Understanding How “This Time is Different” to Make Great Investment Decisions – Week 2

Normalization:

For this portion of our discussion we have to define the term “normalization”. In economics normalization refers to the central bank moving interest rates back to a “normal” relationship.

Our central bank, The Federal Reserve Bank (The Fed), is continuing to unwind the Quantitative Easing (QE) it did during the Great Recession. The Fed influences the American economy via its control over interest rates. The Fed lowers interest rates when they want to encourage economic growth by increasing both liquidity and asset values. The reverse is also true.

Having held interest rates at abnormally low levels since December 2008 as The Fed aggressively encouraged economic growth in our country during the Great Recession, The Fed is now raising interest rates in an attempt to get the financial markets back to “normal”. From a long-term perspective on the economy, it is critical that our USA financial markets get back to a more normal state both from a stability and future economic growth perspective.

An important question is “What is normal today?”. A review of 150 years of economic history shows that there are many definitions of “normal” financial markets. During my almost 48 year career, I would define a “normal” financial market as a Federal Funds rate around 4%, 10 year Treasuries around 5%, and mortgage rates around 6%. To me that is Historical Normal.

During the Great Recession the Federal Funds rate was 0% to 0.25%, ten-year Treasuries were around 2%, a 30-year fixed rate mortgage was 3.5%, and interest rates paid on savings accounts were as low as 0.19%. Clearly those are abnormal rates compared to my Historical Normal. But they existed for so long that they began to feel like they were a New Normal.

The inherent risk of normalization is that adjusting back to higher interest rates because they are “normal” will mean adjustments in asset values. That is a nice way of saying there is a high risk of a total collapse in stock, bond, and real estate values.

In the economic history of the world, I am not aware of a single case of “normalization” that occurred that did not result in either (1) total financial collapse or (2) rampant inflation which then led to total financial collapse.

Our next blog will discuss the “cost of normalization” as we finish setting the stage for a discussion of “Will This Time Be Different?”.