1.||↑||M2 supply consists of the most liquid form of currency such as cash, checking accounts and deposits (M1) and any near “money”, or monetary equivalents that can be quickly converted to currency. This is the measurement of the most liquid currency supply in circulation. Reference: https://www.investopedia.com/terms/m/m2.asp|