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Financial Education: Why You Need to Understand Interest Rate Cycles

One of the key differences between a high-value man and a low-value man is education. The former understands the power of education and he uses that to transform his relationship with money – instead of working for money, money works for him. And how does he do that - he becomes a master investor. We are living in unprecedented times. Stock markets are close to their historic maximums. The Dow Jones Industrial Average (see below), was trading at around 1,000 points at the start of the 1980s. In 40 years, it has rallied to 30,000 points which are compounded return of a fraction below 9% per annum. We have never seen this before,

So what has fuelled this exponential return in stocks over the past 4 decades? Most people would say it has been a technology-driven increase in productivity. That has played a role, but by far the strongest driver has been the interest rate cycle. When money is cheap, a lot of this cheap money finds its way into stocks for obvious reasons. Take IBM for example. This stock pays a dividend of more than 5%. If you can borrow money at 2%, you can buy IBM stock and the dividend pays for your borrowing and provides an additional 3% for good measure. The market is paying YOU 3% to buy the stock - you would be an idiot not to enter the trade.

The chart below tracks the Federal Funds Rate which is the Fed’s main benchmark interest rate that influences how much consumers pay to borrow and how much they’re paid to save, rippling through to influence yields on certificates of deposit (CDs) and savings account to credit card rates and home equity lines of credit.

This rate is very powerful because it determines the cost of money in the United States and because the United States is the most important economy in the world, this rate indirectly impacts the economy of the world.

Whenever there is a crisis, central banks print money. They cut interest rates close to zero and they run the printing presses hot. The belief is if there is more money in the system, people will spend more and there will be a consumer lead recovery. It happened with the bubble in 2000, the subprime mortgage bubble in 2008, and COVID in 2020.

Look at the evolution of the Fed Funds rate since 1955. You can see that there are two clear halves of the graph. From 1955 to 1980 interest rates were on an upward trend. From 1955 to 1972 interest rates went from 0.80% to 3.30%. Then we entered the tumultuous 70s when rates when from 3.30% to 19% in 1981. This decade has become known as The Great Inflation. The Federal Reserve panicked and raised interest rates through the roof to control inflation. What happened to cause this spike in inflationary pressures?

To understand what happened in the 70s you need to go back to World War II. We all know that this war helped the United States come out of the Great Depression. However, when the war ended, the US did not want this momentum to be lost, so a new law was passed known as the Employment Act of 1946. The act declared that it was the responsibility of the Federal Reserve to promote maximum employment, production, and purchasing power. The government wanted to do everything in its power to prevent another depression.

During World War II, Bretton Woods was signed. This pegged all currencies to the US dollar and the US dollar was linked to gold. The problem with this was that as global trade grew after the war, so too did the demand for US dollar reserves because the majority of global trade was indexed to the US dollar. Soon there were not enough gold reserves.

This is when the Philips Curve comes into play. This curve says that there is an inverse relationship between inflation and unemployment. The theory claims that with economic growth comes inflation, which in turn should lead to more jobs and less unemployment. Phillips said there was between unemployment, which was very damaging to economic well-being, and inflation which was sometimes thought of as a mere inconvenience.

Another issue that had to be taken into consideration was the Bretton Woods Treaty. This had been signed in 1944 pegging all currencies to the US dollar which was in turn pegged to gold reserves. As global trade grew after the war so too did the demand for US dollars because the bulk of the trade was done in this currency. Soon, there was not enough gold to back the dollar.

As inflation drifted higher in the latter part of the 1960s, US dollars were increasingly converted to gold until the system could no longer be maintained. In 1971 Nixon unlinked the dollar to gold and all hell broke loose. The US dollar and global currencies were no longer anchored.

In the 60s, President Lyndon Johnson announced the Great Society legislation. Remember the collective paranoia of another depression. These spending programs addressed education, medical care, urban problems, rural poverty, and transportation. Then the Vietnam War started so government spending was high. The government was spending more than it raised in taxes and had to borrow. Then you had the Arab Oil embargo that began in 1973 and lasted five months. Over this period, oil prices quadrupled and held those levels until the Iranian revolution brought a second energy crisis in 1979. The second crisis tripled the price of oil.

During this period we realized there were two kinds of inflation- demand-pull when high demand pulls prices higher and supply push - where supply disruptions push prices higher. The Fed pushed rates higher to combat inflation and we entered into a period of stagflation which showed that Phillips was an idiot.

So why is all this relevant? You need to understand the relationship between inflation and interest rates. When inflation goes up, central banks do their best to increase interest rates to put the brakes on these higher prices. They make money more expensive in the hope that demand for goods and services will decline and this will bring prices down. The opposite is true when prices are going down or when there is deflation.

Stock market crashes and other financial crises tend to be deflationary. Whenever there is such an event central banks print money. They cut interest rates and they run the printing presses hot. The belief is simple - with more money in the system, businesses and consumers will spend more and this will lead to a recovery in the economy.

Let us now bring this back to the modern-day situation. Interest rates are back to the same levels we saw in the 1960s, but notice how in the last few months they have started to rise sharply. This is because inflation is raring its ugly head again on account of higher oil prices thanks to Putin's war in Ukraine.

The question therefore is are we heading into the same scenario as we saw in the 1970s? It looks similar, So what happened to the stock market in the 70s? The market gained a grand total of 5% in 10 years. However, when adjusted for inflation, stock market investors were down almost 50% over the decade. With borrowing costs close to 20%, stocks were no longer so attractive.

The Fed's effort to tame inflation came to zero - they were powerless in trying to tame soaring prices. Inflation peaked at 13.5% in 1980. Living standards declined. In 1979, only 19% of Americans were satisfied with the way things were going in the US, and peaked at 71% in 1999. By the way, the percentage in April 2022 was only 22%. Gold was the best-performing asset class. People who invested in real assets did well. Beef prices almost doubled - corn prices tripled. Wheat prices quadrupled. Real estate also did well. California real estate tripled in value. Silver did better than gold rising from less than $2 in 1970 to more than $30 I'm 1979. That is a gain of more than 15x over the decade. Now may be an opportune time to start shifting into physical assets.


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