Restrictive Rate Cycle in the Background

March gave new insight into the restrictive rate cycle currently in force. Conditions are tight due to consumer price inflation. There are no easy answers on how to regain stable prices. Inflation is very much a monetary problem rooted in the behavior of psychology. However, investors providing loans may not want to accept a return lower than the future inflation rate. As a result, bondholders may adjust interest rates until a fair return emerges that investors could be able to depend on. Therefore, inflation is likely to necessitate the restrictive rate cycle.

A tight rate cycle should gradually remove money from circulation, and that process is currently in motion. This country’s broad measure of money supply, recognized as the M2 supply, has begun to shrink after many years of expansion. Account balances representing money started to diminish a year ago. The volume of currency created during the pandemic era was massive compared to what has come back out in the last twelve months. How much more needs to come out before prices and wages normalize predictably? That is one macro-related risk that the Federal Reserve is likely monitoring.

Of course, there are typically unintended consequences in every rate cycle. The consequences can go both ways. When deflationary expectations are present, wasteful spending and speculative asset bubbles can formulate. On the other hand, inflation can bring on deposit destruction and slower growth. Last month, investors witnessed deposit destruction firsthand in March’s regional bank crisis. Fortunately, no hard-working American with a bank deposit lost money. The Federal Deposit Insurance Corp. backstopped deposits above the standard regulatory limit. However, the stock and bondholders of failed regional banks and banks acquired by a stronger competitor will receive losses from the weaker institutions. But at least the crisis remains contained inside the private sector, with minimal assistance needed from the public sector. A private consortium of eleven banks raised thirty trillion to prevent a third bank failure from happening in March.

Higher interest rates can quickly help reveal where the toxic assets live and who made poor investment allocations. Maybe this is what the saying “when the tide goes out, investors get to see who’s swimming naked” is meant to convey. The two regional banks that failed in March are possibly gone due to poor investment decisions and mismanagement of matching creditor liabilities. When expectations cause interest rates to increase, the value of the loans representing bank assets is no longer accurate and can cause serious problems if interest rate risk isn’t properly hedged. One of Fed Chair Powell’s statements in March noted that the Federal Open Market Committee has been entirely transparent about the institution’s intentions since restrictive policies started. Regardless, a deterioration in bank collateral based on standards of quality or marketability forced depositors (creditors) to withdraw money from weaker banks, leading to recent bank failures.

In addition to substandard conditions related to bank assets, elevated interest rates on short-term maturity government debt are likely another factor taking bank deposits out of the monetary system. The current attractiveness of relatively safe debt is removing some of the loanable capital from private sector use. The higher interest rates are helping to finance public deficits. Consequently, the government may gain in size due to the growing debt and create less room for the private sector to pursue innovation. The government can try to use deficits to encourage growth. However, if debt costs rise to unsustainable deficit levels, it may dramatically increase the uncertainty of the future price level because unsustainable spending can lead to further deficits down the road. Fortunately, other powerful forces can allow the US to finance budget deficits, such as the current account trade imbalance.

This ongoing restrictive rate cycle seems to be starting to show its age. Money balances have been retraced by a small margin and private-sector deposit growth seems to be slowing in response. A common narrative is that the restrictive monetary policy will result in a recession that will force the Federal Reserve to reverse course and ease rates. As a result, long-duration bonds and technology stocks are regaining popularity in anticipation that restrictive policies will end and create excessive disinflation. Soft landing or not, the economic implications are not clear yet. With that said, proper diversification and disciplined investment processes can be key investing principles in this current financial landscape.

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