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.