A friend of mine was often fond of asking “who is going to be left holding the dogs”? The “dogs” here were long-term US Treasury Bonds, and this question came up in every conversation about the likelihood of a rise of interest rates.
The failure of Silicon Valley Bank spectacularly identified one such bond holder; but this is an especially egregious case of financial mismanagement. Every bank and asset manager is holding treasury bonds. These bonds represent the world’s biggest market for high quality assets. The question isn’t whether you hold them at all, but how well you manage the interest rate risk that’s inevitably part and parcel of every fixed income portfolio.
The basic business model of banks is transforming short term liabilities into long term assets. Well managed banks have a multitude of ways to hedge the duration risk of their assets. When they don’t, losses are inevitable. And when depositors lose confidence, whether because of losses or other factors, no bank – no matter how well managed or well regulated – can survive a bank run.
There is no fundamental reason, in our view, for the jitters we are witnessing to metastasize into a systemic banking crisis to the magnitude of 2008. Large banks have better capitalisation and higher liquidity ratios than at any time in their history. Credit Suisse’s troubles were rooted in issues that predate interest rate movements and should be seen as a separate issue. Credit Suisse had been running losses for several years. The actions of the Fed and other central banks may well have been the right action in minimising panic from spreading much further. Concerns around the valuation of the assets of European banks since the transition from negative to positive rates are valid.
Regardless of policy measures to assuage investor concerns, the higher interest rate environment is likely to mean that credit conditions will remain tight in the months ahead. Smaller financial institutions will be under greater pressure than larger ones to maintain high liquidity buffers. Given the preponderance of smaller institutions in the growth of credit extension, this will have knock-on effects on economic activity. The probability of a global recession – which was already very high – has just risen further.
The question of whether advanced economies will experience a recession this year, however, is not highly contentious among economists. The big economic debate revolves around the trajectory of interest rates.
Markets have widely vacillated between expectations of further rate hikes, and significant rate cuts later this year. The short run is data dependent, and possibly a less important question than the long run: will interest rates 5 years from now be within the ranges that prevailed before the Covid crisis, or those that prevailed before the global financial crisis? This is the most consequential question because the level at which interest rates will settle underpins the fair valuations of both bonds and equities.
The answer to this question depends on how the real neutral rate of interest of the economy has evolved over time. By this we mean, the rate of interest that does not stimulate nor restrict economic activity, or put another way, the rate of interest that equates demand with the potential output of an economy and equates available savings with investment.
This real rate of interest is a theoretical concept that we cannot really observe with any degree of certainty. Economists have developed various ways to come to an estimate, but there is a considerable variety of opinions on this matter. Consequently, there are very big differences in opinion. Yet, the answer to this question is possibly the most consequential for monetary policy makers, and hence the economy and markets. Because of the uncertainties around this estimate, central banks proceed with action while having only a rough idea of when they will pause.
There are many that believe that the real neutral rate of interest in the US is no more than 0.5%. This implies that – with current market expectations of long-term inflation of 2.5% - the neutral rate of interest is 3%. With the Fed’s rate approaching 5%, if this view is correct, monetary policy is already very restrictive.
Those that hold this view base their argument on several factors. First, that the neutral rate of interest has been declining steadily for 35 years. Thus, the interest rate environment that prevailed since the global financial crisis is not an anomaly driven by policy action, but part of a long-term trend. These factors include a decline in productivity growth, and the success of central banks in controlling inflation. The factors underlying the current bout of inflation, in their view, remain mostly transitory.
There are many others that believe that we are in fact entering a new era for interest rates, and the neural real rate of interest has shifted up to perhaps as high as 2%, in line with the estimates before 2008. This will imply that today’s federal funds rate is about neutral, and the Fed needs to raise rates further so that inflation does not become too entrenched.
They support their argument by several factors. First, that there is considerable evidence to suggest that higher debt levels imply higher equilibrium interest rates. Second, that demographic trends (aging populations) imply that the number of “spenders” (retirees) is growing faster than the number of savers (workers), which means less demand for US Treasury bonds. Third, that the deployment of new technologies (robotics) will raise productivity by increasing the output per worker. Higher productivity means higher growth and hence a higher neutral rate of interest. Crucially, they would argue that the Fed has lost some of its anti-inflation credibility when it shifted its 2% target from being a ceiling to being an “average” without specifying a time frame.
We tend to find the latter position more persuasive than the former. Additionally, we believe that the transition to green energy will need to be financed by debt, which will put upward pressure on interest rates. “Reshoring” and “friend-shoring” of production away from China will necessarily imply higher costs and will not support a fall in inflation expectations.
We therefore think that a Federal Funds rate of about 4% is about right for a neutral environment. And under circumstances when the economy is not heading into a recession, long term yields need to be higher than that by about 1%. The 10-year treasury yield moving back to 5% is not an unreasonable expectation.
In the near term, the situation is likely to remain complex. If banking sector concerns persist, the decline in credit extension will tighten financial conditions enough to reduce inflationary pressures and tip the economy into recession. This means that the Fed will not need to raise rates much further. Long term rates will be capped by the current uncertainties. This is an environment where short duration fixed income will continue to offer the best risk-adjusted returns.
Our view on the neutral rate of interest, however, also means that we need to see a significant downward adjustment to equity valuations to reduce our currently high allocations to cash and short-term bonds. If 4% is a fair short-term rate, the S&P’s current PE of 18, means an earnings yield of 5.5%. A 1.5% difference simply doesn’t justify taking much additional risk.