Interest rates remain the “topic du jour” for investors as a potential headwind to global growth. Jon Adams joins Ben Jones on the Better conversations. Better outcomes. podcast to discuss rising interest rates, monetary policy and more.
Be sure to subscribe to the Better conversations. Better outcomes. podcast on iTunes, Google Podcasts, Player.fm, Stitcher or Spotify to hear Jon’s full, behind-the scenes interview, available on October 31.
Ben Jones: Interest rates, I mean, this is the topic of topics. Everyone loves to talk about it every day, all day in the financial media. And so, really over the past decade, what was the consensus about how this cycle, this rate increase cycle, would work? And now that we’re kind of in the midst of it, what was the, you know, group’s consensus about what the U.S. Fed may do going forward as far as how much further it has to go in raising rates?
Jon Adams: Sure, yeah, the first part of the question, I would say, over the last ten years people in my shoes have consistently overestimated the degree to which central banks would be able to raise rates. We’ve been consistently wrong on that.
Now the Fed, going into the last few years, said “we’re going to raise rates three or four times this year.” They might have gotten one hike over the last few years. This year is significantly different. The Fed came into the year saying “we expect four hikes.” We’re probably going to get four hikes this year.
We’ve been of the view over the last year and a half as a multi-asset team that inflation was going to surprise on the upside, central banks were actually going to follow through with those rate hikes, so we’ve been really proven correct to a large extent on that view.
I would say in coming years, we expect two to three hikes by the Fed next year; the Fed’s telling us three potential hikes, but I think the market continues to really underestimate the seriousness of central banks, the pressure behind inflation overall. But we’ve been talking about monetary policy divergence, it seems like, for the last ten years. We’ve actually finally gotten it really over the last two years.
Ben Jones: And so, you know, there’s a lot of people that talk about the Fed’s ability to raise next year being limited by the fact that the long end of the curve has not moved a whole lot. Did you guys talk much about the potential for inverted yield curves?
Jon Adams: Yeah, we definitely did, and over the past couple of days the yield curve has steepened significantly. But that was a topic of conversation. Does it matter if the yield curve gets flatter or potentially inverts? And we found a lot of reasons that this cycle is different; if you listen to what the Fed’s saying, we’re taking a lot of the focus off traditional measures of the flatness or steepness of the yield curve. Quantitative easing really changed things quite a bit, I would say, from that perspective.
We are still quite a ways away from an inverted yield curve, but even in that situation, a recession follows anywhere from six to eighteen months after that. And equities actually usually do pretty well for the next year following an inversion of the yield curve. So we would caution investors against if the yield curve is inverted, to immediately sell all of their equities, for example, because I think that would be a very emotional response that hasn’t really played out on a historical basis.
Ben Jones: Okay, so we talked about the U.S. Fed, let’s talk about the ECB. It’s a little bit of a different situation, but by what I could tell from the paper, there’s a feeling that the ECB has enough wiggle room to start raising rates themselves. Tell me about the discussion.
Jon Adams: You know, as far as raising rates, that’s probably going to happen in Fall late next year, something like that. As far as unwinding their asset purchases, that already happened starting in October from 30 billion to 15 billion per month Euro, and that’s going to end at the end of this year. So I think there is momentum behind that. As far as raising interest rates, you might get one hike next year. It could be ten basis points, it could be 25 basis points, but likely a bit later in the year.
Where you have seen some change is on wages. In Germany in particular, you’ve seen wage growth around four percent. So I would say there is increasing confidence behind raising rates among the ECB. Core inflation is still right around one percent, so still well below target. Headline inflation is much closer to target. So I think there is a bit more impetus this year than there was last year to potentially hike rates.
Ben Jones: And with growth kind of slowing in the second half of the year in Europe, do you think that kind of limits their ability to raise rates?
Jon Adams: Yeah, I don’t think they’re in a hurry to raise rates, by any means. You might get one hike next year, and then take a pause and kind of see how things work out. The Italian situation is definitely a headwind there; I think the ECB will look at that situation very closely to make sure that they’re not tightening policy a bit too much. I think if inflation does feed through, they’ll be more confident in the overall outlook, but Europe’s been really hurt by the slowing down in emerging market growth this year. Europe’s much more exposed to emerging markets than the U.S. is, and I think that’s been a key headwind for the ECB this year.
Ben Jones: Very good. Now I want to talk to you about one topic that I’ve heard several times come up from advisors, which is the incentive of central banks to raise interest when that ultimately raises the interest payments that they have to make on the bonds that they’re issuing as well. What is your team, or is your team even thinking about the government’s ability to pay back some of the debts that they borrow at higher rates?
Jon Adams: Yeah, I think we’re in a really unique environment where you got this unprecedented, I would say, fiscal stimulus late in the cycle. Usually fiscal stimulus comes right after a very deep recession. We got it at a pretty good stage of the cycle, kind of late cycle, when growth is already pretty good.
So we are getting a lot of questions from clients about the sustainability of the U.S. debt situation. We are concerned about it, we’ve written a lot of pieces on that, but I would say that’s more of a medium to long term theme. In the short term, we’re not as worried about it. You’re going to see a lot more stories in the media now about interest payments, they’re going to be bigger than Medicare in a couple of years, they’ll be bigger than the defense budget in about five years according to CBO estimates, so you’ll be reading a lot more about this theme overall. But if you look at countries like Italy and Japan, they haven’t been punished for having a lot higher debt levels than the U.S. overall.
Investors are still willing to lend to the U.S. at about three percent on a ten year basis, only a bit higher on a thirty year basis. So I think the market would have to really be the enforcer there, and they’re not really at that point yet.
Ben Jones: Now with respect to interest rate policy, should the U.S. actually experience this consensus recession, not the one that you guys have put forth as your base case, but from a consensus perspective, if we went into recession, the Fed has a little bit more limitations in the tools available to them. I noticed that that was a discussion. Walk me through that.
Jon Adams: Yeah, it definitely was, and a couple of our speakers highlighted this that, they had really differing views. One view was that the Fed might have just enough to cut in a recession period. If the Fed can get to, maybe, three percent on their overnight rate, that might be just enough to cut in a recessionary period. But in a traditional recession, the Fed cuts four to five percent. It’s very difficult to think we’re actually going to get to that four or five percent level in this cycle, so I would say a topic of discussion was “you might not have the fiscal ability to respond to a recession that you had in prior recessions.” We already got the stimulus before the end of the cycle.
So the deficit now is about five percent in the U.S., as a share of GDP. It’s going to get bigger; in a recession, it would get much bigger. So fiscal ability will be very limited; monetary ability, the Fed could cut rates from, say, three to zero, that might be enough, they might need to implement additional forward guidance, additional QE, those kinds of things. But I would say, two years ago we were worried that the Fed would ever be able to get off zero and have anything to cut in the next recession, so I think we’re at a much more solid situation now than we were two, three years ago.
Ben Jones: And internationally, should different global economies experience a recession there, this divergence of monetary policy has left them with maybe even less tools. Did you talk about that at all?
Jon Adams: We did a little bit. I would say those economies, like in Europe and Japan, are further behind in the cycle. We think that any kind of recession would probably be caused by the U.S. more than likely than internationally. And so from that perspective, the U.S. could see a recession, Europe and Japan might see a recession or might have very slow, positive growth. But I think the ability there to respond, from a fiscal perspective, is much more than in the U.S. But yes, to your point, monetary policy, there’s really nothing to cut in Europe, nothing to cut in Japan.
We’ve seen central banks get very creative over the last ten years here, do things that we never thought would occur. We’ve seen central banks in Japan, for example, buying REITs, buying equities, so that could happen again, but I would say more likely on the fiscal side than on the monetary side outside the U.S.
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