“Careful what you wish for… you might get it.”
Markets expect a swift series of interest rates cuts will drive prices higher. They are fooling themselves. Inflation remains sticky. Central banks have a debt crisis to address while weaning the economy off the distortions of low-rate addiction. The scope for cuts is limited. Time to focus on what “higher for longer” real-rates and mean for market fundamentals.
Do you remember early 2023? The big question was when will Central Banks start to ease? US Rates peaked in March with a target Fed Funds rate set at 5.5%. Inflation was biting hard, the outlook looked grim and markets look set for further pain. We set up a prediction board in the office: “when” with about a dozen portfolio managers and bankers participating. Only 2 of us are still in the game.
I called The Fed to start easing late Q2 2024. I am now thinking I might be premature. Much of the market thinks cuts are imminent.
Back in 2023 I was amazed by the optimism of some of my younger colleagues – they all predicted central banks would ease very quickly to address potential recession, backed up by their expectations inflation would prove “transitory”, short-lived and a one-off spike. Some expected easing as early as June 2023. Many still believe Central Banks are there to bail out markets.
I argued for caution. I continue to do so.
Strip out the noise, and the January market has largely been up/down depending on how the market’s uncertain sentiment shifts on whatever the latest number or economic releases hints in terms of interest rate cut timing. I reckon the first cut, when it comes, will be a sell the fact moment – that’s what happens when everyone is watching and is positioned.
Generally, stock markets remain convinced eases are just around the corner, and that these will fuel massive upside.
Really?
Let me present the case against:
Inflation remains sticky. I don’t accept inflation was ever a one-off threat – I go with traditional monetarists here; inflationary events are a result of monetary distortions, the effects of which are anything but transitory. Yes, there was a Covid/Supply chain element that magnified inflation, but there were also the long-term monetary effects of QE, financial asset inflation and depressed real earnings. There is still significant inflationary threat in food, energy, and supply chain costs, plus the wage spiral threat is not yet done. In short, the outlook for inflation remains uncertain tending towards sticky.
Central banks will not be bounced into early cuts lest they fan latent inflation. The rhetoric from central banks remains caution over all else. That is not a sign of them making decisions in a vacuum, or being unable to figure it out. The one thing central banks are not is stupid – the central bank dialog flow is very deliberate.
Central Banks learnt critical lessons over the last 15 years about how business/interest rates work within the economy. Set interest rates too low and perversely they discourage investment while fuelling speculation. That speculative force is still apparent in stock market multiples today. Interest rates – the price of money – don’t just act as a control on inflation, but critically inform corporates and consumers about their spending/investment decisions – for the economy to work they need to be set at the right level to ensure that spending/investment is rational and sustainable, rather than speculative.
The long-term results of too-low interest rates include over-indebtness, under-investment and speculative bubbles. Companies borrow money to buy-back shares creating short-term value boost, rather than build long-term value. Consumers leverage up to buy luxury goods of little benefit or long-term appreciation. Investors speculate because they expect low rates reduce financial risks. Ultimately, the result is higher debt servicing costs slow the economy long-term.
Central Banks will aim to keep rates positive, above inflation. They tried NIRP and ZIRP and now understand the consequences. This means there is actually very little scope to actually ease rates much below 4% if inflation remains sticky at 3%. The market is not going back to 2% or Zero interest rates – as many investors believe/hope for. (Hope is never a good investment strategy.)
The lagging effects of the transition from 15 years of ultra-low QE Zero-interest rate policies are only now becoming apparent across the economy; on wages, supply chains, commodities, etc. The multiple distortions that pushed up financial asset inflation from 2010-2022 (The Age of QE) were all monetary distortions, and thus are likely to remain inflationary until they can be “cleansed” from the system.
Consumers and corporates remain heavily indebted. They can barely afford current debt servicing costs – which will remain critical. Easing rates to boost consumption and investment – which will only happen if consumers and corporates take on yet more debt, is not a sustainable option.
Central banks are not saying it out loud, but they have a plan. It requires us to play along: Although higher debt costs are painful, and are impacting consumption and investment, they are bearable – enforcing austerity on borrowers. If they can keep rates higher for longer it will force economic participants to deleverage (and a little inflation helps reduce the debt burden) and make the economy sustainable. Keeping rates higher for longer also limits the threat of a wage inflation spiral (because corporates go into cost-reduction mode and jobs become less secure).
The risks of higher rates for longer include stagflation if inflation rises, corporates default, jobs crash and recession bites. At that point the economy may stall, and even swift interest rate cuts may not help. Key to avoiding stagflation is confidence.
The sure, certain, tried and tested way to plunge the economy into recession is a good, old fashioned market crash, an event Central banks will do anything to avoid. That’s why Central Banks sound so positive in what they are saying, keeping markets hopeful that cuts are coming by promising “Jam Tomorrow”. Should markets come to understand that, and subsequently “correct”, central banks can live with that, and markets will adapt. It would require a full-scale cataclysm similar to 2008 to trigger full QE mode again, and that’s less likely as risk has been spread out from banks.
It’s a delicate balancing act….
