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The world's about to hit a brick wall

This is an edited transcript of a video talk given by geopolitical strategist, Peter Zeihan, on the intended and unintended consequences of recent Federal Reserve rate hikes.

I thought it would be a good idea to give you an idea of why the Fed is doing what it's doing and what that means for all of us.

Normally, interest rates are a tool that are used to regulate demand – the idea being that when demand falls, you want to lower interest rates so you can get them back up and get some normal economic activity moving again.

And in the case of the United States, most of the demand is coming from the millennial class, people who are aged in their 20s and their 30s - which is normal. This is the age group that's usually buying homes and raising kids and buying cars. And in that, this is no atypical period.

But when the Federal Reserve looks around the world, they're discovering that the millennials in the United States don't have a lot of peers around the world. There aren't really many German or Chinese or Japanese or Korean millennials at all.

So, it's not that the Fed is overly concerned about the current economic conditions with inflation – well, although they are – but they're really thinking to what happens the next time. Because we have a number of countries who cannot increase interest rates enough to regulate demand, because they don't have demand. If they raise them too high, too fast, or really moderately at all, it will be their last economic expansion.

And even before you consider the economic impacts of things like the Ukraine war, this was always going to be the end of the road for a lot of East Asia and Europe, it's just down to the numbers. When the Federal Reserve is looking at this, they know this tool will work for us, but it won't work anywhere else. That means the next time American demand falters, the next time the United States falls into recession, it better make sure it has as many monetary tools as possible.

The Fed is not going to stop when rates get to 4%. They're probably not going to stop when rates get to 6%. 6% is kind of like their minimum for what they need in the mid-term to deal with the next economic crisis.

There's going to be a lot of whinging

So, you shouldn't expect the Fed to stop because there's a lot of whinging. Now on the topic of whinging, there's going to be a great deal, and I would say that it comes from two places. Number one are those industries that have boiled up over the last 15 years in an environment of basically having free capital. We had interest rates at zero for a decade, and in many cases, interest rates went negative either because of central banks doing it directly like they did in Europe, or indirectly like the United States did with its quantitative easing programs. But regardless, when money is free, all kinds of weird things happen.

Past periods of low interest rates gave us the Chinese boom. Well, that's over. Past periods gave us the Japanese boom. That's over. Past periods gave us subprime. That's over. In the current boom, we're getting crypto currency. And this is no different from any other technological marvel that we've had in previous economic expansions.

The tech sector in Silicon Valley writ large is more aware of this. They've been around a little bit longer. But it's no surprise to anyone in San Jose that they're facing massive crunches, because ultimately tech requires a lot of young people and a lot of capital. The capital is necessary to pay the young people to do all the big think work, to operationalize the technologies, to prototype it and then to get them out there and keep them updated. That's all very expensive.

If the cost of capital doubles, quadruples, or more, that becomes harder. Whether it's a perspective technological marvel or something that's a little bit more bread and butter, like say, Twitter or Facebook or Tesla, you should expect a lot of whinging as they're dealing with a capital environment that their business plans were not designed for.

Millennials will be crunched

Second – the millennials. The millennials, the oldest ones, were born in 1980, which means that they have not had any experience with high interest rates and high capital costs their entire adult lives. And yes, we have all heard about how life for the millennials has been so hard. But now it's going to be hard with 9% interest rates.

I'll give you an idea what that feels like. At the fourth quarter of last year, it was still possible to get a mortgage in the US at a 3% rate. By the end of the first quarter of next year, it's going to be impossible to get one with less than a 9% rate, and that 6-point increase from 3% to 9%, that increases the monthly payout or the monthly payment requirements for your mortgage by 50%.

And look at your mortgage. Could you afford one that is 50% higher? Now, apply that across the entire millennial cadre for people who are in their first or maybe second home and think about what that does to their life choices, think about what that does to their political decision-making. We're about to experience that on mass. The annual payments that the federal government has to make on interest will go up by at least 0.5 trillion. That's just kind of baked into the pie right now.

Germany is a big worry

What does this mean on the broader scale? Well, it's actually worse than it sounds, because while interest rates are going up rapidly in the United States, remember they can't go up as rapidly everywhere else. If you've got a bunch of money in a foreign country and you want to invest it somewhere, you want to put it in a rock-solid asset, preferably one guaranteed by the government, you want to put into a place that preferably has an appreciating currency, and you want to put into a place where the underlying economic growth is stable to positive. Well, at the same time as rates are going up, we're also going to be seeing the United States hoovering up capital from the world over.

And the country that I am most worried about is Germany. Germany has run a very tight ship from a fiscal point of view for decades. However, the financial crisis that the Europe is brewing up because of what's going on with interest rates here [the US] and the capital transfers and the capital flight combined with the Ukraine war, which is crashing energy supplies to the German system and sending prices through the roof is damaging the entire economic model of the country.

Also, Germany doesn't have a lot of young people anyway, so they depend upon exports. And anything that slows down the world writ large is devastating for them. And now, this is all hitting at the same time.

But finances in Germany are relatively liberalized, so that people can get their money out to safer places. Germany is likely to be the first of the European countries to enact broad scale capital controls because very soon they won't have a choice.

Whether it is crypto, or millennials, Germans, get ready for a lot of complaining. This is going to get a lot worse before it gets better. 

 

Peter Zeihan, founder of Zeihan on Geopolitics, is a geopolitical strategist, speaker and author. This article is general information and does not consider the circumstances of any investor. This article is an edited transcript of Peter's video, Implications of Rising Interest Rates, posted on 3 November 2022.

 

6 Comments
Peter A
November 22, 2022

At the beginning of a 30 yr mortgage, the capital repayment is aprox 1-2 % of the balance.
Eg, 1.5% capital + 3 % interest = repayments of 4.5% of the loan balance.
Vs, 1.5% capital + 6 % interest = repayments of 7.5% of the loan balance.
66% increase in monthly payments.

Mb
November 21, 2022

It may get to a point where a mortgage is not paid off in your lifetime, effectively you will have a lease on your home with the bank, leaving an interesting conundrum when it comes to passing on your partial asset to your children.

Geoff F
November 20, 2022

Fascinating insight/perspective, thanks Peter Z.

Dudley
November 17, 2022

"At the fourth quarter of last year, it was still possible to get a mortgage in the US at a 3% rate. By the end of the first quarter of next year, it's going to be impossible to get one with less than a 9% rate": Look on the bright side, home prices would halve. Per $1 of annual mortgage payment, home price would change from: = PV(3%, 30, -1, 1) =$19.19 to: = PV(9%, 30, -1, 1) = $10.20 With 9% interest on savings, millennials could eschew the smashed avocado, save and buy a home cash on the knocker.

David
November 16, 2022

"and that 6-point increase from 3% to 9%, that increases the monthly payout or the monthly payment requirements for your mortgage by 50%."

Looks more like a 200% increase to me!

David
November 16, 2022

Sure you're not taking ONLY the interest into account? People have to pay off the principle off as well. If your mortgage interest rate doubles from 2% to 4% your minimum required payments do not double.

 

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