The Two Pins That Will Pop The Stock Market Bubble

Each time rates have “spiked” in the past; it has generally preceded a mild to a severe market correction.

As is often stated, “a crisis happens slowly, then all at once.”

So, how did the Federal Reserve get themselves into this trap?

“Slowly, and then all at once.”

In an economy laden with $85 Trillion in total debt, higher interest rates have an immediate impact on consumption, which is 70% of economic growth. The chart below shows this to be the case, which is the interest service on total credit market debt. (The chart assumes all debt is equivalent to the 10-year Treasury, which is not the case.)

Importantly, note that each time rates have risen substantially from previous lows, there has been a crisis, recession, or a bear market. Currently, with rates at historic lows, consumers are rushing out to buy houses and cars. However, if rates rise to between 1.5 and 2%, economic growth will quickly stall. Such was a point we made in our COT Report:

“Can rates rise in the near-term due to “checks to households” that get spent to pull-forward consumption? Absolutely.

However, the limit of that increase in rates is between 1.56% and 2.19%. At these points, rates will collide with the outstanding debt.”

The Federal Reserve is well aware of the problem. Such is why they have been quick to reduce rates and increase bond purchases, as higher rates spread through the economy like a virus.

In an economy that requires roughly $5 of debt to create $1 of economic growth, changes to interest rates have an immediate impact on consumption and growth.

1. An increase in rates curtails growth as rising borrowing costs slow consumption.
2. As of Jan. 21, the Fed now has $7.38 trillion in liabilities and $39.2 billion in capital. A sharp rise in rates will dramatically impair their balance sheet.
3. Rising interest rates will immediately slow the housing market. People buy payments, not houses, and rising rates mean higher payments.
4. An increase in rates means higher borrowing costs and lower profit margins for corporations.
5. Stock valuations have been elevated due to low rates. Higher rates exacerbate the valuation problem for equities.
6. The negative impact on the massive derivatives market could lead to another credit crisis as rate-spread derivatives go bust.
7. As rates increase, so do the variable rate interest payments on credit cards. With the consumer already impacted by stagnant wages, under-employment, and high living costs, a rise in debt payments would further curtail disposable incomes.
8. Rising defaults on debt services will negatively impact banks that are still not adequately capitalized and still burdened by massive bad debt levels.
9. The deficit/GDP ratio will surge as borrowing costs rise sharply.

I could go on, but you get the idea.

Since interest rates affect “payments,” increases in rates negatively impact consumption, housing, and investment, which ultimately deters economic growth.

With “expectations” currently “off the charts,” literally, it will ultimately be the level of interest rates that triggers some “credit event” that starts the “great unwinding.”

It has happened every time in history.

The problem for the market going forward, as noted, is that markets have priced in a speedy recovery back to pre-recession norms, no secondary outbreak of the virus, and a vaccine. If such does turn out to be the case, the Federal Reserve will have a huge problem.

The “unlimited QE” bazooka is dependent on the Fed needing to monetize the deficit and support economic growth. However, if the goals of full employment and economic growth get quickly reached, the Fed will face a potential “inflation surge.”

Such will put the Fed into a very tight box. The surge in inflation will limit their ability to continue “unlimited QE” without further exacerbating the inflation problem. However, if they don’t “monetize” the deficit through their “QE” program, interest rates will surge, leading to an economic recession.

As Doug Kass concluded last week:

“To me, there is only one inescapable economic conclusion – inflation and interest rates are heading higher as better economic growth in the last half of 2021 is delivered by the unprecedented stimulus. Unfortunately, the stimulus is in the form of mostly transfer payments and not in expansion of productivity or capacity.

The economic boom will be a sugar-based high and there is an almost inevitable bust cycle emerging by or in 2023 when the heady fiscal stimulus ends.

Today’s record stock prices belie a likely hard economic landing that may lie ahead.”

Of course, this has always been the case historically. Just as the “Coyote” still wound up going over the cliff when chasing the “Roadrunner,” excessive bullish optimism is always eventually met with disappointment.

Written By: Lance Roberts