Between February 2022 and August 2023, in order to combat hot inflation, the Federal Reserve rocketed its discount rate from near 0% to 5.25% -- the most aggressive interest rate schedule in living memory.
Since then, the Fed has kept the rate at 5.25% -- the 'higher for longer' era
But despite this, even when paired with Quantitative Tightening, economic growth has remained robust, inflation is sticky, unemployment remains under 4%, and the stock market is at all time highs.
In short, the Fed's aggressively restrictive policies haven't cooled things down much.
They've been so ineffective that even the Wall Street Journal is asking: Do interest rates really matter anymore?
To find out, we have the great fortune of speaking today with perhaps the world's foremost living expert on interest rates, James Grant, founder and editor of the highly-respected market journal Grant's Interest Rate Observer.
Jim expects interest rates are going to remain “higher for much, much, much longer” from here. And that the cumulative Lag Effects from that are going to be quite painful.
Here are my top takeaways from this interview:
Jim predicts that interest rates will remain high for much longer than expected, drawing from historical trends of multi-decade cycles. For example, the period from 1946 to 1981 saw persistently rising interest rates, while the following 40 years experienced declining rates. He believes the current era marks the start of another multi-decadal cycle of rising rates.
High interest rates make banks more vulnerable due to their impaired assets, such as bonds and leases from a low-interest era. Many banks have hundreds of $billions in unrecognized interest rate losses. If commercial real estate continues to deteriorate, it could render many banks insolvent, as noted by experts like Paul Kupiec and Thomas Hoenig.
The banking system's risk is heightened by potential downturns in commercial real estate, particularly in office buildings. Hundreds of banks have a high ratio of commercial real estate exposure to Tier One capital, making them susceptible to downturns in this sector. Grant highlights that the banking system lacks a sufficient margin of safety to absorb significant losses in commercial real estate.
Persistent inflation, which Jim expects, will exacerbate
the US debt problem. And should a recession arrive, there’s a chance we may not see a rush into Treasury bonds for safe haven. There’s historical precedent for this: such as the 1931-32 period when Treasurys experienced price drops due to concerns about the dollar and U.S. creditworthiness.
Jim notes that the Fed's is hypothetically insolvent due to it rising liabilities and low asset returns (paying out more interest on reserves than it receives from the bonds on its balance sheet). This reflects broader systemic risks within the banking sector.
Despite the resilience of the American economy, with robust growth and low unemployment, the long-term impact of high interest rates will eventually strain corporations and households. High interest rates are likely to compress margins, reduce consumer spending, and lead to job layoffs, increasing the likelihood of a recession.
Jim advises maintaining liquidity, valuing out-of-favor equities with strong prospects (i.e. an active investing approach), and focusing on value stocks. He also recommends gold and cash as safe havens. The current 5% yield on T-bills/money markets is attractive for investors waiting out market turbulence until clearer values emerge.
Jim emphasizes the importance of not being overly certain in investing. He advises investigating all sides of a story and acknowledging the probabilistic nature of the world. This approach is echoed by successful investors like Paul Singer, who have built substantial wealth by maintaining conviction while being aware of the possibility of being wrong.
For the full interview with James Grant, watch the video below:
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