Friday, January 18, 2019

The Positive Interest Rate Cycle, RIP...1950 - 2019

I'm going to make the case that the US is concluding the final positive interest rate cycle and that upon the next downturn, the Japanese / EU style ZIRP and/or NIRP will become the new norm.  But, before we say goodbye...let's take a look at the ups, downs, and rationale of the post WWII cycles.

Below, the 11 interest rate cycles since 1954, with each subsequent cycle highlighted in a separate box.  Each cycle was unique but, in sum, they were part of an arc that has run its course.  I'll detail that the Federal Funds curve actually represents the real annual change in demand.  Organic demand accelerated up to 1981 and organic demand decelerated from '81 to present but synthetic credit / debt based demand was increasingly substituted.   And, for some strange reason, when the annual core population growth among the consumer nations was at its peak, the Fed (and CB's) restricted the economy and potential capacity via extremely high rates.  Now at minimal to negative core population change (little to no demand growth), the Fed is attempting to incentivize debt and increase capacity with zero and/or with negative rates?
Below, every US interest rate cycle since WWII, showing cycles from initial rate cut until the initiation of cuts starting a new cycle.  Clearly, the '89 to '00 and current "lower for longer" cycles stick out like a sore thumb.
Splitting the cycles into two separate buckets; first looking at the cycles from 1950 through 1980.  During this period, every cycle finished at a higher rate than the cycle began (recouping all cuts plus some).  Cycles were as short as a year all the way up to six years long.
Second, looking at 1980 through 2019; interest rate cuts become deeper, none of the cuts are fully clawed back and rates are progressively lower prior to the next cycle.  The duration of the cycles lengthen and the hikes become slower and gentler.  BTW, the following chart and analysis assumes that the Fed hikes one more time in 2019 to reach a final FFR % of 2.6%, which is likely where 2019 will end...and where this longest and last positive cycle will be complete.
Below, focusing solely on the interest rate cuts of each cycle.  Initially, the cuts were deep but more than fully clawed back in the subsequent "good times".  However, from 1981 onward, the cuts are progressively deeper.
Chart below details the cycle ending interest rates in relation to each cycles beginning interest rate.  Up to 1980, interest rate cuts were fully recovered plus significantly increased above the starting rate during the post cut period.  However, starting in '81, the interest rate recoveries progressively fail to recoup the interest rate cuts and the current recovery (even assuming one more rate hike to come) is the weakest yet.
Below, comparing the duration of interest rate cycles.  Clearly getting significantly longer, meaning during each cycle the economy is subsequently exposed to lower rates for longer and a majority of bonds / debt are reset at the interest rate cycle lows.  The current cycle (assuming no rate cuts through December, 2019) will be 150 months.
Below, putting together the initial cut in interest rates (red columns), the recovery in interest rates by cycles end relative to the initial rate (blue columns), and the cycle duration in months (black).  Two distinctly different periods: 1950 to 1980 and 1981 to present. 
  • 1950 through 1980
    • maximum rate cuts were progressively declining
    • interest rate recoveries were all in excess of the original interest rate
    • durations were relatively short, compared to the post 1980 cycles
  • 1981 through 2019
    • maximum rate cuts getting progressively larger
    • interest rate recovery becoming progressively smaller
    • duration becoming progressively longer

The current cycle is unlike anything seen previously.  It was an unprecedented cut of essentially 100%, "lower for longer" than any previous cycle, and has achieved the smallest claw back of the interest rate cuts.
So, the Fed has made deeper cuts, clawed back less of those cuts, and employed the "lower for significantly longer" policy.  This policy represents that the economy and growth are progressively weaker and the Fed deems an escalating utilization of this crutch is the only means to continue to reap the desired rates of growth.  This can be clearly seen in the chart below, detailing the change per cycle in federal debt (trillion of $'s, red columns), debt to GDP (%, black dots), and full time employees (millions, blue columns).

Above, early cycles see little growth in federal debt, significant growth in full time employees, and declines in debt to GDP.  Progressively, growth in full time employees comes at the growing expense of rising amounts of federal debt and rising debt to GDP.  However, the current cycle with its massive growth in federal debt, rocketing debt to GDP, and half the total growth in full time employees than seen in previous cycles should have everyone looking for answers.

Below, a quick close-up from 1966 through 1980...the good years.
And looking at 1981 through 2018...the progressively weaker years.

I often hear questions about what is wrong with the economy or why isn't it growing up to expectations?  The problem is not really with the economy but with the expectations.  As the chart below details, there is a simple governor on the economy...the growth of the population among the potential work force (green columns) that limits the quantity of jobs growth (blue columns).  As the growth of the work force slows, so too slows potential demand and need for additional workers, additional potential homebuyers, etc.  However, the Federal Reserve and federal government are unwilling to accept the most basic of math and so have long abused interest rates and federal debt in search of "more".
It is important to note that the US economy is essentially presently at full employment.  As the chart below details, the 25 to 54 year old core is at levels typically associated with peak employment, the 55 to 64 year olds are entering the workforce at higher numbers than ever seen previously, and 15 to 24 year olds are likewise at peak employment although far below previous peaks...structural changes around part time jobs coupled with large increases among the student population are driving this change.

Over the next decade, the growth of the 15 to 64 year old potential workforce will be minimal and highly reliant on ongoing immigration.  The vast majority of population growth will be among the 65+ year olds (and particularly shifting to the 75+ year olds over the next decade).  The problem with this is the comparatively very low labor force participation rates among this population.  About 27% of 65 to 74 year olds continue working and just 8% of 75+ year olds (this compared to about 80% of 25 to 54 year olds).  I previously detailed why jobs growth over the coming decade will be minimal (HERE) and why the not in labor force will rocket higher (HERE).

The chart below details the ongoing deceleration of growth among the working age population and that jobs growth (full time, shown below) is likewise decelerating.  Absent some major shift, growth in employment (and economic growth in general) will be minimal.  This is just reality.
And now, without further ado, it's time to say so long to the positive interest rate cycle and may it RIP.  Because, the Fed will soon deem negative interest rates the only means to reap the desired rates of asset appreciation and economic "growth".  Perhaps why this is happening and where is this going are good questions about now?  My best guess won't take long.

Population growth, particularly among the working age populations, drives economic activity.  The charts below detail that the decelerating growth and outright declines among the working age populations have been met with macro-level secular rate cuts while business cycles have resulted in short term rate fluctuations.  To recap, interest rates follow working age population growth over the long term, business cycles are just the short term gyrations.

The US, like Japan, like Germany/the Eurozone...will upon the next economic downturn, (likely in late 2019 or early 2020), almost surely follow Japan and the Eurozone by cutting rates to achieve negative yields.  The Fed will almost surely go lower for longer in lieu of any better ideas.  The chart below details the discount rates set by the Federal Reserve, Bank of Japan, and European Central Bank.  At present, the US interest rate policy is out of step with the EU and Japan.

Below, focusing on the comparative rates of the Federal Reserve (black line), the Bank of Japan (red line), and European Central Bank (gold line) since 1988.  Plus, the dashed arrows suggest that all three will almost surely be converging on ZIRP and/or more likely NIRP in the near future (more on the why, below).
Working Age Population change vs. Interest Rates
Japan 15 to 64 year old annual population change as a percentage of total population (blue columns) versus Bank of Japan discount interest rate, below.  Interest rates chase the core population until the core population turns negative, and since then ZIRP continues.
Eurozone 15 to 64 year old annual population change as percentage of the total population versus German and then EU discount interest rate, below.  Again, as core population turns negative, interest rates "flat line".

US 15 to 64 year old annual population growth as a percentage of the total population versus the federal funds rate, below.  Although the core isn't in decline, interest rates are following the minimal growth among the core.  And, as the chart details, the core growth only continues to weaken (and what little growth there is among the core is entirely premised on ongoing immigration).

But the dollar is the global reserve currency, and as such, is used across the globe.  So, below is a check of the consumer nations of the world core 15 to 64 year old annual population change (the nations with per capita incomes from $80k to $4k annually...this is 3.84 billion persons or half the worlds population) versus the Federal Funds Rate.  Federal funds rate is shown as a dashed red line while a five year moving average is shown as a solid red line to smooth out the noise. This group includes the US/Can, EU, Japan/S. Korea, Australia/NZ, China, Russia, Brazil, Mexico, Iran, etc. etc. (easier to note the exclusions of India, Pakistan, Indonesia, Egypt, and Sub-Saharan Africa, etc.).  These consumer nations represent half the worlds population but 90% of the income, savings, and access to credit.  These nations also represent 90% of the global energy consumption.  So goes the decelerating import markets of these nations, so goes the decelerating exports and growth potential of the poor nations.

Finally, the last chart contrasts total annual births split among the consumer nations (black line, $80k to $4k per capita annually) and the poor nations (blue line, less than $4k to $400 per capita annually) of the world versus federal funds rate (shaded grey).  Consider global annual change in organic demand is following the black line (with about a 20 year lag as they enter adulthood), not the blue line.  To maintain steady demand, for the decline of every birth among the wealthy, it takes a 10 fold increase in births among the poor.  However, productive capacity is following the blue line, not black line.
Conclusion:
Growth among the working age, core populations of the nations that do all the consuming and importing has nearly run it's course.  Rates follow working age population growth among the nations with means and the change in demand they represent.  Given this reality, positive interest rate cycles will soon be a thing of the past replaced by long periods of negative interest rates with cycle highs at or slightly above zero.

If and/or how this will new NIRP world will work is simply unknown but I'm pretty confident NIRP will be for the largest among us while the rest of us will still pay for the privilege of borrowing money.  And the idea of paying the largest among us, corporations and large banks, to undertake debt seems like a terrible idea that will enrich the few but is unlikely to lead to growth or prosperity for the many.  Perhaps it's time to open a wider discussion regarding exactly where we are going.

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