When COVID-19 threatened to topple economies, the Fed and other central banks cut rates aggressively. Some central banks went into deeply negative interest rate territory, and some (Japan) are still negative. But to those who remember the day-by-day decisions of 2020, as I do, just cutting rates did not solve the problem. To avert disaster, central banks also bought trillions of bonds. Some, like Japan, are still buying them to keep yields from rising.
Despite the winding down of the purchase of bonds, the balance sheet of the Fed has declined very modestly over the last year (from a quarterly peak of about $9 trillion at the end of the second quarter of 2022 to the current level of $8.3 trillion at the end of the second quarter of 2023. Source: Bloomberg).
Since the end of 2021, short rates have gone up about 500 basis points. Inflation has come down somewhat, but by central bankers’ own admission, it is still much higher than their target. The last PCE (personal consumption expenditure) was at 6% (Source: Bloomberg), which is still multiples of their target of 2%. Now a question that needs to be asked is the following: if it took aggressive rate cuts AND trillions of bond buying, why would we expect just rate increases to reverse inflation? Wouldn’t it be natural to expect that some of the trillions worth of bonds need to be sold more aggressively to slow inflation down? In other words, if the buying of duration was what was needed to stimulate inflation, wouldn’t it be intuitive to expect a supply of duration of about the same magnitude to reverse inflation?
To put some more context on this observation, we have to realize that businesses do not make their investment decisions based on short rates or short-term Fed policy. They make their decisions based on long-term rates which are averages of the forecast of policy over a time period, say three to five years. In particular, the real estate sector, whose pricing power ultimately ends up flowing into the rental component of inflation statistics, is very sensitive to longer-term rate expectations. So the right metric for the rate that matters to the real economy is not the short term interest rate, but the longer-term forward rate. Yes, sometimes the increase in short rates can get transmitted to the longer rates. But it is almost always the longer rates that actually end up mattering.
Today the US yield curve has inverted to historic proportions, and one does not have to look too far to realize that these economy-influencing, longer-term forward rates have not moved much higher than where they were a couple of years ago. Yet. Which means that the rate that matters — i.e., the long-term forward rate — is still too low to slow things down. For the Fed, it means that if they really want to slow things down, they have to engineer longer-term forward rates up; i.e., they have to try to re-steepen the yield curve. Just raising short term rates is hoping to “push on a string” (this phrase is traditionally used in the context of re-stimulating, but here I find it appropriate to use in the present context to try to bring inflation down).
Here is a derby of how different rates have moved over the period that the short rate has gone up by 500 basis points (source: Bloomberg):
· The 1y forward 1y rate has gone up about 3% (from 1.1% at the beginning of 2022 to 4.27% currently) tracking the increase in the short rate somewhat
· The 1y forward 10y rate has gone up about 1.9% (from 1.5% to 3.4%)
· The 5y forward 10y rate has gone up about 1.6% (from 1.75% to 3.28%)
· The 5y forward 5y rate has gone up about 1.6% (from 1.62% to 3.23%)
The message is clear: the fact that short rates have gone up has done very little so far to increase the rate that matters for economic activity; i.e., the 5y forward 10y, or 5y forward 5y rate. Short rate increases are not being efficiently transferred into longer term rates, which are the ones that matter for economic activity and hence inflation.
By any measure, if inflation is running over 4% (CPI), or 6% (PCE), a forward rate that is lower than inflation is arguably a stimulative posture, not restrictive. Given the swift pivot with which the Fed provided liquidity to banks as they started to fail earlier this year, the market has correctly concluded that the 2% inflation target is unlikely to be achieved any time soon, and when push comes to shove, the Fed will declare victory with 3% to 4% inflation in the short term, with the qualification that it will achieve its 2% target “over time” (without specifying over what time).
So what does this mean for investors?
First, I believe that a re-steepening of the yield curve is essential to, (1) both slow things down and bring inflation; (2) re-energize banks whose business model is based on a steep yield curve; (3) and re-normalize proper risk-taking where there is time value of money that increases with time. The Fed is unlikely to start to take duration out aggressively for now because they are deathly afraid of selling bonds that might further impair the balance sheet of banks that have levered up duration and create a bond market illiquidity black hole (recall Silicon Valley Bank). Remember, in the Fed’s framework of monetary transmission, banks are “it”. No banks, no monetary transmission.
But the very act of not doing what is required is likely to hasten the path to it. As the markets realize that the current unstable equilibrium means, (1) further banking sector problems down the road; (2) an upside-down financial system with long term rates so much lower than short term rates that the whole economy is running “negative carry”; (3) persistent lack of risk-taking; (4) and possibly de-anchoring of the 2% long term inflation rate, markets will demand a higher-term premium. This will mean a sharp and significant yield curve re-steepening. Timing uncertain.
When yield curves steepen, all asset classes will be impacted, depending on whether the re-steepening arises due to short rates falling aggressively or long rates rising aggressively. Short rates fall aggressively when the economy tips into a sharp recession; long rates rise aggressively when inflation expectations reset to a higher level. I am not sure which one will happen this time; but as long as the curve re-steepens, value will start to perform well against growth. Mega-cap tech, which has been the beneficiary of the yield curve inversion and low long-term rate expectations, will likely come under pressure, as it did in 2022 (along with the index funds that are overweighted by the mega-cap techs). If short rates fall aggressively due to a financial crisis, I also expect real yields to crater sharply, which suggest that short duration TIPS with over 2% real yield and an inflation cushion of 4% provide yield with high credit quality. Falling real yields would also likely re-ignite gold as a haven.
The bottom line is this: the effect of short rate increases have not yet been transmitted into softening demand and easing inflation, and possibly never will, unless the Fed is willing to break the banking sector again. The optimal and lower risk solution for both policy and markets is straightforward – long rates have to rise more than short rates over the next few quarters. While I don’t think that the Fed is likely to do fire-sales of duration, the market has demonstrated a persistent habit of doing things for the Fed. This time is likely to be no different.
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