Welcome to the Unhedged newsletter! I’m Jenn Hughes, filling in for Rob. While the Federal Reserve is typically focused on behemoths like Microsoft and Alphabet, these companies managed to grab attention during a rate-setting week. Microsoft’s slowing growth in cloud computing raised concerns despite its AI-heavy pipeline, but Google’s advertising sales indicated that traditional search is still alive. Ethan will be back tomorrow, but in the meantime, I’m open to hearing all your great ideas. Feel free to email me at [email protected].
Rates in the Long Run
When I first started in financial journalism, the 1987 stock market crash and the 1988 battle between KKR and RJR Nabisco were recent events that left a lasting impact on the market. For newbies today, these events are further in the past than the 2008 financial crisis. This illustrates the long period of time during which investors have experienced low or falling interest rates, against which these events took place. The effects of the 2008 shock are still being felt 15 years later. Similarly, the events of the 1980s had long-lasting effects, from the development of exchange circuit breakers to the significant impact of KKR’s deal. However, these events are now part of ancient market lore, just like the idea of ever-higher interest rates before them. Only those over 60 years old have lived through a sustained period of rising rates, which may explain why investors have incorrectly predicted the peak in US rates multiple times during this cycle. Just a year ago, a fed funds rate above 5% seemed unimaginable. Now, bond bulls are once again preparing for a peak, possibly at the upcoming Fed meeting. This is a good opportunity to step back and consider the larger historical context.
Jim Grant, the 77-year-old publisher of Grant’s Interest Rate Observer, highlights five long-term shifts in rates since the mid-19th century. Rates steadily declined from the Civil War to 1900, then rose in the two decades leading up to 1920 due to gold discoveries and inflation caused by World War I. Rates then declined until 1946. Since then, there have been two postwar regimes: rising rates until 1981, and falling rates ever since. Grant argues that rates tend to move in multi-decade cycles, and we have been in a falling-rates world for the past 40 years. Now, Grant believes that yields are on the rise again.
“Market trend reversals often occur at valuation extremes, whether it’s the Japanese stock market in 1989-1990 or the dotcom bubble,” Grant explains. He believes that the reversal began when US 10-year Treasuries had a yield of 0.55% in the summer of 2020, while negative-yielding debt became the norm globally. Grant suggests that this indication, coupled with the historical undulations of rates, invites consideration that we are entering more than a simple reversal leading to a return to 2% yields. Admittedly, Grant and his team first predicted this generational shift in 2004 due to concerns about rising budget deficits and inflation. Nonetheless, he believes that the evidence supports the idea of rates trending upwards.
Bill Gross, the 79-year-old former “bond king” and Pimco boss, shares similar thoughts. Last week, he discussed potential levels for 10-year yields if inflation falls to 2% and the fed funds rate drops to 2.5%. Historically, this scenario has led to a 140 basis point spread for the 10-year over the fed funds rate. Gross suggests that this could result in a 3.9% yield for the 10-year. Currently, the market is already at 3.75%, which means that if inflation remains below 2%, yields could rise to 4% or higher by 2024-2025. Gross emphasizes the upside risk for the 10-year yield, especially if the economy’s neutral rate has increased.
Both Grant and Gross point to the idea of a higher floor for rates, suggesting that bond yields may not fall as much as investors have become accustomed to. This limits the potential profits from timing a bond rally. The $3.4 trillion currently held in money-market funds cannot all be waiting for a better buying opportunity for stocks like Nvidia. In fact, discussions with asset managers indicate that a significant portion of these funds are looking to time the high in bond yields, hoping to capitalize on attractive coupons and price appreciation. However, the expected price appreciation may not be as significant as anticipated.
Pricing Strategy in Japan
After the Federal Reserve, the Bank of Japan will hold its own two-day meeting amid speculation that it may need to adjust its expansionary yield curve control due to a 40-year high in inflation. I have previously expressed skepticism about this year’s rally in Japan. The focus on corporate governance reforms, which require cultural changes at the boardroom level, takes longer to yield results than expected. Additionally, currency effects are not helping as the Korean Kospi index outperforms Tokyo’s Topix, and both lag behind the S&P 500. US investors need a reason to invest overseas, and the yen’s 9.9% decline this year does not provide that incentive.
This leaves everything in the hands of the Bank of Japan. A change in policy could push the yen higher, but Governor Kazuo Ueda must proceed cautiously to avoid squashing inflation. Nomura’s chief equity strategist Yunosuke Ikeda believes that price pressures may be the catalyst for the desired governance reforms. He argues that Japan’s corporate management system has not been effective in maximizing profits due to a lack of focus on pricing strategy. However, if companies start to consider raising prices, it would require a reassessment of their relationships with clients and customers. This presents an opportunity for Japanese companies to rethink their future businesses. Managers enticed by the prospect of earning more offer a more compelling argument for future profit growth than mandated transparency improvements.
A Few Good Reads
When facing inflation, the Lex column suggests that “linkers are stinkers,” referring to inflation-linked bonds and the challenges they currently pose for governments. The Wall Street Journal estimates that there is $3.5 trillion of global debt offering price protection. Perhaps Canada’s decision to stop offering these bonds last year was a sign of being ahead of the curve.
Don’t forget to check out our new podcast, the FT Unhedged podcast, hosted by Ethan Wu and Katie Martin. In each 15-minute episode, they delve into the latest market news and financial headlines twice a week. Catch up on previous editions of the newsletter here.
If you’re interested in the intersection of money and power in US politics, be sure to sign up for the Swamp Notes newsletter. For local and global trends in investment, check out the Lex Newsletter, which offers insights from expert writers in four major financial centers.
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