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Good morning. Yesterday, the Federal Reserve said exactly what everyone thought it was going to say, but, as usual, the market found something in the press conference to get worked up about. More on that below, and on the long-term outlook for bonds. Email us: [email protected] and [email protected]
The Fed doesn’t have a plan, and neither do you
Jay Powell ruled out a plan the Fed never articulated, and markets rallied. That’s the short version of yesterday’s meeting and the overeager reaction to it. A 75 basis point interest rate increase was never really on the table, save for some heavily caveated musings from one Fed official. But markets, poised for a hawkish surprise, were wrongfooted after Powell said such an increase was not being “actively” considered. Immediately after the words left Powell’s lips, the S&P 500 rallied nearly 3 per cent and bond yields fell.
This seems odd to us. Powell’s message was not a dovish one. In yesterday’s press conference, he promised a sprint toward higher rates, partly in 50 basis point increments. The hope is to get near the 2-3 per cent “neutral” (ie, non-accommodative) policy range while engineering a soft landing — that is, moderating inflation without a harsh decline in growth. This will be very hard, as Powell acknowledged. Maybe so difficult that a “softish” landing should be considered a relative success:
I’d say we have a good chance to have a soft or softish landing or outcome . . . Households and businesses are in strong financial shape, you are looking at excess savings on balance sheets . . . businesses are in good financial shape. The labour market is very very strong . ..[A soft landing] will be very challenging, it is not going to be easy. It may well depend on events that are not under our control. But our job is to use our tools to try to achieve that outcome.
Powell is nudging the goalposts here, which worries some people. One rates trader told an FT colleague this:
We had to giggle when he said softish . . . imagine if you’re on a plane and the pilot says get ready we should have a softish landing. Not particularly comforting.
If you stand up in front of everyone saying softish, imagine what you’re saying behind closed doors — if we have to bring about a mild recession here we’re probably OK with it, given how far we’ve missed on inflation.
There’s room to disagree on what “softish” means, and perhaps a mild demand slowdown is in fact the least-worst option now. In any case, we were spooked by something else Powell said:
It is a very difficult environment to try to give forward guidance 60, 90 days in advance, there are so many things that can happen in the economy and around the world. We are leaving ourselves room to look at the data and make decisions as we get there.
This is not shocking but it is a stark contrast to the blissful market reaction. The macro environment is so unpredictable that forward guidance — one of the Fed’s key tools — is just not reliable. In that context a 75 basis points hike, or more, could suddenly be in play the moment a hotter-than-expected wage or inflation report hits the wires. A data-dependent Fed is a jittery one, and likely no friend to stock investors. As Powell reminded everyone:
Of course if higher rates are required, then we won’t hesitate to deliver them.
The central bank says it is trying to minimise policy uncertainty in a world gone mad. But a mad world can produce nasty surprises. The Fed knows no better than any of us. (Ethan Wu)
Are bonds in a bear market now?
Here’s a view:
Guggenheim Partners chief investment officer Scott Minerd called time on the long-running Treasury bull market, warning interest rates could “trend higher for a generation” as the Federal Reserve tightens monetary policy to combat inflation…
“I have to throw in the towel,” Minerd, who helps oversee $325bn at Guggenheim, said in an interview. “The long bull market run in bonds has come to an end.”
Note that his point is not just that the bull market is over, but also that a bear market has begun. Even after the current Covid/war crisis is over, rates will be on a rising trend, reversing the trend of the last four decades.
The interview does not go into the details of why Minerd thinks this will happen, but the topic is important. Is it the case that (a) the shocks of Covid and war, and the policy responses to them, will lead to an enduring financial regime change, or (b) we were headed for regime change anyway, and the shocks hurried us along?
Possibility (a) seems unlikely. Prior to March of 2020, we had a low-growth world and low nominal and real interest rates. The broad reasons for this had to do with demography, technology and inequality. The population of the world’s biggest economies is now growing slowly. There is no massive, productivity-enhancing technological change occurring. And a growing amount of the world’s wealth is in the hands of the rich, who have a low marginal propensity to consume, putting a lid on demand. All of this depresses real interest rates. Once the current crisis abates — through an immaculate disinflation, a recession or something else — all these things will still be true. Why wouldn’t we return to the secular stagnation of the pre-Covid world?
On possibility (b), that Covid has pushed us more quickly toward a change that was coming anyway, the most prominent view is the one proposed by Charles Goodhart and Manoj Pradhan that I have rattled on about several times before, which is that the disinflationary forces of the globalisation decades are over. The ageing of the global population means that it will be harder to offshore production to low-wage countries, as workers grow scarce everywhere. And as the working-age population falls, so will savings. Less money will chase investment opportunities, and rates will rise.
But there is a second view, which is that we are in a new era not of demographics but of policy. The idea is that we have shifted to a time of monetary and fiscal excess, which will lead to sustained higher inflation and therefore higher nominal interest rates.
Michael Hartnett of Bank America lists the key shifts: “deflation to inflation, globalisation to isolationism, monetary to fiscal excess, capitalism to populism, inequality to inclusion.” Albert Edwards of Société Générale has written that “the pandemic recession has allowed policymakers to cross the Rubicon of fiscal rectitude to reach a new land — one where their existing monetary profligacy can now be coupled with fiscal debauchery”. Nouriel Roubini notes runaway levels of private and public debt, and says policymakers will try to inflate it away: “the path of least resistance is to wipe out the burden of debt with fixed interest rates, with gradually higher and unexpected inflation.” Minerd himself has hinted at this view, as well.
Governments might try to inflate their countries out of debt or print their way to prosperity; I have no idea what the probability of this is. But historical instances of this approach, from Germany to Latin America, suggest that it most often leads to crises, in which higher interest rates are the least of everyone’s problems. Adding sustained, significantly higher nominal interest rates into a long-term outlook, while assuming the political, financial and economic firmament remains broadly stable otherwise, seems very strange to me.
One good read
“Beer and loathing in Durham.”