September 25th, 2020

Interest Rates Have Consequences

"If interest rates are prices...and prices have consequences...then interest rates have consequences."

The quote referenced above is from Jim Grant, the world’s foremost author about interest rates. He writes the longstanding “Grant’s Interest Rate Observer”. It’s one of the hedge fund world’s most renowned publications, delivered to subscribers every two weeks. With his quote, he brings up a very poignant thought. Here we aim to address interest rates and the consequences that they have.

If interest rates are prices (which they are) and prices have consequences (which they do) then interest rates have consequences (which they most definitely do). If a person thinks interest rates are just something related to a car, mortgage, or credit card, then they’re incredibly naïve. Interest rates are one of, if not the most, important and impactful issues of the last 40 years (especially prevalent in the last 5 years). Right now, we’re living with the consequences of the lowest ongoing period of interest rates in almost 5,000 years of human history. This has not only impacted our lives financially, but also our day-to-day activities.

So, what exactly are interest rates and what do they have to do with you? Well…everything actually. Interest rates determine the price of money. When you’re looking to borrow money and you go to a bank, they’ll pull your ‘FICO score’. This measurement is supposedly a measure of your ‘loan risk’, i.e. the risk that you, as the borrower, poses to the bank based on your historical track record of repayment. When it comes to lending money, the logic goes that the greater the risk the borrower poses to not repay the money loaned, the higher the interest rate the bank will propose. This is done to ensure the bank is being adequately compensated for the risk they’re taking in loaning any amount of money to the person with the higher default risk. Therefore, the interest rate is the price of the money loaned and it should be directly correlated to the credit risk of the borrower.

This is a natural exchange that’s worked for eons of human history – which has proven to be a cornerstone of stable and prosperous economic ecosystems. Letting interest rates fluctuate to match borrowing risk inherently curbs irresponsibility in borrowing. What a novel thought? If you manage your loan portfolio over the course of your life, remain diligent, act as a steward to your covenants, and always repay to the terms of your credit, then you should be rewarded with cheaper rates of interest. This is how it is ‘supposed to work’ and has theoretically worked for thousands of years. Well…that’s until the last 12 years as our world’s Central Banks have removed the naturally fluctuating interest rates and replaced them with zero consequence interest rates (interest rates at the very low end of the scale towards zero).

What happens when we remove the consequence part of the above exchange equation? What if, no matter what your credit risk, you automatically got a low interest rate? What if no matter how many times you borrow and then default, you’re not required to pay back the principle or the interest? You think that it might have a behavioral impact, right?! It most defintely will. Let’s discuss further.

If you remove the consequence of default or the incentive of cheaper rates for better credit behavior, then what do you think will happen? If you guessed that the behavior of borrowers will dramatically change, then you’re correct. Not only does the monetary arrangement change (the borrowing and lending of the money) but also the behavior, character, and intent of the borrower. This is because there’s no incentive for the borrower to participate in behavior that exhibits sound credit stewardship, practice good risk management, save funds for a rainy day, or be proactive in trying to create circumstances that have positive outcomes.

Instead, the opposite behavior is exhibited when there’s no default risk and cheap/free money. Excessive greed, wastefulness, sloth (anti-stewardship), zero value for savings (there’s no need when money is free, cheap, and always charged off), moral hazard, destructive and poorly measured risk taking, and a misallocation of capital to untenable places are the norm when the risk from the borrower is removed.  

We’ve been living in a state of the latter (removing risk from borrowers by constantly decreasing nominal interest rates and in turn propagating the worst types of behaviors) for the last 40 years. Interest rates are now currently sitting at zero. More than likely, they’ll soon go lower (to negative) in order to accommodate the overhanging burden of debt that now faces our global economic ecosystem. When we multiply the personal scenario mentioned in this example to account for every country in the world and all of the businesses and citizens participating in those economies, the negative behavior impacts are exponential.

You’ve probably heard a few of these in the news lately:

  • The ‘share buyback’ bubble in stocks the last 10 years
  • WeWork and/other SoftBank entities that never made/make money but are on magazine covers
  • Lifetime epic price bubbles in global stocks
  • Lifetime epic price bubbles in high yield bonds
  • Lifetime epic price bubbles in investment grade corporate credit
  • Lifetime epic price bubbles in commercial real estate
  • Lifetime epic price bubbles in residential real estate
  • Lifetime epic price bubbles in consumer vehicles
  • The largest amounts of credit card debt in US history
  • The largest amounts of student loan debt in US history
  • The largest amounts of subprime vehicle loans in US history

None of the items listed above come into existence unless there are inverted interest rates. AND NONE OF THE CONSEQUENCES OF THESE EXIST WITHOUT THEM EITHER. When you break the relationship of the interest rates (the price of money loaned) from the credit risk of the borrower, and then create an infinite money supply to loan out, you can/do change people’s behaviors. You push forward consumption and create entitlement at the very minimum. You encourage negative behaviors like wastefulness, greed, destructive risk taking, and moral hazard at the worst. You break the laws of economics, and ultimately, the laws of physics.

  • When you do this at one local bank – it influences negative behaviors at a community level.
  • When you do this at a regional bank – it influences negative behaviors at a geographic level.
  • When you do this at the entire federal level – it influences negative behaviors at a country level.
  • When you do this at the global level – it influences negative behaviors of everyone in the world.

We've now done this on every level, from local to global. The consequences have begun to manifest themselves in the last two years. The rise of populism, the well-publicized disparity of the ‘haves’ and ‘have nots’, generations of young people coming into this world with a more limited financial future than their parents, the polarization in the belief systems of U.S. citizens, the hollowing out of the U.S. middle class, millennials being forced to live with their parents…at some point down the line these are all byproducts of the inverted interest rate-induced financial decisions that’ve allowed all of the future wealth and production around the world to be pulled forward and delivered to a small subset of the population in the banking system.

This blog is written in June of 2020 – after the COVID-19 epidemic has truly expedited the consequences of all of these negative interest rate policies and brought them to the forefront of conversations in everyday lives of global citizens. As you can see below, many of the aforementioned items have already blown up:

  • There is now discussion of share buybacks being ‘outlawed’ by the government.
  • WeWork blew up and is in receivership/reconstruction.
  • Global stocks have blown up.
  • High yield credit blew up and had to be bailed out
  • Investment-grade corporate debt blew up and had to be bailed out.
  • Commercial real estate is still in the process of blowing up and is having to be bailed out.
  • Residential real estate is seeing the first price decreases YoY since 2008.
  • Credit card delinquencies are through the roof.
  • Consumer vehicle delinquencies are through the roof.
  • Student loans have had to be forgiven.
  • Subprime vehicles are being repossessed at the fastest rate in history.

Interest rates seem meaningless. Interest rates are not meaningless. They mean everything, and the consequences that are brought forward as a result of removing the natural order of the risk pricing are very serious. Once risk is mispriced, reality becomes mispriced. Once reality becomes mispriced, our expectations become unrealistic. Once our expectations become unrealistic, volatility comes knocking. What’s volatility? Volatility is a mechanism of truth. It’s the reconnection mechanism bringing expectations back in line with reality. When there’s a great chasm between the expectations of reality (which is exacerbated by mispriced risk and unlimited monetary supply), then there’s a greater velocity of reconnection to reality – one which is typically violent in many ways.

Although unintended, we’ve now ushered in what’ll be an age of heightened realized volatility, and we did this by artificially suppressing interest rates and mispricing and falsifying reality. We’ve mispriced risk in life and in money. And we’re now having to account for it all at once.

In closing, we took the liberty to rephrase Jim Grant’s phrase (we hope he doesn’t mind):

Interest rates are prices. They price risk and reality. Prices have consequences. Therefore, interest rates have risk, price, and reality consequences.

vig.io Interest Rates
TagsMacroDebtTechnical Money Management Interest RatesGeneral Investment Consequencesrates
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