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Written by: Tim Pierotti
There is an old expression that “economic expansions don’t die of old age”. Some important factor has to change for the worse. What often changes (sort of the way this is all supposed to work) is the Federal Reserve raises interest rates in a rising demand environment to prevent the economy from overheating and inciting inflation. It has been 27 months since the Fed started raising interest rates and after raising rates by more than 5%, the economy is still rolling along like Ole Man River and inflation is still somewhere between accelerating and stubbornly sideways north of the Feds 2% target. Despite all those rate hikes, “Financial Conditions” as measured by Goldman Sachs or the Chicago Fed remain historically easy. Credit spreads are tight, volatility is low across asset markets, stocks keep rising, and perhaps most importantly, longer-term interest rates have not gone up as much as the front end thereby suppressing borrowing costs.
The sustainability of this expansion has been more than just the massive post pandemic fiscal stimulus. The tight labor market has led to strong wage gains. Balance sheets of the consumer and corporations were, and largely remain, in excellent shape while much of the outstanding debt was termed out at low rates (think 30yr mortgages). Baby boomers are, by far, the wealthiest generation in history and that cohort is sharing that wealth with their offspring at a clip estimated to be as high as $2Trillion per year. So, not only is this expansion not dying of old age, but there remains plenty of fuel in the form of accumulated demand and income growth to keep the party going for some time. The risk is not what the Fed does with Fed Funds rates. The risk is that fixed income investors eschew duration due to the fear of secularly higher inflation thereby pushing long rates higher undermining housing affordability and demand. As we have written about ad nauseum, there are several drivers of secular inflation such as aging demographics, deglobalization, commodity supply/demand mismatches, etc. But, the fire closest to the barn may be governmental ineptitude.
The term “bond vigilante” was coined by Ed Yardeni in 1983 when he wrote, “Bond investors are the economy’s bond vigilantes…If the fiscal and monetary authorities wont regulate the economy, the bond investors will.” We currently live in a period of unprecedented fiscal excess. Never before have we run such high budget deficits at a time of full employment.
During the post WW2 period, the cyclical pattern has been quite consistent. Deficits rose in and immediately following recessions when unemployment was high and deficits fell during long expansions like we currently enjoy. But that relationship has broken down. Despite super tight labor markets and strong corporate profits, deficits have endured and are projected to remain well over 5% of GDP. In other words, policy makers are no longer doing their jobs. In Congress, compromise is now anathema to self-preservation. The risk is a loss of credibility. To Yardeni’s point, our fiscal authorities have failed and it will be bond investors who “regulate the economy”.
Bill Gross, the famous bond investor, recently wrote,
“The U.S. economy requires fiscal deficits and net increases in Treasury debt of 1-2 trillion or more annually in order for the economy to grow… They have to price money to satisfy the “vigilantes” now that QE is history and QT is underway. Look for 5% plus 10-year yields over the next 12 months — not 4.0%. Those that argue for lower rates have to counter the inexorable upward climb in Treasury supply and the likely Sisyphean decline in bond prices.”
In the face of all that supply, would it really surprise you if global managers of fixed income portfolios meaningfully reduced their duration for which, with an inverted yield curve, they aren’t even getting compensated anyway? The days of ZIRP (Zero Interest Rate Policy), otherwise known as free money, are over. The collective realization of that fact has yet to be expressed in long-term treasuries, but our view is that eventuality is inevitable.
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