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Macroeconomic & Geopolitical

Pick a Number, Any Number

6 September 2019 - 4 min read

Among Three Central Rate Forecasts, The Middle Still Feels Right.

While most of the financial world stares at the U.S. Treasury curve with a mix of discomfort and confusion, those investors who are taking a view mostly line up around three forecasts for 10-year yields. These predictions may be carefully modeled and explicit, or they could be more like a feeling in their bones. But it helps to know where you line up as you put your own money on the table.

So pick a number, any number. If you choose 3%, you believe the reflationary case that yields will drift higher over the next 12-18 months. The darker scenario has rates dropping to zero along with a variety of associated cataclysms, plagues and locusts. The cowardly case, which simply projects the recent past into the foreseeable future, assumes rates will hover around 1.5%.

At this stage, the overwhelming evidence supports the cowards. But let’s examine them in turn.

While a world in which rates hit 3% may offer the best outcome for the global economy, it probably represents the biggest risk to investors.  The stalwart defenders of the Phillips Curve, which has traditionally linked lower unemployment with higher inflation, have dwindled to a precious few. This means that there is a lot of money that has been invested on the continuing promise of very cheap funding.

“The cowardly case, which simply projects the recent past into the foreseeable future, assumes rates will hover around 1.5%. At this stage, the overwhelming evidence supports the cowards.”

There’s still a long list of structural forces that are likely to keep wages and prices in check: competition from low-wage countries, automation that replaces physical labor, weaker trade unions and an expanding share of service jobs. Still, if prices started rising from, say, a spike in commodity prices or regional conflict, the jolt to the financial system from higher interest rates would be considerable. 

Payments would be missed, loans would be called and the cycle would end definitively in textbook fashion.

If you have chosen zero as your target for 10-year Treasuries, you are not reading from the standard textbooks. (Chances are you don’t get invited to a lot of parties either.) That doesn’t mean you’re wrong; it just means your outlook is alternately depressing and frightening.

A Treasury bond that pays no interest implies a world on the verge of deflation. Not only are we approaching the end of a cycle with falling profits and overextended balance sheets, but the structural forces that keep inflation in check undercut any recovery in aggregate demand. Add in fiscal policy that remains too tight and mounting trade frictions, and it becomes easier to see how this scenario might play out.

The irony here is that political uncertainty should be driving risk-free rates higher, but expansive central bank balance sheets and insatiable demand for safe assets have kept yields down. What makes this outlook so worrisome is that U.S. rates could follow European and Japanese equivalents into negative territory with all sorts of unpredictable and understudied effects on the behavior of investors and savers.

In some ways, this story sounds a little too deterministic. The structural headwinds to growth and inflation are real, but it doesn’t feel right to make such a big bet against the world’s largest central banks. They don’t have the leeway to cut rates that they did in the past, though they do have plenty of room to expand their balance sheets should growth drop sharply. And with rates so low, there’s also space for fiscal policy to respond – especially when debts are so affordable.  

This makes the cowardly prediction –- projecting current conditions indefinitely -- especially appealing. Rates won’t remain exactly 1.5%, but they are as unlikely to cross a 2% ceiling as they are to breach a 1% floor.

BENCHMARK 10-YEAR SOVEREIGN YIELDSource: Bloomberg as of August 30, 2019

For investors, this scenario means that asset prices may remain inflated by historical standards. But it also means the debt that drove them there can be sustained for a long time. Sometimes pretending that a questionable loan will be repaid makes sense, at least for a limited time. 

Can this go on forever? No, but probably a lot longer than most people think. Ample cash makes loans plentiful; cheap rates make loans affordable; fewer defaults make high leverage more comfortable. It’s a pretty simple scenario.

Won’t the zombies survive? Possibly, but cheap credit will not save bad business models in a world of rapid technological innovation that includes mobile networks, cloud storage and data analytics. Smarter firms that can deliver a better product or service at a lower cost are a much bigger threat than higher interest rates.

What does this mean for markets? Weirdly, investors are now enjoying capital gains in the fixed income markets and more attractive income from stocks that pay a good dividend. More money looks likely to flow into private equity and credit markets as investors stretch for higher returns. Meanwhile, firms seem likely to issue more debt as long as they are vigilant that their businesses can survive in an age of transformational technology. 

It’s not a bad scenario, if that’s your number.

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