Arete Market Review Q421: The Low-Rate Conundrum
Back in the mid-2000s then-Fed chair Alan Greenspan remarked on the curious phenomenon of long rates staying low even though there was healthy underlying growth. He called it a “conundrum”. A decade and a half later, long rates are much lower than they were then, even as inflation has started rearing its ugly head. The consumer price index, for example, hit a 6.8% annual rate in November.
What gives? As rising prices are killing a lot of household budgets, long rates have bounced around but are still incredibly low. Are rates wrong or is inflation wrong? Regardless, this is a monumentally important puzzle for long-term investors to solve. Different answers imply dramatically different portfolios.
Rates and inflation
Historically, inflation has figured prominently in long-term interest rates. Gary Shilling highlights in the January 2022 edition of his Insight letter what many market followers have also observed, "Treasury bond yields reflect inflation, with a 60% correlation between those yields and CPI inflation over the entire post-World War II era."
Based upon the premise that inflation expectations are largely embedded in rates, and inflation is currently high, the question must be asked, "Why are rates so low?" Shilling’s answer, essentially, is that rates are so low because economic growth prospects are poor and current inflationary impulses will not persist.
He goes on to list ten major factors that are likely to dampen growth and ease inflation. Among them are an inventory cycle that has created excess supply, continued supply chain disruptions that will inhibit growth, a softening economy, and softening growth in China. In short, his read is that the recent spurt in inflation will pass and ultimately reveal weak economic growth.
Shilling reinforces his thesis by contrasting current conditions with the environment of structurally excess demand of the late 1960s and early 1970s. As he notes, it was the forces of "military outlays for Vietnam and spending on Great Society programs, on top of a fully employed economy," that drove prices up at the time. Fair enough.
An important assumption made in such a thesis, however, regards the validity of rates as good signals. Indeed, this is exactly the issue Grant Williams posed to Greg Jensen of Bridgewater Associates: "[D]o you believe that the bond market still sends [sic] uncorrupted signal?" Jensen answers with a very thoughtful analysis:
"But you move to this world, where in a sense, the Central Bank is controlling the short rate. They're also in a soft sense with QE controlling the bond yield and in a soft sense, controlling the aggregate corporate spread and mortgage rates. I mean, you went from one level of control to multi layered control of the economy. That's a big difference. And so, when you look at market prices today, what do you see? It's much more like what you're seeing is what the market thinks the policymakers will do to achieve the outcomes that they want rather than reflecting what economic conditions it will be."
"That's why, why is it that the bond yield is where it is? Well, people think that's where the Fed wants it, and that the Fed can get what they want. And so that's the thing. Now, I think, even on that basis, the markets are going to prove to be wrong because I think the Fed is going to be forced to change their policy, and they're going to allow a higher bond yield because they'll be overwhelmed by the evidence."
Wow, that packs a punch. Let's break out a couple of points. When Jensen calls the migration from “one level of control” to “multi layered control of the economy”, he’s right; it is a big difference. Because the magnitude of monetary intervention has changed, it is fair to entertain the notion that the relationship between rates and inflation has changed.
When Jensen hypothesizes that long rates are low because that’s where the Fed wants them, he makes another good point. The Fed might be misguided, obtuse, sophomoric, or ham-fisted, but it will also always have a bigger balance sheet than other traders. If the Fed wants something, it has been safe to assume the Fed can get it, and therefore risky to bet against it.
That bet is made riskier yet by persistent flows into passive funds that have zero interest in fundamentals. As the Fed leads, passive flows follow. As a result, betting on what you believe could happen, or should happen, is an expensive bet if Fed policy indicates otherwise. Just stroll through the hedge fund graveyard from the last thirteen years and you can see the evidence.
Louis Gave chimed in with his own similar interpretation of rates in an interview on MacroVoices:
"[I]nflation was a massive surprise but it had no impact on the markets. Didn't impact the bond market. Didn't impact the currency market. Didn't impact the stock market. And I think the reason for that is pretty simple is that the markets fundamentally don't really care about macro. They care about the policy environment. So they care about how perhaps the macro might impact the policies."
In short, Gave describes in even more explicit terms that market metrics are not providing good signals on inflation. In this regard, it is probably more appropriate to consider metrics such as long rates to be more an indication of investor obedience to central bank policy goals than a revelation of information content about macro conditions.
The power of narrative
Yet another piece of the low-rate puzzle can be explained by the phenomenon of narrative. Ben Hunt of Epsilon Theory has produced some of the most prescient analysis on inflation and the recent piece, “Inflation and the Common Knowledge Game," is an excellent refresher.
Hunt describes the powerful role “Missionaries” play in establishing common knowledge. For example, when Fed chair Powell characterizes issues like inflation as “transitory”, it sends a strong message to the entire market that not only is inflation not a serious problem, but everybody knows that everybody knows inflation is not a serious problem. This helps explain why the market's reaction to rising inflation through 2021 was so muted. The reason is the Fed told everyone inflation wasn't a problem. This explanation dovetails nicely with comments by Jensen and Gave that markets care more about the policy environment than about macro conditions per se.
The narrative explanation also describes why long rates have recently been surging upward. When Powell made remarks at a Congressional hearing in late November and explained that inflation should no longer be considered transitory, he changed the narrative. Those comments were reinforced by hawkish comments in the Fed's minutes which came out in the first week of January.
Now, “everyone knows that everyone knows that inflation is here to stay.” Worse, this common knowledge becomes self-reinforcing. As Hunt describes, “And when everyone knows that everyone knows that inflation is here to stay, ALL businesses can raise prices to maintain margins without fear of competitive pressure or customer pushback.”
Money, money, money
Just as the power of narrative helps better understand changing views on inflation, so too does a fresh economic theory shed additional light on the inflationary process. As economist John Cochrane elaborates, it is not so much money printing, per se, that creates inflation, but rather the amount of money printing that funds deficit spending.
His theory, outlined nicely in the Economist, uses the analogy of equity dilution to describe the concept. Just as the value of stock gets diluted by the issuance of additional shares, the value of money gets diluted by the amount of deficit spending a central bank monetizes.
“The logical extreme of this argument is known as the ‘fiscal theory of the price level’, created in the early 1990s (and in the process of being refreshed: John Cochrane of Stanford University has written a 637-page book on the subject). This says that the outstanding stock of government money and debt is a bit like the shares of a company. Its value—ie, how much it can buy—adjusts to reflect future fiscal policy. Should the government be insufficiently committed to running surpluses to repay its debts, the public will be like shareholders expecting a dilution. The result is inflation.”
One key point is that fiscal spending is an important element of the inflation equation; it is not just a monetary phenomenon. To this point, additional comments by Greg Jensen are instructive:
"And today, we've moved from, the period from let's say, the 1950s through 2008, and a period of interest rate, what we call MP1 [monetary policy phase 1] into MP2 being quantitative easing, and now this phase that's been accelerated with the pandemic, has been this movement in the monetary, what we call Monetary Policy 3, but it's the merger of fiscal and monetary policy."
In other words, by Jensen’s analysis, monetary policy has evolved over time to the point where the inflationary process, at least according to the fiscal theory, has been institutionalized. As a result, the process of monetary "dilution" can be dialed up at any time. This doesn’t require the government to significantly outspend tax revenues, but it does leave the door wide open for it to do so.
This leads to another point: The quantity and duration of monetized deficit spending are also important factors to the inflation equation. As such, it is easy to see how the pandemic stimulus packages could produce a noticeable, but ultimately temporary, inflationary impact. Although the programs were quite large, they were also mostly one-off programs of limited duration.
What happens when the economy slows down the next time around though? When that happens, the signs are pretty good fiscal spending will crank up again and the Fed will monetize deficits again. Except next time, there is a good chance spending programs will also be more recurring in nature. In an environment of excessive debt and chronically weak growth, the temptation for politicians to “help” struggling citizens with substantive programs will be enormous.
Indeed, this now sounds a lot like Shilling’s characterization of structural inflation. Vietnam war spending was huge, but one-off in nature. However, on top of that came large, recurring programs like Medicare and Medicaid. Perhaps the two episodes are not so different after all.
Bringing all of these ideas together, we see the low-rate conundrum can be explained largely as function of two different factors. On one hand, since central banks have pursued increasingly extraordinary monetary policy, the information content of interest rates has migrated more to policy objectives than to inflation expectations. At the same time, those inflation expectations have largely been kept in check even despite some extremely high readings over the last year.
All that said, a really important takeaway, especially for long-term investors, is the seeds of significant inflation have been planted. The presence of low rates should not be used as an excuse to ignore the potential for inflation, to forestall acting on inflation for too long, or to act in too small a size to matter.
Also, however, the trajectory of inflation is rarely a straight one and never a completely predictable one. Even though inflation is likely to persist on a higher trajectory than it has been, that path depends on many unknowable factors. Nobody knows what situations might arise or how the Fed might respond to them at any point in time. The path is inherently uncertain.
The last few weeks are certainly indicative of that uncertainty. While rates did rise a couple of times last year in response to higher inflation expectations, rate levels remained extremely low. It was only after Powell agreed inflation was not transitory and his comments were backed up by hawkish minutes from other Fed members that the market really seemed to react. Herein lies another lesson: Narratives can flip quickly.
Finally, systemic inflationary conditions and big market moves in both directions are not conditions that are conducive to passive management. Rather, these are the types of conditions that enable astute investors to dynamically manage risk and identify opportunities as they arise.
Inflation is one of those really big things in investing that if you get it mostly right, most other things take care of themselves. Conversely, if you get inflation wrong, your nest egg can erode away. As a result, resolving the low-rate conundrum is an especially important one for long-term investors to resolve.
Lastly, if you want to get more frequent insights, check out my weekly investment newsletter, Observations, at https://abetterwaytoinvest.substack.com.