Feeding The Bear
- Ryan Bunn
- Sep 21
- 4 min read
Rising interest rates provided stimulus to savers — Cutting rates will remove this interest income — Contrary to popular belief, cutting interest rates may harm the economy.
FEEDING THE BEAR: Why Cutting Interest Rates May Harm The Economy
Conventional economic wisdom suggests lower interest rates will result in a better economy and higher stock prices.
Lower interest rates reduce the cost of capital for businesses, spurring investment and driving demand. Lower interest rates also drive the TINA (“there is no alternative”) phenomenon. Investors seeking a targeted level of return have no choice but to buy more equities to hit their return hurdles as interest rates decline.
This wisdom has held for the past few bond cycles. Rates rose from the early 1960’s to the early 1980’s, a period where stocks delivered a dismal 1.4% annual real return. The trend changed after Paul Volcker “broke the back” of inflation. Equities rose 11.5% annually, again in real terms, as interest rates declined. When Greenspan and Bernanke raised rates in the early 2000’s the Great Financial Crisis took hold and stocks underperformed again. The response to the GFC, declining rates and quantitative easing, supported equities until the brief Covid crisis.
The End of the Trend
In 2021, inflation returned and the US Fed raised interest rates. In a rising interest rate environment, equities briefly took a step back. But then conventional wisdom broke.
Equity markets soared in 2023 and 2024, despite interest rates rising. Liquidity has continued to flow into the stock market even as investors have an alternative: 4% interest payments on their savings. Rising interest rates have not had a negative impact on equity valuations as the S&P 500 continues to trade at over 25x P/E.
The reason rising rates have not been a drag on the stock market is the “shadow stimulus” created by the interest rates themselves. Massive interest payments on our bloated federal government debt, a stimulus that has not existed in past cycles, may be propelling equity markets higher.
Interest Rate Stimulus
Interest paid by the US government is a function of interest rates, the amount of government debt, and how the government decides to finance its debt.
US government debt was <40% of GDP in the early 1980’s. Interest rates had to soar to double digit levels before interest payments rose to over 2.5% of GDP. But with these high interest rates, and a growing government debt level, interest payments reach 3% of GDP and provided a tailwind to equity markets in the early 1990’s.
In the late 1990’s, US government debt levels declined, resulting in declining interest payments. As this liquidity was pulled from the market US investors ran straight into the Tech Bubble.
Equity markets did not soar again until the period after the Great Financial Crisis. This period appears to contradict our argument, as interest payments remained low. But during this time period the Fed began its policy of quantitative easing, massively growing its balance sheet and providing plenty of stimulus in an absence of substantial government interest rate payments.
2022—2024
In 2022, as the Fed raised interest rates and simultaneously began to shrink its balance sheet, the US equity markets momentarily suffered. Monetary policy was solely focused on addressing inflation and slowing an overheating economy.
But the combination of massive US government debt (over 120% of GDP) combined with higher interest rates has resulted in US government interest payments once again rising to over 3% of GDP, a massive fiscal stimulus. This surprise stimulus has propped up US GDP and supported equity markets despite rising rates.
In 2024, government interest payments were nearly equal and offsetting to the run-off of the Fed’s balance sheet. Just as monetary policy tightened, fiscal policy, via interest rates, stepped in to save the day.
But now interest rates are on the decline, which will reduce US government payments.
The last time US government interest payments declined from over 3% to less than 2% of GDP we experienced the Tech Bubble. So what happens next?
2025 and Beyond
As the Fed reduces interest rates we see the potential for a counter-intuitive impact on the markets. Just as the market did not decline when rates rose, due to the shadow stimulus of government interest payments, an opposite reaction could occur as rates move lower.
The Fed continues to shrink its balance sheet. As rates decline, so will government interest payments. If fiscal spending does not grow to offset declining interest payments, the market may suffer as liquidity is removed.
If the stock market declines it will be hailed as the bursting of the AI bubble. In reality, the driver of a market rout will be declining liquidity. The move that the market expects to drive the next bull market—the Fed’s cutting of interest rates—may actually begin the process of removing liquidity and seeding the next bear market.
Sources: