This Is the End


Markets, Risk and Human Interaction

October 25, 2007

What if there comes a time when the Fed has to tighten?

It might seem now that it was in a different world, but it was in this one, and in fact it was in the United States. Traders watched their bank of broker screens as the 30-year Treasury dropped below 8% for the first time in their youthful memory. That was in the 1980s. I was working at Morgan Stanley at the time, and someone on the Treasury desk made a trade for his own account just so he could frame the ticket from that momentous event. Yes, interest rates can go above 8%. In fact, at the time an 8% rate seemed quite reasonable.

I mention this because over the past decade or so we have constructed a financial landscape where an 8% interest rate not only is hard for us to envision, but where it would be disastrous. The reason is the huge stock of adjustable rate mortgages. Looking at the dislocations that are coming about from the subprime problems and the related credit crunch, it is hard to fathom the effect on the housing market and the overall economy if all those remaining homeowners with various flavors of adjustable rate mortgages saw rates shoot up hundreds of basis points. I don’t know how to quantify the effect, but I would hope that there are researchers at the Fed who do. And I would bet that the implications are pretty scary. Maybe so scary that the Fed would not be able to push interest rates up very far for fear of triggering a populist revolt.

Of course, now all of the discussion is about possible Fed easing. So I am worrying about something that is not even on the radar screen. But can anyone envision a scenario where a substantial increase in interest rates would make sense from an economic standpoint, but where the Fed finds its hands tied because the costs to homeowners would be too great?


  1. So the Fed is unable to fight inflation? Shouldn't this reality be enough to tank bonds?

  2. I'd worry about attempting to envision the scenario, to be perfectly honest; the human mind is extremely good at deceiving us in this regard. An 8%+ interest rate has happened before, and it is clearly theoretically possible without having to stretch the mind too much. Do we need to know more than that? Envisioning any particular scenario ahead of others can be a problem.

    With a scenario in mind, we begin watching for the signs that point to that scenario, even unconsciously, and perhaps miss signs leading to another scenario with a similar endgame, yet which traveled a different path to the end result. Is it possible the best belief for someone truly trying to manage risk could be to acknowledge the possibility, but have no concrete idea about what could bring us there?

  3. The healthful thing ruight now would be for the fed to raise rates and stop out the sollar and geopolitical "shorts". it would be a one way ticket to correcting fiscal imbalances and capital market imbalances. The Us bond market is perhaps one of the greatest bubbles going. For the most part the people who should own would continue to be able to own albiet less one SUV - although their operating cost in the form of oil would come down! it would rapidly be a crash course in forced saving sof rthe overstreched us consume if not a full fledged woodshed. As for geopolitics, it would defacto force the rethinking of the trade balances and grant the US a platform for renegotiating the insidious globalization tradeoffs it has lived with.

    Those things that have the greatest impact - the fat tales - are those events that are NOT anticipated.

    The United States woyuld be better suited to see the fed raise rates and burn these shorts than continuing top cut reates and burn the very people advocating the appropriate course of action - despite one's aversion to rewarding speculators. Sometimes speculation is good!

  4. I remember those days well.

    I was just looking at some valuation reports that I had prepared in the early 1990s in which I had used costs of equity ranging from 18% to 23%.

    When Paul Volcker raised rates in the beginning of his term, to end the stagflation that we had endured through most of the 1970s, he received house keys in the mail from people who felt they had lost their houses due to his actions.

    Back before the last Fed cut, I had commented on my blog about the impact on mortgages (although I was looking at the impact of a rate reduction). Corelogic put out a report (that I referred to) that looked at some of these issues.

    Given that the market is currently pricing in 2.3% inflation (and requiring a real return of just over 2.0%), I don't expect that any rate increases are imminent.

    Given the effect that lower interest rates are having (and may have in the future) on the Dollar, we might start to see more inflation percolate through the system. Under those circumstances it's highly likely that the Fed would begin raising rates again.

    An 8% Treasury yield would imply real required returns of 3% and expected inflation of 5%.

    These assumptions, unfortunately, may be feasible at some point within the next three to five years as the markets adjust to the aging of the baby boom (both here and overseas) and as other tectonic economic shifts occur in the world economy (for example, China and India starting to make a greater impact on the world economy, potential energy inflation, etc.).

    We can't forget that sub 5% Treasury yields have been the aberration, not the rule, for most of the past thirty-five years.

    Definitely something that bears watching.

    Larry Loeb


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