What can we learn from the 2006 Fed Fund Rates

Mark Twain famously said, history doesn’t repeat, but it often rhymes. So let’s see if what happened in 2006 when the US Fed Fund Rate reached 5.25% could rhyme with 2023 as the rates reach the same level.

Rate Hikes and Timeframe

From May 2004 to June 2006 the US Fed increased the Fed Fund Rates from 1% to 5.25% (Red line). This is a 4.25% increase over a period of 23 months and it was then kept at that level for roughly 18 months. In Feb 2022, inflation in the USA hit almost 8%. In an effort to try and curb exploding inflation, the Fed started increasing the rates from 0.25% all the way back to 5.25% in May 2023. But this time around it’s a 5% increase in 15 months. So comparatively, this time, the rates were increased faster and for a bigger range. Noteworthy, in May 2004 inflation was at 3.5%, so not really problematic.

What were the consequences in 2006

After stopping the rate hikes at 5.25% and keeping them there for 18 months, the consequences started to appear. Over the course of the next two years, US unemployment went from from 4.7% to almost 10% in Oct 2009. The S&P 500 (or the US Stock Market) crashed by 55% during the same period. This caused the 2008 – 2009 financial crisis where in 2008, only 25 banks with half a trillion USD under management, collapsed! It is important to note that the 2009 financial crisis was exacerbated by the Sub-Prime problem that also caused the Real-Estate Market to crash.

How does this compare to today?

As mentioned above, this time around, rates went up more (an additional 1%) and in a shorter timeframe (15 months Vs 23 months). Although we have not even started the period of sustained rates at 5.25%,  the first consequences are already here. Three major banks in the US holding half a trillion USD are failing (see below chart from the @NYTimes). Keeping in mind that this time there is no Sub-Prime problem, we can also see demand for Mortgages collapsing (CNBC reports a 28 years low) and the Real Estate market showing its first signs of weaknesses. This being said, at this point in time, employment and the stock market remain strong.

The Lag Effect

Where a lot of people understand correctly the consequences of the recent Fed Decisions (in this case destruction of demand to curb inflation), what they often get wrong is how long it takes for the them to materialize. This is because of the “Lag Effect”. It takes about 12 to 18 months for the consequence of a rate hikes to have an impact on the economy (see first graph). The recent bank failures are therefore the first consequences of the hikes that happened in Feb 2022.

Many are now expecting the Fed to hold the rates at 5.25% for an as yet unknown period of time. The Fed could even hike the rates further if inflation stagnates. If we believe 2023 could rhyme with 2006, the economy should contract into a recession in the next 12 to 18 months.  So all eyes on the unemployment rates, as this is the last domino to fall. Many say the Fed can just cut the rates if things start to look ugly, and they will, but this too has a lag effect.

Bitcoin and the unknowns

One important difference between 2006 and now, is the size of the debt that has to be serviced. In 2006 it was $8.5T and 65% of the GDP. Now it is $31T, 123% of the GDP and the ceiling needs to be raised. This could eventually force the Fed to cut rates faster than it normally would. If this happens before inflation is under control, things could get… ugly.

Another big unknown, is how would Bitcoin (and other cryptos) perform during a recessionary period. We don’t really know this as Bitcoin was launched in 2011 as reaction to the 2009 Financial Crisis and has only know a period of sustained growth since. One exception however  was the “COVID flash recession,” that cause Bitcoin to also correct significantly.

To this date, Bitcoin remains a “risk on” asset highly correlated to the stock market. Many are hoping for the decoupling of Crypto from the stock market to come sooner than later but we might not be just there yet. Time will tell, but in the meantime, a prudent approach on risk on asset could be advised.

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