Well, everyone wants to talk about rates these days and it’s no mystery why.
The Fed is under new leadership at a pivotal juncture. Balance sheet rundown has commenced and the Trump administration has embarked on what multiple sellside desks (see here, here, and here for a few takes) have described as an ill-advised quest to try and supercharge an already hot economy with late-cycle expansionary fiscal policy.
And so, the supply/demand dynamic in the Treasury market has shifted. Financing the tax cuts and increased spending means more supply and with the Fed out of the market, it’s left to price sensitive private investors to provide the bid. This comes as the global reserve diversification debate heats up and as second-order effects of increased bill supply could further sap foreign demand for U.S. debt (see here). To be sure, the market will clear – the question is, at what price?
That gets to the heart of the debate about where yields go from here and the concern is that between everything said above and the suspicion that between fiscal stimulus and now tariffs, price pressures could build quickly, the Fed will be forced to take a hawkish turn that’s not yet priced in by markets. All of these concerns helped fuel the bond rout that conspired with the February 5 vol. shock to send global equities careening into correction territory last month.
Well, one person you might be interested in hearing from on all of this is Jim Grant, and happily, Erik Townsend welcomed him to the MacroVoices podcast this week.
You can listen to the interview in full below, but here are a couple of excerpts that touch on the questions everyone wants answered.
On Jerome Powell:
Erik: What is your expectation? Is Jay Powell a good pick to replace Janet Yellen? Do you think that we’re going to see a change in policy from the Powell Fed as opposed to the Yellen Fed? And what’s your overall reaction to the state of the Fed, so to speak?
Jim: Well, Jay Powell has one commanding credential. And that credential is the absence of a PhD in economics on his resume. I say this because we have been under the thumb of the Doctors of Economics who have been conducting a policy of academic improv. They have set rates according to models which have been all too fallible. They lack of historical knowledge and, indeed, they lack the humility that comes from having been in markets and having been knocked around by Mr. Market (who you know is a very tough hombre).
Jay Powell at least has worked in private equity. He knows a little bit about the business of buying low and selling high. Also he’s a native English speaker. If you listen to him, he speaks in everyday colloquial American English, unlike some of his predecessors. So I’m hopeful. But not so hopeful as to expect a radical departure from the policies we have seen.
And on yields:
Erik:What do you think is driving this backing up of interest rates? And where do you see it going from here?
Jim: I’m a little bit more fatalistic. You know, we have come to accept that financial markets are driven by people and by policies and by personalities. And, what is Chairman Powell going to do? What will President Trump tweet next? As if they were in charge.
Well perhaps sometimes they are not in charge. I have observed over the years that the bond markets have tended to move in generation-length cycles. Anywhere from 20 years to 35 years. This is not an ironclad law of physics, but it is an observation from the middle of the 19th century forward.
So we have concluded (perhaps) the bull market in bonds that began in 1981 and that maybe ended in the early days of July 2016 (I think). So it might just be that interest rates are going up because they are going up. It sounds a little bit mysterious and indeed fatalistic, but I’m a little bit less inclined than others to assign causation to people and policies.
And on the all-important question of rapidity:
Jim: 1946 to 1956. Ten years. Rates went up about ten basis points a year. One tenth of a percentage point a year. Very, very slow and deliberate. Now, I think – not know, mind you – I think the tempo will be rather more brisk.
I say this because there’s more leverage in the system, because there’s more debt around. Although one could argue that the debt is going to constitute a damper on things. I happen to think the debt will, in fact, become a problem that will lead to higher rates. That is another guess rather than a piece of knowledge.
So I’m looking for a bear market in bonds having begun in July of 2016. I think it’s upon us. And I think the tempo will be brisk enough to notice.
Now remember, there’s certainly an argument to be made that when it comes to the rapidity of rate rise, it is sharp increases that cause the stock-bond return correlation to flip positive, an eventuality that imperils 60/40 portfolios and, by extension, risk parity. Recall what happened just 6 weeks ago:
Here’s Jim on risk parity:
Jim: First, risk parity, as you know, is based on the proposition that bonds are inherently less risk-fraught and less volatile than equities. To someone who was around in the ‘60s and ‘70s and ‘80s, that proposition is somewhat contestable. But that’s the idea.
So if stocks are inherently riskier, what you want is to equilibrate risk, so they say. You want to have a parity of risk in the portfolio. And to do this you lever up the bonds. You get more bonds, having financed the increment with borrowed money. And that increment of bonds is going to equilibrate risk with equities, the stocks.
All right, that’s the theory.
Now that may work in a gently trending market. It has not worked at certain times and junctures in which both stocks and bonds decline together. So my sense is that there’s a lot of money in risk parity and that a forceful rise in interest rates, a steep decline in bond prices, is going to force liquidation of some part of the risk parity portfolios.
Oh, and here are some critical bits on inflation:
Erik: One of the things that your answer brought to mind, you mentioned this might be about real rates versus nominal rates. For several years now, deflation has been the backdrop. And everybody says nothing else is possible. It’s almost as if people have forgotten that inflation is a real phenomenon.
Is it coming back? Is it on the horizon? Is it nearby? Or are we still likely to see continuing deflationary pressure in the economy for the next year or two?
Jim: Well, Erik, I happen to be in the inflation camp. I’m most humbly placed there. There are powerful arguments on both sides of the question. But something to bear in mind is that nobody issues a press release at the start of an inflationary cycle. It kind of creeps in on little cat’s feet.
The 1960s are a case in point. In the early ‘60s there were four consecutive years – 1961 to 1962, ‘63, early ‘64 – in those years the measured rate of inflation in the CPI was, if memory serves, less than 2%. In fact in some years it was less than 1%.
Parenthetically, nobody thought that was a problem. That seemed like a good thing. But it was the high noon of Keynesian fine-tuning and the economists thought they had the system figured out.
What relevance does this have today? Well the relevance is that you really don’t know. So, when I think about inflation, I think mostly about the risk/reward proposition of the bond market. We can’t really predict these big cosmic cycles.
We can observe what is in front of us and how people are positioning themselves. And what I observe is a lot of muscle memory. A lot of looking backwards. A lot of fitting the present-day news into the template of the Irving Fisher debt deflation model of the fussing over the weight of encumbrance on the world’s economies.
I’m in the inflation camp. I think it’s coming.
There’s a ton more in the full interview which you are certainly encouraged to spend some time listening to this weekend. It’s embedded below
And do check out MacroVoices if you haven’t. It’s a fantastic resource.