Hyman Minsky, the late Columbia University credit cycle expert, taught us that a long credit and asset-market boom fueled by cheap money inevitably leads to a moment when those markets flip and panic selling sets in. All too often, those moments came when interest rates started to increase at a rapid pace. In turn, defaults become very much more common as borrowers find it difficult to service their debt when they have to roll over low-interest-rate loans at very much higher interest rates. At the same time, stock markets at high valuations lose their appeal as high-yielding government bonds offer a more attractive and less risky investment alternative.
If ever we have had a long credit and asset market boom, it must have been over the past five years, when those markets were propelled higher by cheap central bank money in the wake of the 2020 COVID-19 economic recession. While it is always difficult to predict the precise moment when the market bust occurs, the recent rise in long-term interest rates to multiyear highs both at home and abroad would suggest that we cannot be far off from another Minsky moment.
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This would seem to be especially the case considering the excesses in the private credit and the artificial intelligence debt markets as well as the close to record high valuations at which the U.S. stock market currently trades.
Beginning in 2020, unusually low interest rates both at home and abroad fueled a strong U.S. and worldwide credit and stock market boom. In response to the 2020 recession, the Federal Reserve engaged in yet another round of massive quantitative easing, reducing the 10-year Treasury bond yield to below 1%.
Meanwhile, through its yield control policy, the Bank of Japan reduced long-term Japanese government bond rates to close to 0%, and something similar occurred with European interest rates in response to the European Central Bank’s government bond-market buying activity.
Fast forward to today, and it appears that the low-interest-rate party has come to a sudden end. Long-term government borrowing rates both at home and abroad have skyrocketed to multidecade highs on the back of market concerns about large budget deficits, high inflation, and the prospect of massive AI company debt issuance. With little prospect for improvement on any of these fronts, the 10-year Treasury bond rate has spiked to 4.75%, and the 30-year rate has climbed to a 19-year high of 5.33%. Meanwhile, Japanese long-term bond yields are at four-decade highs, and those in Europe are at their highest since the 2010 European sovereign debt market crisis.
One reason for concern about rising long-term interest rates is that they could spell trouble for the $2 trillion private credit market, which could spread to the rest of the financial system. Even before the most recent interest rate spike, Fitch rating agency warned that private credit defaults had hit a multiyear high of 6% in July.
Meanwhile, the Federal Reserve has reported an acceleration in withdrawals from private credit funds, forcing those funds to impose their contractual 5% redemption caps. With little prospect of long-term interest rates declining anytime soon, there is a real risk that in the months immediately ahead, problems in the private credit market will intensify. This would seem to be especially the case, considering the strong pressure for additional defense spending that will cause a further widening in the budget deficit.
High long-term interest rates could also constitute a strong headwind for the AI investment boom. Over the past year, that boom has accounted for around one-third of U.S. economic growth and a major part of the increase in overall investment. The maintenance of high long-term interest rates, coupled with high energy costs, could raise questions about the economic rationale for a meaningful part of that investment surge.
If high interest rates spell trouble for the credit market, they certainly spell trouble for the stock market, especially at today’s nosebleed levels. By any measure, today’s stock market valuations are at similar levels to those that preceded the 2001 bursting of the dot.com bubble.
It is not only that corporate earnings will now need to be discounted at higher interest rate levels, or that relatively risk-free government bonds at higher interest rates will offer greater competition to stocks in investment portfolios. It is also that high interest rates may cause earnings growth to slow by constituting a headwind to overall economic growth.
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Unfortunately, at this stage, there is little that policymakers can do to prevent a day of reckoning in the markets. That train has long since left the station.
However, what they can do is to make contingency plans now as to how to mitigate the financial and economic damage that could flow from a disorderly credit and stock market.