The Wall Street Journal's in-depth analysis: After an aggressive monetary policy cycle, a financial crisis is not far away!

Interest rates are soaring, will the financial crisis be far behind? Maybe, but things are often not that simple.

This week, the 10-year Treasury yield topped 5% for the first time since 2007. While not high by historical standards, it is a significant change from the less than 1% rate seen through most of 2020.

James Grant, founder and editor of the Grant Rate Observer, said: "The problem is the structure created by a decade of ultra-easy money, which people blame on interest rate normalisation, and the last round of abnormal rates was the problem."

We have had two crises since interest rates began to rise in 2022. In the US, soaring rates triggered regional bank failures earlier this year. In the UK, leveraged pension funds were hit by rising rates a year ago. In both cases, the government intervened to prevent the problem from spreading.

Historically, large swings in monetary policy have increased the likelihood of financial marekt dislocations. A study published in May summarised 150 years of interest rate rises in 17 advanced countries and concluded that "monetary policy hikes that precede a series of rate cuts (or long-term low rates) substantially increase the risk of a crisis." A senior researcher at the Bank of Spain and three co-authors refer to it as the "U-shaped monetary rate path", which increases the risk of a banking crisis through credit and asset price cycles.

Sometimes the causal link between rising interest rates and financial crises is clear. Other times they are more chaotic. Credit losses, liquidity crunches and high leverage often play a crucial role, but the effects of different factors cannot be clearly isolated.

Here are some historical examples:

The savings and loan crisis of the 1980s

In the late 1970s and early 1980s, the Federal Reserve raised interest rates to combat inflation, leaving much of the U.S. savings and loan industry insolvent. The federal government set the deposit rates that savings institutions were allowed to pay, and many customers moved their money elsewhere in search of higher returns.

Savings loans, meanwhile, offered mostly long-term fixed-rate mortgages. As interest rates soared, the market value of these assets plummeted. (Similar scenarios occurred at First Republic, as well as Silicon Valley Bank, which collapsed this year.) Regulators kept zombie savers going for years, and their finances got worse. By the late 1980s, more than 1,000 savers had failed, and Congress approved a taxpayer bailout.

Continental Illinois National Bank and Trust Company

In May 1984, Continental Illinois National Bank and Trust Company was the seventh-largest bank in the United States when the bank suffered a global run on deposits. Meanwhile, the yield on the 10-year Treasury note topped 13 percent, up from just over 10 percent a year earlier. The bank grew rapidly, making risky loans at below-market rates even as interest rates soared. In 1981, a Chicago competitor told the Wall Street Journal, "They also offer fixed-rate loans at 16 percent, and I don't know how they did that."

Banking regulators ended up providing billions of dollars in assistance and safeguards for all depositors and creditors, resulting in Continental Illinois National Bank and Trust Company being dubbed the original "too big to fail" banks.

Black Monday

After-the-fact analysis of the stock market crash of October 19, 1987, when the Dow Jones Industries Average Index fell 22.6 per cent, often points to large losses caused by programmed trading strategies. Margin calls followed, and computerised trading systems of the era could not handle such volume.

But interest rates and money markets are key drivers. The dollar has been weakening against the West German Mark, while the 30-year Treasury yield has surged above 10% from 7.5% in March. When interest rates rise, stocks typically fall because the value of a company's future earnings declines. In any case, stocks continued to rise that summer, setting the stage for a rapid decline.

1994

The Federal Reserve surprised the market by doubling interest rates to 6 percent in 12 months. The increases roiled bond portfolios and Mexico's economy, and exposed a sham trading profits scandal that led to the bankruptcy of Wall Street brokerage Kidder Peabody.

The increase includes a 0.75 percentage point increase in November. The next month, after a series of disastrous and wrong interest rate bets, Orange County, California, filed for bankruptcy and the county treasurer resigned and later pleaded guilty to fraud.

The dot-com bubble burst in 2000

Speculators are disillusioned with the next hot dotcom darling, and they don't care about investment fundamentals. There are many reasons why the dotcom stock bubble burst.

But the Fed did raise rates six times, from June 1999 to May 2000. The last time it raised rates by half a percentage point, to 6.5 percent. By then, the bubble had burst. By 2003, rates had fallen to 1 percent, setting the stage for nearly two decades of low rates.

2007-09 recession

Here, the Fed is blamed more for keeping interest rates too low than for raising them too high. From June 2004 to June 2006, it raised rates 17 times, by a quarter of a percentage point each. Signs of this were already emerging when the housing downturn stopped. In 2007, the financial crisis erupted and the Fed resumed cutting rates later that year.

For millions of Americans, the impact of rising interest rates hits their pain points directly as they take out adjustable-rate mortgages, which are rescaled when the lowest interest rate matures. Often, customers can only pay the original advance rate, and lenders don't care because they quickly sell the loans in bundles to investors backing complex mortgage bonds.

The ensuing credit losses may have been caused more by lax underwriting standards than by rising interest rates. Still, higher interest rates on loan replacements have led to a record number of redemption rights forfeited.