In the Trenches: As Good As It Gets

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In the first installment of In the Trenches on October 29th (A False Sense of Stability), I wrote: “It’s a matter of when rather than if — the Minsky moment is becoming more palpable. The stability caused by a decade of central bank financial suppression has led to the unintended consequence of creating a more fragile global financial system… one more vulnerable to shocks. The next shock is likely to be one of central banks’ own collective design.” The most recent decade of central bank financial suppression covers only the most recent cyclical rates trend. Importantly, this policy cycle was augmented by an almost 40-year secular rates trend towards zero.

Why is this significant? Unlike any cycle in recent memory, the sun is concurrently setting on both trends. A generation of investors has Paul Volcker to thank for almost 40-years of slowly falling rates. This trend contributed to asset appreciation in the housing, credit and equity markets. He handed countless baby-boomers a free 100 points of investing IQ, for which most never thanked him. Is it a coincidence that many of the world’s renowned, cult-status investors began their careers in the late 1970s? For long-term investors, the last 40-years were likely as good as it gets.

Volcker, now 91 and in ill-health, is six-foot seven-inches tall. Even more extraordinary than his stature was the courage he demonstrated in his campaign to quell inflation after the 1970’s oil price shock. U.S. inflation peaked at ~14.8% in March 1980. In response, Volcker raised the federal funds rate, which had averaged 11.2% in 1979, to a peak of 20% in June 1981. A recession ensued, but as a result, by 1983, inflation fell below 3.0%. This courageous action elicited political attacks and widespread protests, as high rates temporarily overwhelmed construction, farming, and industrial sectors. In his recent memoir, Volcker recounts how James Baker, in the President’s library next to the Oval Office, asked him on Reagan’s behalf not to raise interest rates before the 1984 election. At that time, he had no plans to do so. In fact, in 1981 into 1982, the Volcker Fed had already begun to ease, helping lead to a resumption of economic growth and setting the stage for a multi-decade secular slide in rates.

Figure 1 illustrates the secular trend in 10-year yields as well as the cyclicality withinthe trend. These cycles generally occur alongside Fed policy action and always in response to economic or financial conditions. The trend demonstrates that peaks in cyclical long-rates (as denoted by the dotted vertical lines and red circles) correspond to local peaks in equity market prices (bottom panel). It is unlikely a simple coincidence that equity volatility picks up in every instance the 10-year yield rises to the secular trend line. As denoted by the red circle at farthest right, rates approached the secular downtrend line in October 2018. The intersection was almost immediately followed by a risk-off not just in equities but also in the corporate credit markets. This cyclical intersection with the secular trend was exacerbated by the Fed’s “mistake” in its December meeting when Chairman Powell expressed seeming intransigence around balance sheet reduction. The Fed communication added insult to injury as the European Central Bank (ECB) ended quantitative easing (QE) the week before.

We did not, however, expect the Fed to make this mistake so early. Indeed, my team and I wrote in late October and again in November that “the Fed is likely to stay the course and raise rates into 2019 based on a false sense of U.S. domestic economic health – largely fueled by the impact of misguided and temporary fiscal policy – at exactly the same time the rest of the world slows and the U.S. housing market cools. The feedback from the global slowdown, which is ironically being caused by higher U.S. rates, will bleed back into the U.S. economy by mid-2019. Europe’s woes will be an important component of the global slowdown story, too. Adding likely housing weakness to the mix paints an even stormier picture for 2019.” So far at least, this is playing out. Subsequent to the December miscommunication, we suggested the Fed would walk-back, and it has. The Chairman and various Governors, including Bullard and Clarida have conveyed a more ‘flexible’ message. Markets responded, and our call for a bounce in U.S. equities was finally realized.[1]

Unfortunately, while we believe the Fed stops hiking this year, it will be too little too late. A prolonged use of monetary policy, especially when extended across the entire term structure of rates, is tantamount to setting a maximum cost of capital.  Were central banks to articulate policy by explicitly saying they were going to set prices rather than use monetary policy tools, would not public perception of Fed action be different?  We think it would. It might remind market participants of other such episodes in history.[2] A 20th century example of price controls might be the Hepburn Act, a 1906 law that gave the Interstate Commerce Commission (ICC) the power to set maximum railroad rates, amongst other broadened powers. The ICC’s authority enabled it to replace market rates with “just and reasonable” maximum rates. Some argue that the passage and enforcement of the Hepburn Act led to the unintended collapse in rail shares that exacerbated the Panic of 1907. So, what unintended consequences might the Fed’s setting of maximum prices for capital costs have today?

When the Fed wonders why the ‘neutral rate’ is so low or why term premia never widened as in previous cycles, it need look no further than – itself. Markets are now dependent on low rates, and there is a reflexive mechanism at work. Consider that the Fed funds rates had historically been generally managed into a channel using what the Fed calls temporary open market operations or OMOs. While QE is simply an extension of this idea to ‘permanent’ OMOs, QE’s suppression of term-premia – over which market forces normally dominate – is a powerful tool. Suppression of term premia enables corporations and individuals to term out maturing obligations and prevent defaults. Another unintended consequence is a propensity for firms and individuals to overinvest in low ROA projects because capital costs are artificially lower than hurdle rates. Overinvestment tends to suppress inflation – in turn, this keeps term premia low. Importantly, companies adjust their expectations and behavior. They become reliant on low rates, which makes it difficult for the Fed (and other central banks) to move off the zero bound.

As the maximum price for capital costs is reset, companies reliant on low capital costs ought to suffer. This does not happen overnight, as many companies have termed out their obligations. However, it will begin to happen as maturities grow in 2020 through 2022 when some firms look to refinance obligations. For other firms reliant on bank loans, they will feel it even sooner, as short rates have quadrupled over the past two years (from .61% in January 2016 to 2.8% 2-years later). Many more firms are reliant on bank loans this cycle than ever before as commercial and industrial loans outstanding approaches $2 trillion. This is two standard deviations above trend for loans outstanding. Not only will refinancing risk increase for these firms, but interest expense ought to rise. Companies will feel this impact all the more as global growth slows, and as they draw on revolvers to fund operations. Yes, U.S. rates remain historically low, but actors within the economy have adjusted to low rates and are now dependent upon them.

Here’s one final point: there’s little incremental benefit to the economy or markets from squeezing rates back to the zero-bound. In the two most recent cycles, an average federal fund target rate cut of 5.5% was implemented. A move back to zero from 2.5% is likely to fall short. The next cyclical downturn in the economy may require steps beyond rates policy and QE as currently conceived. If a wholesale debt “monetization” were to take place, would this not send the message that these policies were artifice all along? This is why central banks should look to normalize now. This is why it will be so hard for Chairman Powell to pivot even as global growth slows. The credibility of monetary policy itself is at issue. Now, market participants must reshape their thinking and prepare for the unexpected in markets and for the unexpected responses from the Fed and other central banks. Yes, it is different this time. Monetary policy was as good as it could ever get for market participants.


[1] We think the bounce could extend as high as 2,800. For U.S. equities, we suggest 2019 is likely to be a tale of two halves. The first half (or perhaps even just the first quarter) may well see U.S. equity markets generally rally on improved central bank communication, the perception of reasonable valuation, and optical improvements around trade with China. Unfortunately, we think any central bank pivot will end up being too little, too late as the global economy weakens. Moreover, in any severe downturn, it would quickly collide with the secular rate boundary – zero. Thus, we feel the second half of 2019 will be more volatile than the first, and U.S. equities may again experience negative returns for the year.

[2]  One of the earliest recorded examples of a government fixing prices (in this case to a maximum) was Diocletian’s Edict on Maximum Prices in Rome in around 300A.D. In fact, this edict was needed because Roman currency had been debased by profligate production, which caused inflation.  Lactantius, an early Christian author who became an advisor to the first Christian Roman emperor Constantine I, wrote that Diocletian “by various taxes he had made all things exceedingly expensive, attempted by a law to limit their prices… Until, in the end, the [price limit] law, after having proved destructive to many people, was from mere necessity abolished.” The unintended inflationary consequences of a variety of policies (currency debasement and taxation) led to an attempt to limit prices, which further distorted markets.


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Mike S
Member
Mike S

Among the major central banks in the world, the Fed stands out as the only one that is pursuing a policy of increases in its nominal interest rate target. This policy, referred to as “normalization,” was initiated in December 2015. Normalization, however, is projected to take place slowly and is not motivated explicitly by Neo-Fisherian ideas, though James Bullard, president of the Federal Reserve Bank of St. Louis, has shown interest. What is the risk associated with Neo-Fisherian denial—a failure to take account of the Fisher relation in formulating monetary policy? Neo-Fisherian denial will tend to produce inflation lower than central banks’ inflation targets and nominal interest rates that are at central banks’ effective lower bounds—the low-inflation policy trap. But what of it? There are no good reasons to think that, for example, 0 percent inflation is worse than 2 percent inflation, as long as inflation remains predictable. But “permazero” damages the hard-won credibility of central banks if they claim to be able to produce 2 percent inflation consistently, yet fail to do so. As well, a central bank stuck in a low-inflation policy trap with a zero nominal interest rate has no tools to use, other than unconventional ones, if a recession unfolds. In such circumstances, a central bank that is concerned with stabilization—in the case of the Fed, concerned with fulfilling its “maximum employment” mandate—cannot cut interest rates. And we know that a central bank stuck in a low-inflation trap and wedded to conventional wisdom resorts to unconventional… Read more »

Sandy McIntyre
Member
Sandy McIntyre

A couple of questions. If nominal GDP is the sum of trailing growth rates in working age population, productivity & inflation; how can declining growth rates in these three series lead to structurally higher NGDP growth & higher interest rates? 2018 was debt fuelled growth advanced from the future. Using trailing 10 yr growth rates for the 3 series, NGDP potential is around 3.2%; real sub 2. Track potential NGDP using trailing 10 yr growth rates for the 3 series and the realized R squared is > than 90%. Then smooth USGG10YR index (constant maturity 10 Yr) and you have a crazy graph. The belly of the curve has an amazing correlation to potential nominal GDP. Is this why rates in countries with declining working age populations have structurally low rates? Question 2; if QE and central bank distortions of interest rates are the only reason for low bond yields, why have yields remained low and in recent months declined as the FED’s reserves have declined? Could there be primary investment flows that actually affect rates more than the FED? Since 2007 flows into combined fixed-income mutual fund and ETF portfolios are double the flows into equity funds. Did record flows into fixed income over the past three years have any affect on rates? On the aggregate quality of fixed income indices and ETFs? As an aside, capitalization weighted indices might make sense in equity markets: winners have the biggest impact. They make no sense in debt markets: biggest borrowers… Read more »

Nicholas Allen
Member
Nicholas Allen

The Fed seems to try really hard to not let their rate deviate too far below LIBOR. LIBOR’s continued rise is why I thought they would hike in December despite the perception of a slowing economy, and they did exactly that. If LIBOR continues to rise do you think they’ll continue to try to stay within shouting distance, or will they accept the risks associated with the deviation and try to avoid being blamed for any downturn by holding off on rate hikes?

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