1% Interest Rates Were Never Normal—Here’s Why

Following the FOMC rate decision, Trump reiterated his position that the US should have 1% rates, the lowest in the world. He believes that because the US is the safest credit in the world, we should have the lowest interest rates. While that may make some sense, we’re a long way from getting 1% rates, and we don’t really want to be in a place that has 1% rates.

Why wouldn’t we want to be in 1% rate world? For starters, long rates are most tightly bound to nominal GDP. If you want rates low, you need a much worse, recessionary economy. Who wants that? Long rates can be regarded as a string of short rates (the 5Y yield should roughly match the next five 1-year yields,) so a low Fed funds rate combined with high longer rates isn’t going to happen, either.

If you want to dig into more detail as to why having higher interest rates makes more sense, you can read The Price of Time be Edward Chancellor. In his usual style, he writes a very thorough story about a big topic in a pretty readable manner. Basically, time is scarce and has a price. Keeping rates low discourages savings, exacerbates inequality, and creates asset bubbles, which inevitably burst.

Realistically, what would happen if we did just go to 1% rates in these conditions? The financial system is basically a machine, if you push on one lever, another will act to counterbalance the action. Since rates are the flip side of currency values, the value of your dollar would crash. That would drive other assets up, at least initially, purely because the dollar would be worth less.

Since a sharp devaluation would send a message the government doesn’t care about inflation (they just crashed the dollar, so inflation will soar because your dollar buys much less,) long bonds would likely suffer over time, as the expectation would be the dollar will be worth much less over time, and stocks may get hit as well, at least in real value. Basically, we’d be some version of Zimbabwe and their hyperinflation. Nobody should want that, and if you’re wondering, hard assets is what wins in that scenario.

OK, we can’t do and don’t want 1% rates. Was a rate hike merited? I’d say it basically had to be done, even if it may not make sense. What? OK, the stated reason for the rate hike was basically stubborn inflation. The thing is, recent inflation trends, like Core CPI, continue to trend down, though they do remain higher than desired. Shouldn’t we have hiked a while ago if inflation was the cause?

The other things the Fed mentioned are likely more important causes of a hike, namely continued economic growth and ‘geopolitical tensions.’ That combo is what the market is focused on, where continued deficit and AI spending are keeping nominal GDP quite high. Additionally, continued Iran war brings the fear that inflation will pop back up.

Sophisticated financial investors, along with the Fed, have tended to use esoteric financial models, like r*, to estimate where rates should be, and those estimates keep moving up. Broadly speaking, a strong push for financing, such as large deficit and AI spending, is largely to blame for most of the recent move higher, though this has been going on since we let the inflation genie out of the bottle in 2021. Those models are insistent that we needed to hike or the market would have a temper tantrum, and here we are.

There is reason for optimism, though. We’ve already priced in a lot of cuts, and odd as it may sound, that’s already de facto tightening. A big question is if more hikes get priced in or the market is doing the usual act of pricing in a worst-case and moving it back. We also have a Fed and Treasury working to improve the situation. The Treasury has implied their next financing will be more bill heavy, which should help. Oil settling down would also help tremendously. In short, there’s good reason to believe we’re around maximum hawkishness, here. For instance, the 10Y yield peaked last Tuesday morning and recent histrionics haven’t been able to top that.

So, we’re not getting 1% rates anytime soon, nor do we want to, as it would indicate big problems. I don’t believe the rate hike made sense, but the market demanded it, so it had to be done or we’d see worse trouble. If nothing else, it’s worth realizing that the market has already priced in quite a lot, as those implied expectations of the future impact action right now. There’s reason to believe market tensions can take a break, here.

Industrial Production was 0% m/m vs. exp. 0.3%. Capacity Utilization was 76.3% vs. exp. 76.4%.

Trump decided against US strikes on Houthi’s for now, helping send oil down 2% and putting a bid in risk assets. There are also some amount of negotiations to end the war.

Bitcoin broke above $83K resistance and is now trading at almost $85K.

Novo (NVO) is -6% as competition and lawsuits in the obesity market pile up.

Critical Metals (CRML) is up 29% after the US and Denmark reached a security agreement on Greenland.

Chicago Fed National Activity Index today.

Bottom line: Tensions lessened in the Middle East, aiding a bid in markets

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