Never smile at a crocodile
What warnings do rebellious charts give us about fiscal policies? Our resident Michael Lienhard explains.
Those who smile at crocodiles may be called many things: brave, rebellious, or just plain stupid. But what if the crocodile smiles at us first? Disturbing as it is, that’s exactly what’s happening in a growing number of charts now circulating around social media and research forums.
Disturbing – not because we fixed income investors believe crocodiles will jump out from our monitors – but rather because the widening “jaws” in the charts signal a disturbing disconnect in markets whose underlying message we’d do well to heed.
The cryptic crocodile charts
These intriguing charts, with two lines resembling a crocodile's open mouth, are becoming increasingly prevalent. They depict developments within asset classes and financial market segments. What's striking is that many of them show a stark disconnect between short-term interest rates or Central Bank policy rates and various market segments. They raise questions about the validity of historical relationships, leaving us wondering: What's disconnected, and does the rising number of these charts convey a more profound message than meets the eye?
To understand the cryptic crocodile charts, we first need to appreciate the significance of bond markets. If you've been a dedicated reader of my previous FOLIO blogs, you're likely aware of my belief that bond markets serve as the storytellers for the capital market world. They are large and fragmented markets often perceived as over-engineered, boring and technical, but equally often used as an indicator to explain current and future market trends in other marketplaces or asset classes. The world of interest rates and credit risk is an asset class of its own and investable, but has also become a policy tool and playground of policy makers. It is widely understood as “the basis” of the financial system as the determination of the base rate by Central Banks influences discount curves among asset classes. Therefore, rates and/or the investment grade segments reserve the right, justified or not, to be “unquestionable” as they are constantly able to explain the market trends happening at least partially in other marketplaces in a risk premium format. So, the market loves to do the unavoidable: Compare your asset class/segment vs. interest rates – touch the base.
Unravelling broken relationships
Traditionally, interest rates were our North Star, guiding us through the financial seas. They indicated system stress levels, market attractiveness, and even future consumer spending. However, these charts suggest that interest rates are losing their predictive power. To put it simply, the North Star isn't shining as brightly as it once did.
The recent narrative highlights the diminishing importance of interest rates in explaining short-term economic dynamics. The world has witnessed governments committing to unprecedented fiscal support during times of rising policy rates. Fiscal support, especially when directed towards consumers, as seen in Europe, has provided a financial cushion during periods of financial tightening. It's essential to recognize that governments are merely executing their electoral promises by providing this support. As a result, we observe interest rates climbing higher, yet credit contraction remains conspicuously absent, at least for now.
The lagging impact of monetary policy
Massive stimulus packages, triggered by the COVID-19 pandemic, arrived after years of ultra-loose monetary policy. Despite Central Bank claims of more efficient policy transmission, there's a noticeable lag in the system. Fiscal policies have built unprecedented buffers in recent years, thanks to nearly a decade of ultra-low interest rates. The current inflationary environment complicates matters. While Central Banks have raised policy rates substantially, the impact has mainly been felt in nominal interest rates on cash balances rather than debt. The lock-in effect on debt from the QE era means that the interest rate burden on consumers, corporations, and governments is moving slowly. The prolonged average debt duration in the system contributes to this delay. While markets anticipate a narrowing gap between funding costs and traded yields, this process is sluggish due to the "unprecedented weighted-average duration" in the system. Consequently, there's a temptation to remain complacent when comparing different market segments to short-term interest rates, despite divergent trends. In essence, many market segments don't appear particularly attractive when viewed in comparison to policy rates and corresponding short-term interest rates. They seem to discount the possibility that today's interest rate changes might not pose an immediate threat, as Central Banks would likely step in to provide support. Thus, the crocodile-mouth charts may maintain their patience, as market reactions don't occur immediately following today's interest rate shifts.
Demographics and economic trends
Demographic changes play a pivotal role in this complex financial ecosystem. The negative growth of the working-age population has made consumer balance sheets less vulnerable, offsetting the adverse effects of higher interest rates to some extent. Despite the challenges posed by rising rates, higher job security ensures that the relationship between wages and rates remains more stable compared to previous episodes. However, the departure of baby boomers from the labor market results in a negative "replacement rate," a trend likely to persist unless net migration can balance it out. Given current anti-migration sentiments, this remains unlikely. Consequently, a recession with full employment no longer appears alien, and stagflationary trends loom on the horizon. While AI and automation may help address some productivity gaps, their impact on consumption remains uncertain. In sum, as long as consumers do not disrupt the funding channel, stress levels are determined by this patient factor, poised to navigate more puzzling trends related to short-term interest rates and "something."
“Kick-the-can-down-the-road”enomics
The era of "kick-the-can-down-the-road" monetary policy (2013-2021) has integrated fiscal policy within Central Bank balance sheets. This approach resulted in longer average debt durations, greater acceptance of higher debt levels, and disinflation. The shift to a pro-inflationary regime, fuelled predominantly by de-globalisation and geopolitical tensions, has brought fiscal policy to the forefront, gradually sidelining monetary efforts. The fiscal version of "kick-the-can-down-the-road" contributes to a pro-inflationary environment, challenging Central Banks' ability to combat inflation with higher interest rates. Higher rates are intended to be painful, and fiscal stimulus is unlikely to fully compensate for this pain. The disconnect between short-term rates and other market segments gives rise to multiple interpretations. However, a common theme emerges: a question of whether we should embrace declining purchasing power and accept economic cycles rather than relying on “kick-the-can-down-the-road”enomics. It's a thought-provoking issue that we should all consider. Governments have significantly increased their debt levels during times of super-low interest rates, meaning indebtedness has risen but interest rate burden has not. Higher interest rates for longer means that 'old and cheap' debt has to be rolled into 'new and expensive' debt in the absence of austerity. While this is not the end of the world, it does imply that we are transforming towards a negative-cash-flow-economy as average coupons may exceed growth rates. This fixed income investor does not have an answer, but it seems intuitive that in such a regime, the chances of the crocodile biting may dramatically increase.