Unsustainable 7% prime interest rate – Interest rates set to crash in 1-2 years

Pee

I love the old adage “everything in moderation”. The extremes on either side of anything are never sustainable, as seen in the image above of the woman holding the side of a mountain with one hand. With regard to interest rates in the economy, we can say the same thing.

Investors should appreciate the importance of interest rates in the cost of servicing debt, particularly as measured by the size of the economy.

The US economy, and the world for that matter, has an inflation problem. The problem is precisely that the cost of living exceeds the rise in wages, creating what is called stagflation. The inflation rate in the United States is 7.76% in October 2022. Wages in October only increased by 4.72%.

One of the main drivers of inflation is the overall credit growth rate. The Federal Reserve Bank aims to raise interest rates or the cost of borrowing new funds in an effort to slow credit growth. This in turn will have a strong impact on the inflation rate on the monetary side.

The Fed raised rates very quickly and the US prime interest rate is now at 7.00%. This is the rate banks will charge their best customers for the cost of borrowing money. It is this rate that is a good exercise of how big the interest rate on money is relative to overall debt and the size of our economy.

Preferential rate

Preferred lending rate

Prime Lending Rate (St. Louise Fed FRED)

In December 1980, the preferential loan rate peaked at 21.50%! A year later, it would be 15.75% and a year later, in December 1982, it would be 11.50%, ie 10% less than just 2 years earlier. At almost any peak in the prime rate, the 1-2 year prime rate would be significantly lower.

Looking at the longer-term prime rate, since 1980, the bank loan prime rate has consistently experienced lower highs and lower lows. Today the rate is 7% and that is higher than the last high at 5.50% in 2019. So we have now broken those lower highs levels. It certainly sets a new paradigm for what’s to come, I think.

There is, however, a substantial difference this time around and it has to do with the amount of debt versus the overall economy, as I will try to elaborate.

Debt

When we look at debt, we have to look at the overall debt of the US economy. Mortgage debt, commercial debt, federal government debt as well as state and local government debt. Student loan debt, auto loan debt, and credit card debt. Add it all up and we have what is called “all debt securities and loans in all sectors”. The graph for it looks like this:

All Sectors Debt and Lending

All-Sector Debt and Loans (St. Louis Fed FRED)

In the 2nd quarter of 2022, it was 91.225 billion dollars. At a minimum, it’s probably increased by around 2% since then in Q4 2022. To estimate the current level of overall debt in the US economy, I would estimate it at around $93.05 trillion.

US economy – GDP

US GDP

US GDP (St. Louis Fed FRED)

US GDP was running at an annualized rate of $25.663 trillion in Q3 2022. I would estimate that in Q4 the US economy would grow 1.4% from Q3 which would put GDP at 26 .02 trillion in the 4th quarter.

Prime rate/debt/GDP

A good exercise to do is to see how the cost of prime rate money would compare to the overall economy or GDP.

I simply take the prime rate and multiply it against the overall debt of the US economy and compare that as a percentage of GDP.

First, I would like to show the magnitude of US debt relative to the US economy, as this plays a substantial role in the interest rate it can withstand.

Debt to GDP

Debt to GDP (St, Louis Fed FRED)

US debt stood at around 3.61 times its GDP in Q2 2022. This compares to 1980 when it was around 1.6 times GDP. Today, the US economy is highly indebted and its ability to service debt at high interest rates is not only unsustainable but impossible if rates get too high.

Everything is relative, so this exercise allows us to put the prime interest rate into perspective in relation to the level of indebtedness and the economy.

Prime rate/debt/GDP

Prime rate/debt/GDP (St, Louis Fed FRED)

It is in fact the cost of carrying the debt relative to the economy. It has been, frankly, well managed over the years. It fluctuated between 11% and 32.56% in the third quarter of 1981. It reached 26% in 1989 and again in 2000. In 2007, it reached nearly 29%. In 2019, it peaked at just under 19%.

In the 2nd quarter of 2022, it was 14.20%. In the 2nd quarter, the prime rate averaged just 3.93%, with the Fed just beginning to raise rates substantially and quickly. We are now in the 4th quarter of 2022 and the rate is 7.00%.

The bank prime rate at 7.00% today with debt of $93.05 trillion is about $6.51 trillion. With an estimated GDP of around $26.02 trillion in Q4 2022, that’s debt service of $6.51 trillion at around 25% of GDP by my exercise.

Conclusion

History suggests that such a high interest rate relative to an economy’s debt is simply unsustainable. Perhaps interest rates will peak in Q1 2023, but once they do, as has always happened in the past, rates will fall sharply to eventually ease the heavy burden of the cost of silver.

Inflation could very well fall to 2% easily. It looks like inflation is starting to come down, although wages are also falling. The two will fall in tandem, although wages could very well fall faster than inflation. What will matter will be household wages and incomes and their ability to keep pace with the rising cost of living. It’s a horse of another color.

In the markets, what goes up very quickly, goes down very quickly. Interest rates have risen very quickly and we could very well find ourselves soon enough where interest rates will drop very quickly as early as 6-12 months into the next year. The prime rate should return to a level where debt service is between 12% and 15% of GDP, which would put the prime rate between around 3.5% and 4% again. 7% today I think.

This is more or less what needs to happen to keep the economy buoyant given its indebtedness. A slowing economy and the destruction of demand will certainly prove to be a deflationary force that will help push rates down. The same goes for falling real wages which will help reduce inflation as demand will be forced to fall. This implies a lower standard of living compared to recent years.

Of course, anything is possible and policies can change. Rates could stay very high and defaults could also become the answer to lower debt and inflation, but lead to huge economic hardship in the process.

It should boil down to what is in the best interest of humanity and in this case, always in moderation.

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