This column has warned relentlessly this year that sticky services inflation will thwart the rapid mean-reversion in prices that gullible bond and equity markets were projecting. In January, bond bandits foolishly expected 175 basis points of interest rate cuts from the Fed this year, beginning in March. It was never going to happen.
Following no less than four consecutive upside surprises in the monthly US CPI prints, lackadaisical investors have been compelled to discard their “hopeium” and now anticipate only 42 basis points of cuts from the Fed, which they think will not begin easing until September or October.
Martin Place errs
For what it is worth, the even more dovish Reserve Bank of Australia is not handicapped to chisel down its target policy rate until December (markets were at one point pricing in the middle of this year), which seems heroic.
Notwithstanding that the RBA has to contend with demonstrably more challenging labour cost and productivity problems, it persists with a 4.35 per cent cash rate that is conspicuously lower than all our key peers, including New Zealand (5.5 per cent), the US (5.25 per cent to 5.50 per cent), Britain (5.25 per cent) and Canada (5.5 per cent).
Yet when Coolabah runs the RBA’s official economic models, they emphatically signal that Martin Place should have its cash rate at 5 per cent or higher in line with policy settings overseas. No wonder the Aussie dollar is so low.
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Given US inflation is re-accelerating and miles above the Fed’s 2 per cent target, there is no basis for any cuts at this juncture. There is, in fact, a possibility that the world’s most important central bank could be forced to lift its cost of capital once again. Complacent investors are coming to grips with the realisation that monetary policy may not be as restrictive as it seems given President Joe Biden is running an immensely stimulatory budget deficit that represents 6 to 7 per cent of GDP. It is unprecedented in its magnitude in the post-World War Two period save for the spending required during the global financial crisis and the pandemic.
The Fed’s dovish pivot last year, predicated on ephemeral goods price deflation as supply chains reopened, was profoundly misguided, particularly in light of the fact that it precipitated the mother-of-all risk rallies, as evidenced by soaring equities and house prices, among many other things.
Fed scrambles
In the central banking lexicon, this was an easing of financial conditions that served as de facto interest rate cuts at the worst possible time. And now the Fed is desperately trying to cling to its rapidly diminishing credibility by repeatedly dismissing high inflation prints as merely part of its “bumpy road” in the vain hope that it can start lowering rates before the November presidential election. It is self-evident that rate cuts close to an election statistically favour the incumbent, and the Fed would like not to be tarred with a politically partisan brush.
After hitting 5 per cent in October last year, the US 10-year government bond yield slumped to 3.8 per cent in December as a direct result of the Fed’s pivot. The mantra was that the rate-rising cycle was over, and investors were on the cusp of securing generous rate relief that would bail out households and businesses that had based their finances on the presumption of the low-rates-for-long paradigm.
Since that time, the 10-year yield has climbed sharply higher again, hitting almost 4.6 per cent following the stonking US inflation data this week. Bizarrely, equity markets have for the time being tried to ignore the jump in their discount rates. Yet one is hard-pressed to find any serious investors who do not worry that equity valuations are rich. The last time 10-year yields hit 5 per cent, US stocks slumped more than 10 per cent.
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With the spectre of intensifying conflict between Israel and Iran forcing oil prices higher and an ascendant Trump campaigning to slash migration, which would boost US labour costs, coupled with the inflationary idea of slapping tariffs on Chinese imports, the downside risks for asset prices are becoming increasingly acute.
The biggest mistake central banks always make is the vainglorious attempt to construct grand intellectual narratives that presuppose they can accurately divine their own destinies. Think the RBA’s 2020 promise – enshrined by its 2024 yield curve target – not to raise the cash rate off its 0.1 per cent lower bound until 2024 (anyone who believed Martin Place has to swallow a 4.35 per cent cash rate today).
Hogwash persists
The Fed’s dovish pivot, which hinged on the bet that transitory goods price deflation would be superseded by mean-reversion in services prices, was another rubbery vision. Indeed, it echoes the misguided belief in 2021 that persistent demand-side inflation was but a temporary phenomenon and the mistakes made by the Fed in the 1970s when it cut rates too quickly only to watch inflation re-accelerate again.
If the Fed and the RBA do not lower rates this year, there is going to be blood on the streets among cyclically sensitive borrowers. Notwithstanding the hogwash from anyone exposed to risky debt securities that their default rates are benign, substantial fissures are emerging for those inclined to open their eyes.
Standard & Poor’s reports that global corporate defaults this year are the worst since 2009. US bankruptcies last year were the highest since 2010 sans the pandemic-affected 2020 year. Australian insolvencies are the most elevated they have been in a decade, led by construction and hospitality. Defaults on non-bank home loans are rocketing through the roof in contrast to the modest arrears recorded by intensively regulated bank balance sheets.
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Following the GFC, banks stopped lending to borrowers who had high probabilities of defaulting on their debts in any stress-test. These zombie borrowers were forced into the open arms of non-bank lenders eager to capitalise on the search for yield at a time when cash paid nothing. It is unambiguously this unregulated sector where all the zombie borrowers can now be found.
From a portfolio construction perspective, I like averaging into fixed-rate bond exposures (known as “duration”) as we move ever closer to a 5 per cent 10-year government bond yield. I also like moving up the capital structure in search of superior safety and liquidity, to provide optionality when asset prices do capitulate. The one thing I want to avoid like the plague is any form of illiquidity, which cannot appropriately reprice to the new normal of persistently higher risk-free discount rates.
Given high cash rates, floating-rate bonds continue to provide attractive all-in yields. And the most aggressive A to AA rated floating-rate strategies have performed robustly over the past 12 months, delivering total returns before fees north of 17 per cent. Of course, past performance is no guide to future returns.
