Ghost Walking
We are not makers of history. We are made by history ― Martin Luther King Jr.
In October 1979, Paul Volcker, the Chairman of the US Federal Reserve, implemented a significant change in US monetary policy. At that time, the US was grappling with stubbornly high inflation rates that had soared into double digits. Volcker introduced a strategy of tightening the money supply by raising interest rates to unprecedented levels. This move marked a departure from previous Fed policies that had focused more on managing short-term economic fluctuations.
The primary objective was to curb inflationary expectations and restore confidence in the US dollar. Volcker believed that aggressive measures were necessary to break the inflationary spiral and stabilize the economy in the long term. Under his leadership, the Federal Reserve raised the federal funds rate to over 20% by June 1981, effectively making borrowing more expensive and slowing down economic activity.
The impact of the Volcker Shock was profound and far-reaching. In the short term, the sharp increase in interest rates led to a severe recession in the early 1980s. Many businesses faced higher borrowing costs, which constrained investment and expansion. The housing market suffered, and the following recession was one of the most severe in post-war US history.
However, the Volcker ultimately succeeded in its primary goal of reducing inflation. By the mid-1980s, inflation rates had fallen significantly from their peak levels. His tough stance on inflation laid the groundwork for a more stable economic environment in subsequent years. His policies earned him both praise and criticism, with some commending his resolve to tackle inflation head-on and others pointing to the high human cost of the recession.
Beyond the United States, the “Volcker Shock” had global ramifications. The high-interest-rate policy contributed to a strong appreciation of the US dollar, which posed challenges for other countries, particularly those with dollar-denominated debt. Developing nations faced difficulties servicing their debts, leading to debt crises in parts of Latin America and elsewhere.
Volcker's tenure as Fed Chairman marked a significant shift in central banking practices. His emphasis on controlling inflation through monetary policy set a precedent for subsequent Federal Reserve chairs. The Volcker Shock underscored the importance of credible and decisive central bank actions in maintaining price stability and anchoring inflation expectations.
In retrospect, the Volcker Shock is viewed as a pivotal moment in modern economic history. It demonstrated policymakers' willingness to prioritize long-term economic stability over short-term considerations. Volcker's legacy extends beyond inflation control; he played a crucial role in shaping the central banking framework that remains influential today. The Volcker Shock serves as a reminder of the challenges and trade-offs inherent in managing monetary policy to achieve macroeconomic objectives.
Today, there is extensive discussion regarding whether the Federal Reserve has achieved the same goals as Volcker. Although the rate-hiking cycle commenced in 2022, initial stock market declines were followed by a strong recovery, reaching another all-time high. Unemployment remains remarkably low, underscoring labor market tightness and GDP growth remains robust.
Despite interest rates rising from zero to five percent due to rate hikes, corporate credit spreads have not widened; they remain at record lows, indicating a lack of financial stress. These factors have contributed to loose financial conditions, as evidenced by various financial conditions indices.
Throughout this year, however, the labor market has displayed slight signs of weakness, prompting widespread debate on whether this trend will persist. Jerome Powell's recent statements on the labor market have fueled hopes for additional rate cuts. Consequently, market participants now anticipate one more rate cut beyond the one previously expected.
Will the Fed indeed cut rates twice? Given that financial conditions are as loose as when the Federal Reserve began raising rates, several commentators doubt this possibility. Although Powell ruled out another rate hike this year, some argue that was a mistake, predicting that consumer price inflation will either stabilize or rise.
Another claim is that long-term interest rates are not sufficiently high to curb economic activity. They anticipate continued bear steepening of the yield curve, pushing long-term rates higher until they begin to affect the economy. However, opinions diverge on the stock market.
While some believe the equity markets have not experienced their "Minsky moment" yet, suggesting we are on the cusp of a speculative mania that will propel stock prices higher, others hold a bearish outlook. They believe further market-driven rate increases on the long end, resulting in lower bond prices, will drag down the stock market.
To assess which scenario is more likely, examining historical market turning points is prudent. Regarding bonds or stocks, I feel that both camps may be only partially correct, but I will revisit this point later.
The last soft landing the Federal Reserve achieved was in the mid-1990s, under the leadership of Alan Greenspan, known as "the Maestro." However, the economic landscape then differed vastly from today, as the Fed focused on preventing inflation from rising rather than bringing it down.
The 1990s began with a brief recession attributed to a few factors: a spike in oil prices after Iraq’s invasion of Kuwait, the Fed’s attempts to lower inflation, and accumulated debt from the 1980s. But by 1994, the economy was expanding and the labor market was stronger. Economic forecasters worried, though, that inflation would soon rise.
In 1994, the Federal Reserve began raising interest rates in response to potential consumer price inflation concerns. As a result, yields rose, but the stock market maintained levels similar to those before the initial rate hike.
By 1995, the Federal Reserve initiated a series of rate cuts after raising rates from 3% to 6%. Consequently, long-term yields declined slightly, dropping from 8% to 6%. This downward trend had already begun in anticipation of rate cuts, and by the latter half of 1995, the 10-year yield reached its lowest point shortly before the Fed's final rate cut.
After that, the Fed kept interest rates steady for about a year before raising them again one and a half years later. While interest rates slightly increased again after the last cut in 1996, it's worth noting that consumer price inflation remained steady before it started to fall, dropping below 2% in late 1997.
During that period, the 10-year yield traded between 6% and 7%, trending downward from 1994 onwards. Unemployment steadily declined during this period, though it was higher than today. Whether AI will lead to a similar economic boom as the internet did in the second half of the 1990s remains to be seen, but there could be similarities. However, it seems somewhat presumptive to assume that the future will mirror the perceived patterns of that era.
What's intriguing here is that despite the Federal Reserve maintaining higher interest rates for longer, long-term rates did not increase further or drag the stock market lower. Stocks continued to rise, yields slightly decreased alongside CPI and unemployment, while the economy continued to expand.
Nevertheless, while a no-landing or soft-landing is the widely expected consensus, rising long-term interest rates could result in a hard landing of the economy accompanied by falling stock prices. To assess this, let's examine two other decades to observe what occurred then.
Following the dot-com bubble burst in the early 2000s, the Greenspan-led Fed slashed interest rates from 6% to 2%, driving yields lower. However, as the economic situation worsened, the stock market followed suit and reached its cycle low in 2002 before beginning an ascent.
Consumer prices also began to decline as the US economy entered recession, subsequently picking up as a consequence of easy monetary policy and the ensuing economic expansion. The surge in stocks persisted until 2007, when the S&P 500 finally surpassed its all-time high from the early 2000s.
Upon the housing bubble bursting, the Fed responded by lowering interest rates, which initially propelled stocks to another all-time high before they began to retreat as economic troubles intensified. After the Federal Reserve made significant interest rate cuts throughout the year, stocks resumed declining and fell substantially.
Following Ben Bernanke and his colleagues at the Fed lowering interest rates to zero, stocks continued to decline until they began a notable recovery in 2009. Loose monetary policy paved the way for the longest equity bull market in modern history, which ultimately concluded when the pandemic struck, prompting governments to shut down large portions of the economy.
It is noteworthy that in both cycles, bonds began to rise well before the stock market collapsed. During the dot-com bust, they rose while consumer prices remained around three percent. In 2008, consumer prices fell first, while bond yields remained higher for longer and began to decline when inflation rose again.
It appears that the Federal Reserve's decision to lower interest rates in late 2007 had a more significant impact on bonds than the increase in inflation during that period. This increase in inflation coincided with a decline in total output that outpaced the drop in demand. Eventually, as demand collapsed, inflation followed suit.
Interestingly, unemployment started to increase around the time stocks hit their highs. That could support the thesis that stocks might be nearing a turning point. However, during the GFC, the gradual rise in the unemployment rate began before stocks reached their all-time high. Hence, it’s possible that we haven’t yet seen the peak in stock prices until there is a noticeable uptick in the unemployment rate, which could take several more quarters.
Throughout the 2000s, bonds were in an upward trend, indicating that interest rates did not climb to a level that significantly affected the stock market in both events. Similarly, during the soft landing in 1994, interest rates began to fall before equities, although it took some time for equities to recover afterward.
It's important to note that in modern history, there has never been a scenario where a decline in bond prices resulted in a drop in equities. In all discussed events, bonds began to rise before equities started to fall. However, there was a decade when a falling bond market appeared to be one of the driving forces behind stock market declines.
That decade is the inflationary period of the 1970s, characterized by three strong inflation waves in the US before Volcker finally broke the cycle by significantly raising interest rates in October 1979.
The first inflation wave of the 1970s occurred at the beginning of the decade when equities started to decline alongside bond prices. The difference from today is that soon after the Fed began reducing interest rates, equities rose, followed by bonds, as consumer price inflation decreased.
During the second inflation wave, which began in 1973, bonds fell while equities rose, similar to what we're witnessing today. However, consumer prices also increased substantially during that period until they reached a level where equities began to decline and were dragged down by falling bond prices.
After equities hit their low in 1974, the second wave ended, and inflation declined again. Although stocks recovered, bond prices rose only slightly. Unlike today, Arthur Burns was proactive, raising interest rates in response to inflation and lowering them as consumer prices fell.
During the first two inflation waves of the 1970s, stock market declines resulted from short-term interest rate policy rather than long-duration bond yields. Only during the Volcker shock did bond prices fall significantly enough to put substantial pressure on the stock market, with bond yields rising by 200 basis points between 1980 and 1981 while the stock market dropped by 24%.
Yet, during the first two inflation waves in the '70s, bonds began to rise after inflation dropped slightly below a certain level. Only during the last wave and the Volcker shock when CPI dropped further did bonds fall alongside equities.
Therefore, if one believes that yields will continue to climb and eventually pull down stocks today, it would imply that the Federal Reserve won't prioritize unemployment. That seems unrealistic given Powell's recent statements, where he indicated the Fed would act in response to significant weakness in the labor market.
Additionally, during the 1970s, unemployment typically rose later, often when stocks were either at (during the first two) or near (during the third wave) their cycle lows (during the first two waves). Only during the third wave did yields continue to rise shortly after equities started dropping. But as consumer price inflation was also accelerating back then, it raises questions about whether betting against bonds today would yield significant returns.
It's also noteworthy that the most similar wave of the 1970s is likely the first one, where the decline in bond prices that drove stocks lower coincided with the buildup of the second inflation wave and an increase in the Fed Funds Rate. However, today's conditions do not point to a re-acceleration of inflation and rate hikes of similar magnitude as back then, although this scenario might unfold in the coming years.
The current pause in disinflation appears short-lived, considering it followed a sideways trend in the growth rate of monetary aggregates in 2022. Despite the hotter-than-expected US PPI data on Tuesday, it's important to note that the prior month was revised down from 0.2% to -0.1%. Although bonds sold off after the event, they quickly recovered in the US market, though more slowly in Europe.
To assess how the current hiking cycle might unfold, market participants closely watched US data published on Wednesday, especially the April CPI number. Although the year-over-year numbers were in line with expectations—core CPI at 3.6% and headline at 3.4%—consumer prices rose only 0.3% compared to the prior month instead of the expected 0.4%.
Those claiming that inflation is re-accelerating have been somewhat disappointed, but on CPI day, there's always a metric supporting various narratives. This time, it was Supercore CPI, driven mainly by the rise in motor vehicle insurance costs. I believe inflation will continue to trend downward this year, possibly reaching 2% or even lower if a recession occurs.
More interestingly, retail sales remained flat in April compared to March—a significant miss from the expected 0.4% increase. The prior month was also revised down from 0.7% to 0.6%. That suggests the US economy is starting to slow, as I have suspected for quite some time.
With CPI falling and the economy slowing, it's challenging to argue that we're in an environment like the 1970s, which drove yields higher and caused a stock sell-off. Furthermore, this also does not support a soft landing thesis akin to what occurred in the 1990s. Instead, I believe we're experiencing something resembling the dot-com crash or the GFC.
The rise in bonds and stocks after the recent data release supports this thesis. If yields continue to decline—as indicated by the first higher low and higher high in bonds this year—the stock market could see another leg up if the economy continues to slow. Yields will reflect the slowing economy, while stocks will rise on expectations of more rate cuts.
However, the situation remains complex due to geopolitical factors that could disrupt markets, causing unsustainable supply-demand imbalances that push prices higher in the short term. While this may unsettle market participants, it won't change the trajectory toward further disinflation.
The extent to which long-term yields will decline depends on the depth of the economic slowdown and whether businesses can manage rates that are still considerably higher than during the ZIRP era. Currently, it's unlikely the Fed will immediately return to an interest rate environment similar to what the markets experienced during the 2010s. However, markets might be slowly ghost-walking toward another crisis again.
Night blind on the shining path
Ghost walking in the aftermath
Hypnotized, 60-cycle hum
The broken cadence of a distant drumLamb of God - Ghost Walking
Have a great weekend!
Fabian Wintersberger
Thank you for taking the time to read! If you enjoy my writing, you can subscribe to receive each post directly in your inbox. Additionally, sharing it on social media or giving the post a thumbs-up would be greatly appreciated!
All my posts and opinions are purely personal and do not represent the views of any individuals, institutions, or organizations I may be or have been affiliated with, whether professionally or personally. They do not constitute investment advice, and my perspective may change over time in response to evolving facts. It is strongly recommended to seek independent advice and conduct your own research before making investment decisions.