Are we there yet?

Rates markets struggle to escape "secular stagnation"

Photo: JanBaby

“It’s the economy, stupid.” – James Carville

James Carville, President Bill Clinton’s campaign strategist, neatly summarized the frustrations of American voters in 1992 and, unintentionally, bond markets today.  Markets that were unprepared for the scale and rapidity of interest rate rises in 2022, the worst year on record for bond returns, remain puzzled that the US economy continues to evade the most-predicted recession in history despite interest rates the consensus regard highly restrictive.

Markets’ bafflement is rooted in two mistaken beliefs: (1) that central banks set interest rates; and (2) that the US is afflicted by an ill-defined malady called “secular stagnation”.  As late as September 2021, the Federal Reserve expected to raise interest rates by no more than a quarter percentage point in 2022 and not more than 2 percentage points this cycle.  That the Fed was compelled to raise rates by 4.5 percentage points since and project further increases this year clearly demonstrates that the economy, not the Fed, dictates rates.  That the US economy continues to grow robustly amid prevailing interest rates well above the Fed’s and consensus’ anæmic estimates of neutral reveals secular stagnation for the unfounded narrative that it is.

Readers of Thematic Markets will be well aware that automation-driven Localization has been and continues to be the primary driver of both the economy and the rise in real rates.  But after a 400bp+ rise in frontend rates in just over a year, it is reasonable to question whether rates now have adjusted sufficiently to reflect Localization’s effects on the marginal product of capital, and if not, where the most compelling risk-reward opportunities lie in rates and other asset classes.