By Haddon Libby
The Federal Reserve appears to have hit its terminal rate for Fed Funds at 5.25%. The ominously sounding ‘terminal rate’ term means that the Fed has achieved what it expects to be the highest interest rate for this economic cycle. Many commercial real estate borrowers are expected to struggle as lower-rate loans mature and are replaced with higher-rate loans. At the start of May, the Prime Rate was 8.0%, up 4.5% from last year. The Prime Rate is the rate that banks charge their best clients. Some loans are based on LIBOR aka the London Interbank Offering Rate. Three-month LIBOR was 5.3% to start May.
A look at the 10-year Treasury bond rate tells us that market participants do not believe that rates will remain at current levels high for very long. Where the 10-year Treasury hit a peak rate of 4.06% at the end of February, it stood at 3.5% at the start of May despite continued Fed Funds rate hikes. Compared with this time last year, the 10-year is only 0.5% higher. In contrast, the 3-month Treasury bill at 5.2% is more than 4.25% higher than this time last year.
A 30-year fixed rate mortgage hovers around 7% while a 5/1 ARM is 5.75%.
Rate increases by the Fed seem to be having their intended consequences on inflation. In June of last year, inflation was 9.1%. As of the end of March, inflation was down to 5.0%. Expectations are that additional declines in inflation will be more difficult to achieve due to higher labor costs. As such, the Fed may have to amend its objective of a 2% inflation rate to a more reasonable 3-4% level.
A look at the M2 money supply (money in the bank accounts and mattresses of people, not government or business), shows that it peaked at $21.7 trillion in March of last year. At the end of March 2023, M2 was $20.8 trillion, down $500 billion in one quarter marking one of the steepest declines in decades. This is not a surprise as the government pumped historic amounts of money into the economy during and after the pandemic. In February 2020, M2 was $15.4 trillion. M2 grew by $5.2 trillion during the two years of the pandemic and another $2 trillion over the next year.
The large money supply is likely to lead to a period of stagflation. Stagflation is normally a mix of high unemployment and stagnant demand. This time we are likely to see a variation where wages grow at a slower rate than inflation where the economy stagnates. With an unemployment rate of less than 3.5%, the impact of stagflation will be muted by better employment levels than would typically be the case.
While this sounds dire, the downturn is not expected to last for very long. While that sounds good to the employed, those looking for work will hardly find solace in this muted optimism.
Optimism is due to the stronger financial health of many individuals and businesses as we enter the long-anticipated economic slowdown. Additionally, the debut of ChatGPT may usher in a period of increased output like the debut of the iPhone 16 years ago. Over time, its impact may be similar to the early computers.
ChatGPT (Generative Pre-Trained Transformer) was developed by the company OpenAI in November of last year. OpenAI was founded by Elon Musk, Ilya Sutskever, Amazon Web Services, Peter Thiel and a few others in 2015. Google has its own version named Bard while Facebook aka Meta has LLaMa. Each of these services offer the ability of a chatbot to do many of the tasks that a person would do. It can have human-like conversations while learning from the data fed into it.
While near-term concerns are for a weakening economy, every day we get closer to the next big thing that can power the economy to higher levels as other technological developments have done.
Haddon Libby is the Founder and Chief Investment Officer of Winslow Drake Investment Management. For more information on this Registered Investment Advisory firm, please visit www.WinslowDrake.com.