Holy Cow, They’re Naked!

Mr. Warren Buffett — Omaha’s sage:

“A rising tide floats all boats….Only when the tide goes out do you discover who’s been swimming naked.”

How many presently wade waist-deep without swim trunks?

We do not know precisely. Yet we hazard the number is vast.

Interest rates have endured a magnificent increase commencing last March.

To date, they have worked little economic or financial wreckage.

The tides are evidently favorable. The bathers’ nudity is concealed, gleefully.

Yet beware the tidal swing. Beware the ebbing tide.

Beware the “lag effect.”

Mr. Michael Lebowitz of Real Investment Advice:

Despite surging interest rates, there are few signs they are impeding economic activity or causing distress amongst borrowers. It may seem strange that higher rates are not proving troublesome for an economy with such a high amount of leverage. Don’t breathe a sigh of relief quite yet. There is often a delay, called the lag effect, between higher interest rates and economic weakness.

How great a lag?

Expect a 2024 Recession

The average duration between the Federal Reserve’s final rate increase and recession’s onset is 11 months.

Of course we refer to averages. Recession may menace far sooner — or far later.

Yet 11 months is par as history runs.

It is moderately expected that the Federal Reserve will elevate rates once more this year. Jim Rickards believes in November.

Thus you can conclude — approximately — that recession will enter effect next October.

What follows October 2024? The answer is the November 2024 presidential election.

And voters are exquisitely attuned to the economic settings.

“It’s the economy, stupid,” argued Democratic campaign strategist James Carville against the 1992 presidential election.

It remains the economy, stupid.

Maybe June

If the Federal Reserve does not elevate rates in November… or December… its final increase will have transpired in July.

And so the recessionary calendar advances to June 2024.

Voters would have four additional months to absorb the recessionary blow — and plot their revenge.

“Throw the bums out” is the eternal refrain.

Will voters heave the sitting bum out? Will they put a new bum in?

We must await our answer. All is guesswork at present.

Let us then return to this so-called lag effect… and to ungarmented swimmers wading presently unexposed.

The abovesaid Lebowitz:

“This so-called lag effect is even more pronounced when rates were very low for extended periods before the rate hikes.”

The Federal Reserve’s target rate hovered at or near zero for much of the prior decade.

It began coming up later in the decade. But it came back down against the 2020 pandemic.

Only last year did they begin to jump — from near zero to today’s 5.25–5.50%.

Yet a question arises: Have interest rates truly jumped?

Get Real

In nominal terms rates have jumped, it is true. Yet in real terms? That is, in inflation-adjusted terms?

We find that rates remain historically guttered. Observes former colleague David Stockman:

During the 186 months through August 2023 the fed funds rate was negative in real terms fully 97% of the time (180 months)…

As recently as May, the inflation-adjusted fed funds rate was still -0.48% and turned ever so slightly positive in June and July. Yet [year-over-year inflation] still posted at +4.47% in August, meaning that [last week’s] freeze of the target funds rate at 5.33% yielded a real rate of just +0.48%.

A +0.48% real rate is miles and miles from a 5.33% nominal, face-value rate.

Perhaps it should not surprise us that the economy has repelled recession thus far.

The real rate scarcely exceeds zero — even after a hiking cycle that crowns the ages.

And the real rate is… after all… the real rate.

It’s All About Leverage

We must nonetheless be cognizant of the nominal rate and its lag effect.

Let us turn again to Mr. Lebowitz’s economic comments:

Each instance of higher [nominal] rates led to a crisis. The crisis sometimes involved an individual bank, company or even a county or country. Other crises were systemic, spreading through an industry, economic sector or financial market.

What do these assorted crises share in common? The answer is leverage:

The reason these occur with clockwork-like accuracy is leverage… leverage significantly increases the odds of a default for the borrower and, potentially, the lending institution.

Businesses borrowed immensely when rates dangled near zero. And why not?

Interest payments were a burden so light they scarcely represented a burden whatsoever.

Yet at today’s rates interest is a millstone heavily upon their necks.

Or in today’s analogy, leverage is the rascally hand seizing bathers by their trunks… and yanking the things off.

When the tide transitions… when flood tide yields to ebb tide… their embarrassed status will be exposed.

They will be nude. Lebowitz:

High tide is starting to ebb. When the lag effects catch up with the economy and asset prices decline, today’s high interest rates will allow us to see who has been swimming naked…

U.S. debt levels and its ratio to GDP are significantly higher than when Fed Chair Paul Volcker was taming inflation with double-digit interest rates 40 years ago. Total debt is double what it was in 2008. That crisis almost bankrupted the entire banking system.

Simply put, there are plenty of naked swimmers in our financial system.

Debt Has Doubled!

Debt levels were already handsome in 2008. And today they are double. Double!

Yet today’s interest rates exceed 2008’s rates.

It is a potentially lethal mixture.

Consider it from the governmental dimension alone.

Between 2022 and 2024… interest payments on the nation’s debt… will increase more than in the prior 50 years.

Thus 50 years compresses into two years.

Impossible — but there you have it.

What about the corporate sector of the economy?

This Lebowitz fellow claims that a “wall of maturing debt” rapidly approaches.

$525 billion of corporate debt comes due this year. $790 billion comes due next year?

And in 2025 — the year after next?

Over $1 trillion corporate debts come due.

Thus we hazard many swim trunks will come down across the following two years.

Will rates come down… and keep swimming trunks up?

It is possible. And reduced rates ease the debt burden.

Higher Rates Forever?

Yet as we recently wrote, the future may be a future of “forever” elevated rates. We cited The Wall Street Journal:

In their projections and commentary, some [Federal Reserve] officials hint that rates might be higher not just for longer, but forever…

This matters to any investor, business or household whose plans depend on interest rates over a decade or longer.

Thus they may confront a decade — or longer — of ebbing tides.

Again we ask: How many bathers… whose nudity is presently concealed… will be exposed as the tide rolls out?

Also again, we do not know.

Yet we do know that tides run to regular cycles.

We likewise know that economic high tide has been an extended cycle.

Trunkless bathers beware:

Ebb tide is due…