May you live in interesting times…
Capital markets are funny things. Prior to the election, you could of read all kinds of predictions about what a post-Trump world might look like.
A little over a week later, the results are in: Bonds down, Stocks up, Dollar up.
For those of us who participate in capital markets for a living, this is pretty bullish market action.
Expectations for American growth just went up, a lot.
What’s interesting to us about this market action, is not that investors are expecting higher growth (there’s lots in Trump’s 100 day plan to support higher growth), it’s the degree to which everyone has forgotten how dependent American growth and asset prices have become to low interest rates…
Meaning if we get higher interest rates before we get the spending growth, the impact of higher rates might kill any nascent boom while it is still in the womb…
Before we get into the details though, it might be helpful to walk through a couple of historical case studies of bond market sell-offs.
Couple things stand out from the chart above:
- Man, bond yields are low.
- Bonds could sell off a lot more and bond yields would still be low by historic standards.
- The magnitude of yield tightenings has been steadily decreasing as interest rates get lower.
This third point is perhaps the most interesting to us. Not only have rates been more or less in steady decline since 1980, but the increases have become less and less intense. Which, to some extend makes sense when you consider this:
The US economy is much more indebted than it was in the 80s, so smaller and smaller increases in interest rates have greater and greater impact on balance sheets, cash flows, and incomes.
Additionally, what that bond market chart also doesn’t tell you, and what we think a lot of market participants are missing, are the prevailing economic conditions at the time of each of these sell-offs.
So we took a look.
That’s a lot of data, but couple things stand out in our nine cycles:
- Bond yields sold off around 200bps.
- Growth rose around 1.3% in the following year and a half.
- Inflation didn’t change much.
- Real Yields (as measured in a hacky, and technically incorrect way, by taking the difference between the bond yield and inflation) absorbed most of the increase in yields.
Which to sum up, meant that bond yields sold off because people thought there was going to be a lot more growth (and there was). Higher interest rates reflected greater demand for credit (to finance spending and investment amidst the boom) rather than investors worrying about greater inflation.
Note this isn’t true in our 1979 example, nor would we expect it to be true for most of the stagflationary 70s (where bond yields went up because people expected higher inflation, not higher growth).
Comparing today to those periods, we can see pretty clearly that economic conditions are much worse than in prior tightening cycles, and monetary policy (as defined by our hacky real yield estimate) is much easier.
Were this tightening to continue, it would represent a significant normalization of monetary policy, at a time when conditions are relatively weak.
Higher interest rates would flow through to higher debt service costs to borrowers, lower asset prices (on stocks and real estate, which are also interest rate sensitive), and a stronger dollar (which would make US products less competitive). All in, higher interest rates represent a significant tightening in liquidity that would need to be offset by a fundamental improvement in the ability of the US economic machine’s ability to generate liquidity.
This isn’t to say we at Snow doubt this could happen. More just to point out the magnitude that this shift would represent.
In short, the market is buying what Trump is selling.
As an aside, the market is also pricing in very good times for banks..