We’ve officially entered a very different financial climate, where prudent investors may want to reassess where they put their money. The Fed’s principal policy lever is interest rates; when they go up, the value of future cash flows goes down—hurting assets from stocks and bonds to housing and many currencies. So when Fed Chair Jerome Powell tells you he wants to reduce inflation by raising rates (aka tightening), he’s telling you the central bank needs investors to lose money. The goal is for those losses to seep into the rest of the economy when capital investment and consumption decline, slowing growth, demand, and—ultimately—inflation.
To understand how we got here, you have to go back to the 2008 financial crisis, when the Fed was doing exactly the opposite. The central bank felt forced to take rates to zero to alleviate the distress indebted households and companies were feeling. Lower rates meant smaller interest payments for debtors seeking to repair their balance sheets. In 2008, household debt topped 97% of gross domestic product; today, it’s about 75%, the lowest in 20 years.
For savers, though, high-interest accounts that once yielded 5% interest suddenly paid 1%. The annual return on $50,000 in savings fell to $500 from $2,500, forcing people who relied on interest as a principal source of income to rethink their strategy. That usually meant turning to riskier assets, so money poured into stocks, pushing the S&P 500 index up sevenfold from its post-crisis nadir to its peak in January.
With the Fed funds rate near zero, ordinary savings accounts paid minimal interest, spurring some to quip that “cash is trash.” This mantra seeded the psychology that fueled crypto assets and meme stocks, even as it created a windfall for the economy, allowing companies from Amazon.com to General Motors to Marriott to boost capital investment. Sure, some of that was foolhardy. Australia’s BHP Billiton, for example, poured $20 billion into US shale oil projects early in the 2010s. That paid off when crude rose to more than $100 a barrel, but it looked less wise when oil fell below $30. By 2017, BHP was taking billions in writedowns on those investments as shale oil flooded the market.
By that time, the US economy was back on track. With unemployment sinking to 4.3%, cheap money had served its purpose, and the Fed slowly began raising rates. It soon found the economy was still too weak to handle them, so it reversed course in 2019. Then it had to try other stimulative measures in 2020 to reduce damage done by the coronavirus pandemic.
Now the economy can handle higher interest rates—and with inflation above 8% for the first time in four decades, the Fed desperately wants to apply them. In fact, it’s rushing to make up for lost time. As a result, investors are quickly discovering that cash is no longer trash—it’s an important asset class that provides a haven. Imagine if, next summer, your bank were to offer 5% interest on a three-year certificate of deposit. Would you take the sure thing?
Many Americans will, showing just how quickly the psychology of investing has changed. If the slowing economy lowers inflation to more acceptable levels, a host of investment opportunities will look better. Treasury yields and investment-grade bond yields are rising now. At some point soon, interest rates will top out, and the returns from those less risky options will look enticing.
This change in psychology won’t be limited to safe assets. Wall Street is in the midst of a bear market: The S&P 500 this year is down more than 20%, and the Nasdaq 100’s decline has topped 30%. Those returns won’t get much better with interest rates rising, the economy slowing, and corporate earnings taking a hit. So investors have already begun to withdraw money from stocks, with equity mutual funds registering 32 straight weeks of outflows, according to the Investment Company Institute.
They won’t come out and say it, but when members of the Fed’s Board of Governors see this reaction, they’re probably pleased. Capitulation makes their job easier. The quicker asset prices react to the tightening of conditions, the faster inflation will fall. But after the slowdown induced by higher interest rates, the selloff will end and inflation will decline. We’ll be in a new investing regime for the first time in more than a decade. Now is the time to prepare.
-- ByEdward Harrison, September 28, 2022
