Macro Post #1: January 20th, 2023
After a once in a lifetime pandemic brought supply chains and economic activity to a halt, the Federal Reserve lowered what were already historically low interest rates to effectively zero. Coupled with the Fed’s signals to provide endless liquidity, the “easy money” that markets had grown accustomed to after the Great Financial Crisis became that much easier. This changed in 2022 with the specter of inflation rearing its ugly head.
2022 saw financial markets twist in ways that may not have close historical parallels. With the washout of both bonds and equities in the first half of the year, investors had few places to hide outside of the energy sector.
The outlook for 2023 is anyone’s guess. [website name] does not purport to be in the business of market forecasting, timing, or crystal ball gazing. This website instead hopes to provide useful commentary and data revolving around economics, investing, and politics. Each month will feature one long-form “macro” article in addition to investment ideas and reviews published each month. Our first 3 long-form publications will deal with competing macro-level forces at play in the world, the first of which is published below.
First Three Macro Articles:
- Rising Interest Rates vs. Sovereign Debts
- Pax Americana vs. Multipolar World Order
- ESG vs. Old Energy/Economy
Rising Interest Rates vs. Sovereign Debts
The Federal Reserve reported that the US Federal Debt on July 1st 2022 stood somewhere in the ballpark of $30,928,912,000,000….. Which is trillions with a “T”. It was half of that at the beginning of 2012, which was double the debt level at the start of 2005. With rapidly rising interest rates, the question that naturally arises is how long can they stay risen.
Most people interested in financial markets knows of the mythological tale of Fed Chair Paul Volker “breaking the back” of the inflation that erupted in the 1970s with rapid and steep interest increases. The current outlook is a completely different ballgame, as the debt level relative to GDP has skyrocketed since those days of yore.
The only way that this gravy train kept running down the tracks was a policy seemingly agreed upon by every major central bank around the world: unprecedented rock bottom interest rates…. For decades.
When debt levels were skyrocketing, and interest rates remained low, the debt could still be serviced reasonably. But some combination of debilitated supply chains, fiscal responses to Covid lockdowns, low interest rates, and over a decade of post-Great Financial Crisis liquidity that the Fed has provided have led to something not feared in generations: Inflation. And the Federal Reserve fights inflation with raising interest rates.
High debts and rising interest rates mix like oil and ESG funds. But hey, if you’ve been long US equities and holding tight, the Fed has been your friend for a long time.
But friends change. And despite your feelings about the Fed, which are likely all justified, this old friend has been clearly signaling its intention to continue to raise interest rates into early 2023. Last year, the US yield curve inverted and then inverted some more. This is thought by many investors to portend a recession, as it has often preceded recessions of the past.
Inflation may be fading or it may be secular. We’ll know one day. But if central bank interest rates remain high for long, governments the world over will feel the pressure of larger and larger portions of their annual budgets being earmarked for servicing interest payments on their colossal debts. The interest rate policies of major central banks are caught between a rock and a hard place, as they must fight inflation without blowing out debt burdens.
The stalwart Bank of Japan capitulated in late December 2022, with a 25 bps rate increase on their 10 year bond, something seemingly sacreligious in their eyes mere weeks ago despite their international counterparts hiking rates much earlier in the year. Investors are looking to see which will be the first to blink and cut if economic indicators sour.
If interest rates remain high to combat potentially persistent inflation, the fiscal and monetary policy responses by governments and central banks across the world will likely prove to be defining investment signals of 2023. They also have the potential to lead to a dramatic reshaping of the current political world order, which will be the topic of next month’s long-form article.