The New, New-Normal; or, the Old Abnormal, I’m getting confused!
Remember back in spring 2013 when Fed chairman Ben Bernanke mused publicly that interest rates may rise one day? Bond investors raced for the exits and for the next few years the prospect of rising borrowing costs was off the table so long as inflation held steady at a manageable 2% or so.
It was the touchstone of a new creed, a new faith, that the Fed had vanquished the economic cycle just as sure as St. George had slain his dragon and the hymn “rates lower for longer” was sung with brio from the fixed-income choir. Anfield refused to drink from that delusional brew, however. Indeed, during speaking engagements and meetings I was roundly harangued about the horrors that would visit the global economy should U.S. borrowing costs inch northward in divergence with rates worldwide and with assets liquidity-driven. I responded by associating the “rates will never go up” conceit with the free-money dementia that had consigned Japan to over a generation of flat growth and the economic and social malaise that goes with it.
In the end I converted no one. The zealots continued to embrace their New-Normal orthodoxy right up until this month, when the outcome of the most bizarre election in U.S. presidential history produced, among other things, America’s first “inflation” head of state along with a major bond rout.
I am proud to say that Anfield went on the defense some time ago, conceding a few points during sustained rallies in exchange for diversified sources of yield. In this way – one basis point at a time – we managed to claw our way to the upper alcoves of our peer rankings. True, it took the Fed a long time to come around. We believed the bank would raise interest rates sooner because we thought they understood that this economic cycle was different: it was a financial, or Wall Street cycle that undermined the real, or Main Street economy. Once fiscal stimulants like TARP exhausted themselves Washington should have addressed the damage that wanton deregulation has done to the real economy, which is many times smaller than the near $300 trillion financial economy of stocks, bonds and derivatives. What was needed then was tax relief and subsidy programs aimed at creating top-line aggregate demand. But that would have obliged President Obama to promote tax cuts for corporations and the middle class – a tough sell for an administration that had spent its formative years in power vilifying Wall Street. So despite record-low interest rates, capital – denied productive enterprises due to the uncertain regulatory environment that followed the 2008 crash – flooded asset markets and drove prices to bubble-level proportions.
We thought the Fed understood that printing money and hoping for the best was neither effective economically nor sustainable politically, particularly with asset inflation flashing red for the last two years. We surmised that once the Fed finally began raising interest rates that inflation would jack-rabbit. Wise money would prefer to be early than late and prepositioning could be done without sacrificing solid returns. We have entered the first phase of what we believe will be a prolonged return to monetary normalcy. We expect the Fed Funds rate will reach 1%, followed by a strategic pause and consolidation. To go from near-zero to a 2%-Fed Funds rate and 4.5% to 5% ten-year Note would be reckless and unnecessary.
Thank you for flying with us. We are now cleared for landing after circling the runway for what felt like an eternity. Now prepare for a year or so of jet lag as the easy-money age comes to an end. We anticipate a challenging environment for global bond and asset markets though we do not see a 1994-style tightening. (In part because we doubt financial institutions and markets could sustain it.) We will avoid sovereign durations and may even take short positions when opportunities arrive. We see credit and high-yield bonds as sound, unlike Agency MBS because of the duration-extension risk. For now we are staying put in the non-agency space and we are particularly happy with durations of 2%-to-4% plus portfolio YTM, weighted average credit quality of investment grade or better, and target volatility of 1% to 2%.
Having structured much of our investment culture around opportunities of yield, we fear not the return of inflation. There is, however, an administrative legacy of the last eight years that give us pause. I remember walking down Butterfly Beach in Montecito, California with my wife in mid-2014 when my phone started buzzing with the news that crude oil prices had collapsed. My first thought was not about the likely impact of cheap energy on economic activity, earnings or personal spending but how it would allow the Fed to duck its responsibility to begin tightening interest rates. In effect, it had surrendered its authority to price the value of money to the markets. Most recently, at its annual conference this August at Jackson Hole, the Fed launched an appeal to legislators to create demand where its own policies had failed. It is now as much a spectator as a shaper of monetary trends, an abdication of power that may be impossible to reverse.
Fortunately the Fed will have an opportunity to reassert itself in the second half of this epic interest rate normalization. We hope it does. While I have been critical of Chairperson Yellen for the reasons outlined above, I believe her hands-off instincts will serve her well now that the economic cycle has finally turned.