Tag: Rates

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Macro Minute: Inequality and Monetary Policy

On February 1st, at Credit Suisse’s 2022 Latin America Investment Conference, Enio Shinohara moderated a conversation with Rogerio Xavier from SPX and Luis Stuhlberger from Fundo Verde. In it, Luis made a very interesting remark on the US interest rates curve, which loosely translates from Portuguese to “so far in the United States, the increase in interest rates being priced by the market has simply anticipated a series of hikes, but has not changed the terminal interest rate. In other words, the first probability that appeared during the pandemic was for the first hike to happen in 2023 or 2024. In the past year, these expectations were repeatedly pulled forward. It started with one hike in 2022, and now we are talking about 5 to 6 hikes of 25 bps in 2022. But the terminal interest rate has not changed; the terminal interest rate is around 1.80%. In my opinion, and I agree with Rogerio, this will not be enough.” (I highly recommend watching the entire conversation, especially if you have any interest in Brazil: English Link, Portuguese Link).

Central banks around the world have one big problem today – inflation. This issue is even more apparent in developed markets that are mostly seen as behind the curve. From traditional macroeconomic models, we know that central banks can restrict the supply of money to ease pricing pressures; however, there are a few ways that this can be achieved. The two most common approaches are hiking short-term interest rates and pressuring long-term rates higher, both with meaningful, but different, redistribution effects. Historically, hiking short-term rates has been the method of choice at the Fed. That was also communicated at the last FOMC meeting and markets are pricing for it. Nevertheless, the situation is fluid and central banks, especially the Fed, may conclude that influencing long-term rates might be a better tool for the current environment and their updated mandate that now includes improving inequality.

The traditional way of relying on short-term interest rate hikes to lower inflation has the effect of controlling prices of goods by curbing demand through a flat or inverted interest rates curve, thereby causing a recession that generates the necessary slack to keep prices from rising. This method acts through raising unemployment and having little effect on asset prices. As Luis mentioned, hikes have only been anticipated with minimal impact on long-term rates, which in turn had little effect on mortgage rates and equities. In other words, this method exacerbates inequality. This is what the market is pricing today, with forwards implying an inverted curve in the US and Europe one year from now.

We believe that once this becomes apparent, the Fed will move into a more aggressive posture regarding balance-sheet reduction and steepening of the yield curve. Central banks have tools to control term premia, and by doing so can influence mortgage rates and asset prices. By increasing mortgage rates, they can keep home prices in check and consequently OER, with the added bonus of improving affordability. By decreasing asset prices, they might be able to bring early retirees back into the labor force (due to the decreasing values of their nest eggs), slowing, but not reversing wage growth, and consequently keeping services inflation tamed. Since we are not going through a balance-sheet crisis, central banks can engineer a soft landing without killing growth by pressuring long-term rates higher. This method would potentially have a positive impact on inequality. We hold a strong view that the probability of this scenario is higher than what the market is pricing.

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Special Report – A Changing Paradigm

As an investment philosophy, we believe that the best way to deliver above-market returns is to find something cheap, take a position, and hold it for the long term. We tend to avoid market timing and “short-term” investments.

Looking across asset classes, we find that many equities are overpriced on a historic basis by virtually every metric and expect future returns to be much lower than in the past decade, save for a couple of undervalued sectors like energy and materials. When the stock market is on fire, as it has been almost non-stop since 2008, investors ignore companies that specialize in raw materials and other goods. With investors too distracted by their ever-increasing portfolio of technology companies, there was a loss of interest in investing any money in increasing the productive capacity of raw materials, agricultural products, and other hard assets.

In real estate, housing around the world is already too expensive to represent a compelling investment. In the US alone, the S&P Case-Shiller Home Price Index sits a lofty 26 percent above its 2006 peak, with a 17 percent increase year-over-year for the nine US Census divisions. To put this in context, housing prices have been rising more than 5 percent above inflation for the past decade.

Products like copper and lumber seem expensive but as an asset class, commodities are the cheapest. When you factor in inflation, even after the recent run up in prices, most commodities are trading closer to their historical lows. We will further explore this asset class in detail in future reports.

Figure 1: Inflation-Adjusted Commodity Prices

Bonds have never been this expensive in history and are clearly in a bubble. As we write this letter, 10-year real yields in the United States are at their historical lows of -1.2 percent. With the Fed’s new inflation targeting policy of slightly above 2 percent, real rates could still theoretically go down to somewhere slightly below negative 2 percent, assuming the Fed cannot reduce nominal interest rates meaningfully below zero. However, for that to be true one needs to accept that we are living through some type of global secular stagnation[1] process, from the demand or the supply side.

Herein, we hope to show that such a scenario is extremely unlikely. First, we believe it highly probable that the environment of slower growth and inflation from the past few decades has more to do with a series of temporary “headwinds” arising mostly from consecutive deleveraging processes caused by the fact that almost all recent crises were balance sheet crises, and therefore deflationary. Secondly, we argue that even if we were living through secular stagnation before, we are not anymore. The underlying forces in play for the past few decades began reversing around 2015, and the Covid crisis created a catalyst for an acceleration of these forces.

If you wish to receive a full copy of this report, including our directional views across asset classes, please contact [email protected].

[1] Secular stagnation is defined as a prolonged period of low growth. While prolonged and low are not further specified, many economists define low as an average annual real output growth rate of no more than one to 1.5%, and prolonged as covering at least several business cycles. The term secular does not require stagnation to persist forever.