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”.
Subscribe to our blog for more on global equities and other asset classes.
© 2021 London Stock Exchange Group plc and its applicable group undertakings (the “LSE Group”). The LSE Group includes (1) FTSE International Limited (“FTSE”), (2) Frank Russell Company (“Russell”), (3) FTSE Global Debt Capital Markets Inc. and FTSE Global Debt Capital Markets Limited (together, “FTSE Canada”), (4) MTSNext Limited (“MTSNext”), (5) Mergent, Inc. (“Mergent”), (6) FTSE Fixed Income LLC (“FTSE FI”), (7) The Yield Book Inc (“YB”) and (8) Beyond Ratings S.A.S. (“BR”). All rights reserved.
FTSE Russell® is a trading name of FTSE, Russell, FTSE Canada, MTSNext, Mergent, FTSE FI, YB and BR. “FTSE®”, “Russell®”, “FTSE Russell®”, “MTS®”, “FTSE4Good®”, “ICB®”, “Mergent®”, “The Yield Book®”, “Beyond Ratings®” and all other trademarks and service marks used herein (whether registered or unregistered) are trademarks and/or service marks owned or licensed by the applicable member of the LSE Group or their respective licensors and are owned, or used under licence, by FTSE, Russell, MTSNext, FTSE Canada, Mergent, FTSE FI, YB or BR. FTSE International Limited is authorised and regulated by the Financial Conduct Authority as a benchmark administrator.
All information is provided for information purposes only. All information and data contained in this publication is obtained by the LSE Group, from sources believed by it to be accurate and reliable. Because of the possibility of human and mechanical error as well as other factors, however, such information and data is provided "as is" without warranty of any kind. No member of the LSE Group nor their respective directors, officers, employees, partners or licensors make any claim, prediction, warranty or representation whatsoever, expressly or impliedly, either as to the accuracy, timeliness, completeness, merchantability of any information or of results to be obtained from the use of FTSE Russell products, including but not limited to indexes, data and analytics, or the fitness or suitability of the FTSE Russell products for any particular purpose to which they might be put. Any representation of historical data accessible through FTSE Russell products is provided for information purposes only and is not a reliable indicator of future performance.
No responsibility or liability can be accepted by any member of the LSE Group nor their respective directors, officers, employees, partners or licensors for (a) any loss or damage in whole or in part caused by, resulting from, or relating to any error (negligent or otherwise) or other circumstance involved in procuring, collecting, compiling, interpreting, analysing, editing, transcribing, transmitting, communicating or delivering any such information or data or from use of this document or links to this document or (b) any direct, indirect, special, consequential or incidental damages whatsoever, even if any member of the LSE Group is advised in advance of the possibility of such damages, resulting from the use of, or inability to use, such information.
No member of the LSE Group nor their respective directors, officers, employees, partners or licensors provide investment advice and nothing contained in this document or accessible through FTSE Russell Indexes, including statistical data and industry reports, should be taken as constituting financial or investment advice or a financial promotion.
Past performance is no guarantee of future results. Charts and graphs are provided for illustrative purposes only. Index returns shown may not represent the results of the actual trading of investable assets. Certain returns shown may reflect back-tested performance. All performance presented prior to the index inception date is back-tested performance. Back-tested performance is not actual performance, but is hypothetical. The back-test calculations are based on the same methodology that was in effect when the index was officially launched. However, back- tested data may reflect the application of the index methodology with the benefit of hindsight, and the historic calculations of an index may change from month to month based on revisions to the underlying economic data used in the calculation of the index.
This publication may contain forward-looking assessments. These are based upon a number of assumptions concerning future conditions that ultimately may prove to be inaccurate. Such forward-looking assessments are subject to risks and uncertainties and may be affected by various factors that may cause actual results to differ materially. No member of the LSE Group nor their licensors assume any duty to and do not undertake to update forward-looking assessments.
No part of this information may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without prior written permission of the applicable member of the LSE Group. Use and distribution of the LSE Group data requires a licence from FTSE, Russell, FTSE Canada, MTSNext, Mergent, FTSE FI, YB and/or their respective licensors.
