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Stability Breeds Instability

In the past three weeks, we’ve witnessed a powerful reminder: human nature does not change. My dear friend and former boss, Jim O’Shaughnessy, often says that “human nature is the last sustainable edge” due to its remarkable consistency over thousands of years. Yes, we trade differently than the first speculators on Amsterdam’s stock exchange in 1602, but from a behavioral standpoint, we certainly do not act differently.

“The nerves of the City were rudely upset last week by the Directors of the Bank of England, who exploded a veritable bomb-shell by suddenly raising the official minimum rate of discount. The advance in the rate was small enough, from 2% to 2.5%, and in former days when the course of the Money Market was more or less regular, would have been accepted as part of the established order of things…

Nevertheless, so ready are even the keen-witted men who work the great machine of our credit system to accept an artificial state of things as normal if it only lasts long enough, and to forget in a couple of years the mental habits of a lifetime, that an upward movement in the Bank-rate came upon them like a thunderbolt, altogether disorganising the discount market for several days, and causing a very severe fall in prices on the Stock Exchange…

It is to be hoped that the lessons of the panic will be taken to heart by the bankers, who, by the freedom with which they lent money on securities at low rates, encouraged the growth of an artificial and dangerous state of things. The effects on markets of a trifling rise in the Bank-rate were severe enough to make one tremble at the thought of what might happen if the Stock Exchange, in the inflated and flabby condition caused by a diet of cheap money, were called upon to face a really dangerous crisis.

There are plenty of materials about for a genuine explosion, and it is evident that our credit system owes hearty thanks to the Bank of England for clearing away a great deal of very awkward- top-hamper in preparation for any real gales that may be brewing.”

This passage from over 125 years ago sounds eerily familiar, doesn’t it? In 1896, London’s stock market was rocked “like a thunderbolt” when the Bank of England’s decided to hike rates by a mere 0.5%, from 2.0% to 2.5%. Why? Like today, British investors quickly grew accustomed to an era of “cheap money” and low rates. Coupled with the introduction of securities-based lending, there was an explosion in liquidity and money supply:

“perhaps the most important of all [reasons], the development of the system of lending money on Stock Exchange securities. The result of this last cause was that the issue of new loans and securities, which has proceeded of late with unparalleled rapidity, instead of diminishing the supply of available money, has doubled and redoubled it, — securities, in fact, became part of the currency of the country. Such a system works comfortably and profitably enough as long as the ‘cheap money,’ which is at once its basis and its effect, continues.

As long as a man can borrow money from his banker at 1% and invest it in Colonial loans to pay him 3%… he can make a substantial income by the mere use of his credit backed by the collateral security of the stock that he has pawned; and thus the banks’ deposits are swelled, and the supply of “money” is increased for the use of others who wish to follow this alluring example. But it is obvious that this “money” is mere paper-credit on a very flimsy basis, and that the state of things thus produced is artificial and has a highly demoralizing effect on the nervous system of the City.

Yet, as shown below, this period of cheap money was brief. In fact, 2% was the lowest official interest rate in Britain on record until 2008! Initially, this worked out well as valuations rose and a speculative public became enamored by investing.

Knowing this, experienced bankers and investors in London surely realized that higher rates were on the not-too-distant horizon, right? Ehhhh, no. It did not take long for these experienced professionals to forget everything they had previously known and embrace this new era of cheap money:

“so ready are even the keen-witted men who work the great machine of our credit system to accept an artificial state of things as normal if it only lasts long enough, and to forget in a couple of years the mental habits of a lifetime, that an upward movement in the Bank-rate came upon them like a thunderbolt.”

The Brewery Bubble & Rising Interest Rates

The brewing industry and other sectors benefited from increased speculation and cheap money, as highlighted by Professor John Turner’s lecture in my first online course.  In the clip below, Turner discusses the role that interest rates and credit played in fueling this Brewery bubble:

Following the “happy hour” phase, however, the inevitable “hangover” emerged as interest rates rose and markets waned. Of course, it should have been obvious that interest rates would eventually rise. Predictably, however, this did little to mentally prepare investors.

So, how did London’s financiers and investors fail to anticipate a reversion to the mean through rate hikes by the BoE? Well, for the very same reasons that many financiers and investors are in trouble today: human nature.

Human Nature & The Recent Banking Crisis

While a variety of factors led to the recent banking crisis, rising interest rates are a leading culprit. As one Bloomberg article stated:

An unparalleled era of easy money came to a screeching halt in 2022, as central banks shifted gears to subdue inflation: The US Federal Reserve raised its benchmark rate from near zero to 4% in a mere six months. That speed led to worries that something in the financial system would break, as the tightening of credit revealed previously hidden vulnerabilities.

Those fears seemed to materialize in the failure of two US banks, while global giant Credit Suisse appeared to teeter on the brink of collapse or bailout. The market turmoil that followed raised questions of whether chastened banks would pull back on lending in a way that could tip economies into recession.”

This Bloomberg chart shows how quickly the Federal Reserve raised its benchmark interest rate in different periods. As you can plainly see, one of these is not like the other.

In an era of cheap money, many companies in more “speculative” sectors – like Information Technology – were able to get funding based on growth projections and exciting narratives (see: the COVID SPAC boom, WeWork, etc.). This paradigm only lasted as long as rates remained low, since a company’s runway lasts a lot longer when interest payments on debt are negligible.

But when the Fed’s benchmark interest rate jumps from effectively 0% to 4% in six months? To put it academically: things break! Specifically, many banks at the epicenter of this “crisis” are ones that failed to adequately prepare for a market environment in which interest rates rose, and rose quickly. After fifteen years of effectively zero interest rates, most market participants grew accustomed to endless liquidity and low rates. Why would it ever change?! *whispers*… inflation.

So, as the Fed started hiking rates, those that failed to consider how a higher interest rate environment would impact their operations were hit “like a thunderbolt”. For example, some banks holding assets highly sensitive to interest rate fluctuations were brought to the brink of collapse, or placed into receivership as rates climbed steadily higher and the value of their long-term bonds fell.

Since the Fed began raising rates, the market has witnessed a chaotic transition that left many companies and banks behind. The fact is, many companies and investors are not joining the broader market in this period of higher rates because they failed to prepare themselves during the preceding “era of cheap money”.

The takeaway from all of this? Human nature remains the same, even in the face of financial history repeating itself time and time again. In both 1896 and now, investors and bankers failed to anticipate the consequences of higher interest rates, and the results were strikingly similar.

The work of famed economist Hyman Minsky best captures this problem. Summarizing Minsky’s work, The Economist wrote:

over time, particularly when the economy is in fine fettle, the temptation to take on debt is irresistible. When growth looks assured, why not borrow more? Banks add to the dynamic, lowering their credit standards the longer booms last. If defaults are minimal, why not lend more? Minsky’s conclusion was unsettling. Economic stability breeds instability. Periods of prosperity give way to financial fragility.

As we move forward, it’s essential to learn from history and recognize the patterns in our behavior. Let’s not be caught off guard by the thunderbolt of higher interest rates again. Remember “economic stability breeds instability.”

Missed last week’s article? Catch up here