Dennis C. Butler, President
of all guest columns written by Dennis C. Butler, CFA
t’s been a long time coming. For forty years the financial markets had seen interest rates move in only one direction: down. It wasn’t a straight line downwards, but beginning in the early 1980s, rates gradually fell from percentage points in the mid to high teens to just above 0% in recent years, even dropping below 0% in the case of certain sovereign bonds, notably in Europe. Two generations of investment professionals and market participants knew only this benign environment in which there was only positive pressure on financial asset values generally, and real assets as well (real estate valuations are heavily influenced by the cost of debt, for example).
Part and parcel of the rate picture over this period was a favorable inflation trend. An inflationary episode in the late 1970s and early 1980s caused fixed-income investors to demand higher returns to compensate for the loss of purchasing power. As inflation subsided in and after the Volcker years in the U.S., the reverse occurred, and rates demanded on debt securities declined. Eventually, inflation declined to the point where central bankers acted to encourage pricing pressures to avoid deflation, which, it was feared, would have deleterious economic consequences. The Pandemic further encouraged such measures as policy makers worked to avoid economic collapse, resulting in the extraordinarily low rates the world has experienced over the past several years.
A confluence of events appears to have finally upended the trend of declining borrowing costs. Pandemic-induced disruption of supply chains, robust consumer demand for goods and services spurred by government rescue spending, the energy crisis in Europe caused by the war in Ukraine (and food shortages in countries dependent on grain shipments from the region), and production shut-downs in China have awakened inflationary pressures that have been long dormant. Growing wage demands and a revival of union activity among workers have also created fears of future price increases.
Additionally, central banks have acted aggressively to blunt price increases and prevent expectations of higher future prices from becoming embedded in consumer and business psychology. Combined with the conditions listed above, this has hit fixed-income markets hard this year. In the U.S., for example, the two-year treasury note’s yield climbed from about 0.15% in the spring of 2021 to 4.2% at quarter’s end. The German government’s ten-year note, an important European benchmark security, which yielded minus 0.8% at the time the Pandemic erupted in early 2020, and which still sported a negative yield at the end of 2021, now returns 2.1%. Such stark increases in yields correspond to significant drops in the securities’ prices, resulting in negative returns for investors. Given the influence of sovereign debt on borrowing costs generally, such costs have risen markedly economy-wide. Thirty-year mortgage rates in the U.S., for example, now stand at 6.9%, the highest in fifteen years — high enough to begin to have a significant impact on the housing industry, a major economic sector.
Has the long-term trajectory of interest rates been permanently altered? It's difficult to say, but it’s hard to imagine a return to what was recently seen as “normal” in financial markets. Continuation of the long-term trend of offshoring industrial activity to lower-cost regions like China seems iffy now due to political and supply-chain related security concerns. A superabundance of capital in the system that fed the “reach for yield” phenomenon may be changing as enterprises raise capital expenditures, partly in response to the perceived need to reduce supply risk through re-shoring of manufacturing, and partly because of government incentives. Demands for better compensation may also put pressure on historically high corporate profit margins (profitability that was often used to fund share buybacks, supporting stock prices).
Financial markets may be returning to a more normal pricing of risk and cost of capital. For example, a thirty-year mortgage costing homebuyers less than 3% at the low point reached in early 2021 was a great deal, but very unusual; the six percent cost that is now crushing the housing industry is more in line with historical norms, as average rates were just under 8% over the last fifty years. With this return to normal, risky borrowers’ access to credit on historically easy terms could be a thing of the past. Finally, the negative interest rate environment that characterized trillions of dollars in sovereign debt just last year could come to be seen as the historical oddity that it was. If these changes result from disembedding the expectations of easy credit that have shaped finance for so long, that would be a good outcome indeed.
A “Minsky moment” may have arrived. Economist Hyman Minsky described how, during periods of prosperity, risks build in the financial system that eventually become unsustainable, which then erupt into the open to destructive effect. The Financial Crisis may be viewed as one such moment, in which new financial products obscured growing financial leverage (debt). Eventually the time bomb exploded, resulting in the failure of Lehman Brothers, the bailouts of other financial institutions, and losses for unsuspecting investors worldwide. The failure of a couple of hedge funds in the months leading up to the Lehman disaster, as well as distress in the mortgage security market, proved to have been the canaries that gave forewarning of the turmoil that was to come.
In a financial world accustomed to low and falling interest rates, buyers purchased almost anything with a yield attached. Now, both rising market rates and actions by the world’s important central banks that encourage higher lending costs to counter unexpectedly high and persisting inflation have produced seismic shocks. For months now, trading in the U.S. treasury debt market — the world’s most liquid market and an important benchmark — has become difficult; on occasion the authorities even flooded the system with cash to ease market conditions. Additionally, potential cracks have appeared in the international financial structure; in April 2021 another hedge fund failed spectacularly due to overleverage, leaving its lenders with heavy losses. More recently, one of those lenders, a large European bank, has seen its market value sink as investors fear its capital buffers will be inadequate to cover its lending mistakes.
Even more notably, in the U.K., pension funds — almost by definition conservatively-managed pools of assets — had to be bailed out by the Bank of England through an emergency intervention in the government bond market. Ill-advised revenue and spending proposals from the new government wreaked havoc in the country’s bonds, sending borrowing rates skyrocketing within a couple of days. As it turned out, much of the bond selling came from retirement funds. A large number of British funds had come to rely on an investment strategy known as “liability-driven investing” that promised to help them meet their future obligations without having to demand more cash from the pension sponsors. The strategy, presciently called a “ticking time bomb” by some, relied on derivative instruments, and, importantly, leverage. Seductively stable during quiescent times, when market turmoil hit, the technique forced these supposedly staid funds to sell to meet margin calls.
We don’t want to imply that these developments suggest another financial crisis is in the making, but they may indicate that the U.S. Federal Reserve and other central banks’ room to maneuver is more limited than Volcker’s was forty years ago. The vastly greater size of global debt markets has arguably made the system more fragile and thus more prone to serious blow-ups. On the other hand, perhaps the authorities won't need to employ drastic rate policies to produce the desired impact on inflation. Everything in finance happens more quickly these days..
You know that the horses have already fled the barn when Wall Street gets around to closing the door. Sure enough, with stocks in the U.S. down over 20% this year, and trading at 22-month lows, the financial press and commentariat are rife with stories about how bad things will get. At quarter’s end one observer said, “the worst is yet to come,” a common refrain. A major Wall Street bank predicted a down 2023, and cut its market forecast for 2022. Another bank says to “underweight equities.” A commentator mumbled “deep trouble,” meaning recession in 2023. A story in a leading financial newspaper recounted how former “crypto” traders were embracing treasury bills. An advisor “recommends prayer,” according to another story (on a day the markets rose 3%). Another favorite theme: what “billionaires” are buying to get through the bear market.
All this sells newspapers and mouse clicks and may address a human need to feel in control of one’s future and comprehend the present, but in fact, it isn’t useful. A truly beneficial market commentary might have recommended in happier times that crypto, along with low quality securities, be avoided (even treasury bills yielding 0% would be a better choice). Preserving capital for a better day, when stocks were down, say 20%, would have been a useful suggestion, but would have involved truly looking ahead and exercising insight, seldom seen when markets are climbing at a rapid clip.
Putting aside the entertainment value of market chatter from Wall Street and the financial media, the real issue has to do with the question of what markets are currently “discounting”; in other words, what information, opinion, and analysis is already built into security prices. Although the answer can never be determined with precision, markets look forward, and declines of over 20% so far this year mean that a lot of bad news is already accounted for in current prices. Can things get worse? Of course, but the fact that such dire scenarios are being discussed among players indicates that at least some of that possibility has also entered the price-setting mechanism.
We can never know where markets will go or when and for how long. Market commentary, though far from providing any useful guidance to what will happen, does instead provide clues about how far along we are in the process of discounting the future.___________________________
Dennis C. Butler, CFA, is president of Centre Street Cambridge Corporation, investment counsel. He has been a practitioner in the investment field for over 37 years and has been published in Barron’s. He holds an MBA from Wharton and a BA in History from Brown University. His quarterly newsletter can be found at <www.businessforum.com/cscc.html>.
“Current low valuations reward the long-term view”, an article by Dennis Butler, appears in the May 7, 2009 issue of the Financial Times (page 28). “Intelligent Individual Investor”, an article by Dennis Butler, appears in the December 2, 2008 issue of NYSSA News, a magazine published by the New Yorks Society of Security Analsysts, Inc. “Benjamin Graham in Perspective”, an article by Dennis Butler, appears in the Summer 2006 issue of Financial History, a magazine published by the Museum of American Finance in New York City. To correspond with him directly and /or to obtain a reprint of his featured articles, “Gold Coffin?” in Barron’s (March 23, 1998, Volume LXXVIII, No. 12, page 62) or “What Speculation?” in Barron’s (September 15, 1997, Volume LXXVII, No. 37, page 58), he may be contacted at:
Dennis C. Butler
Centre Street Cambridge Corporation
Post Office Box 390085
Cambridge, Massachusetts 02139
Your comments and suggestions for these pages are most welcomed!
[Return to Main Index] [Return to Home Page]
Brookline, Massachusetts 02446.2822 USA
© Copyright 2022 Dennis C. Butler, All Rights Reserved
Revised: October 17, 2022 TAF
© Copyright 2022 Dennis C. Butler, All Rights Reserved