By Michael Hampden-Turner, director –fixed income and multi-asset applied research
The world record for limbo dancing involves remaining on your feet but getting under a pole which is only six inches above the ground. I’m just going to let that sink in for a second: six inches. Many readers, like me, will recognise limbo as a Caribbean dance designed to humiliate the less supple and more inebriated party goer. By design, failure is inevitable as the bar becomes lower and lower each time. Equally, economic interest rate cycles have seen peak rates clear a lower and lower bar for the last fifty years. Each cycle the zenith is lower than the previous cycle and each time it seems impossible that the cycle will be able to fit under the bar again. In the years ahead, the question investors want answered is: Will we beat six inches or are we set to knock the bar off?
The two graphs above illustrate this point. Each boom-and-bust cycle has seen a progressively lower interest rate cycle with limbo-like lower highs and lower lows. Things have not been the same since the global financial crisis. Policy rates and inflation have been in the other sort of limbo for over ten years with Covid providing a deus ex machina intervention. Can economic theory help us out here?
Amongst the lexicon of theoretical but unobservable variables that economists like, such as NAIRU and the Phillips curve, there is ‘r-star’. ‘R-star’ is the real neutral rate of interest where the economy is balanced and rates are neither expansionary nor contractionary. Cut rates below this level and it is stimulatory and hike rates above and it slows the economy. For those less keen on the theory side, think of the damage to the economy and resulting slowdown that would be caused if mortgages and corporate loans became twice as expensive as they are now in a short period of time.
Being theoretical and unobservable is a problem for something so useful and while there are differences of opinion on how r-star might be estimated there is a consensus that it has been falling for some time. It is often used as an ex post facto explanation of why inflation has remained low since the financial crisis.
Explanations for a secular falling r-star include an aging population, lower productivity and higher leverage. A sort of ‘Moore’s Law*’ for finance with greater efficiency and higher leverage creating tighter margins and lower returns. More than ten years of quantitative easing must also play a part. All these factors are long-term trends that are decades in the making. Also, they are a plausible explanation for secular trends we see in the two graphs above.
What do these theories tell us about the outlook for 2022? While central bankers are likely to be cautious about some aspects of the current wave of inflation it seems likely that they will need to act in 2022 (perhaps not as imminently as many currently think). However, it seems unlikely that it will take many hikes before the market starts to ‘feel’ it. How far could this be? Government bond curves are currently pricing in very modest policy rate moves.
Markets are pricing in baby steps in 2022 for rates hikes. Implied forwards suggest that the UK will only just reach the self-imposed 0.5% base rate threshold to stop reinvesting APF proceeds towards the end of Q3. In Europe, forwards imply that policy rates are expected to remain negative for over eight years. Now, one should take market implied rates with a pinch of salt. Yields are compressed after years of QE and perhaps register this imbalance of supply and demand. , especially as we look forward as far as five years. But it does suggest that we could be in for a rate cycle with lower maximum than many assume. For now, we remain on course to clear the seemingly impossible bar set at “six inches”.
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