Blain’s Morning Porridge – 30^th November, 2023: Interest Rate Scenarios: Stick with the Normalisation Cure, or another Puff of QE Skunk?

“I’ve been through more cold turkeys than there are freezers.”

Expectations of early interest rate cuts are high, especially as recession signals are set to rise through Q1 2024. Will Central Banks stay the course and normalise interest rates, or will be take the easy option of further low interest rate distortion?

Happy Saint Andrews Day – the Patron Saint of Scotland, Ukraine and Russia, plus some other spots including Barbados. Yesterday, I found myself lunching in London’s Smithfield Market, close to the spot where Sir William Wallace was brutally executed by the English for the dastardly crime of objecting to English raping and pillaging our land. We never forget. We seldom forgive… It’s unlikely the Galilean fisherman ever came close to any of the nations that now celebrate him. What would he think of the World today?

After taking the easy option of stuffing yesterday’s Morning Porridge with lots of Charlie Munger Quotes – today I was thinking of doing the same thing with Henry Kissinger comments. There are many classics, but let’s go with: “There can’t be a crisis next week, my schedule is already full.”

Interest rates

Yesterday, I wrote about my expectation inflation is likely to remain sticky – mainly due to ongoing supply chain disruptions, wages, corporate down/right-sizing, energy volatility plus whatever no-see-ums the pernicious financial gods throw at us. As a result, global bond yields are unlikely to fall much lower. If we are in a new era of normalised interest rates – around 2-4%, that has serious and profound implications for how the global economy will perform. There are a number of competing scenarios:

1. Normalised Interest Rate Environment:

Under this scenario a period of “normalised” real interest rates could prove cathartic for economic growth – restoring the primacy of a market driven economy over the distortions created by Zero Interest Rate Policy (ZIRP) and QE since 2008. By forcing businesses to invest in real stuff to generate real returns, and households to budget on the basis borrowed money has consequences as a result of real interest rates, over the medium-term the global economy will rationalise and revert to growth. The transition will hurt – cold turkey. The outcome? A rational market.

Policy makers are keen to restore economic sanity and create “real” economy growth rather than push up the price of financial assets. Unravelling the consequences and distortions of ultra-low rates will not be without cost. 15 years of zero interest rate policies did little to stimulate growth – but simply created enormous financial asset bubbles and widened income inequality.

Normalised rates will hurt, but are necessary. The housing bubble could pop with home prices reverting to affordable levels, while stocks could trade down to sensible P/E expectations. Normalised rates lead to large transition costs as over-levered “Zombie” companies fail, unemployment spikes, and households are forced to budget for limited discretionary spending – triggering recessionary conditions.

However, these negative effects could be balanced by new corporate investment into new plant and infrastructure as the world adapts to changed supply chains and geopolitics, by the productivity gains expected for AI and increased digitalisation, and the increasingly subsidy focused efforts of governments to plan for climate change by sponsoring energy and economic transition.

Under this scenario, cold turkey hurts, but something stronger emerges.

2. Deflationary Risk:

Many economists see massive downside risks associated with normalised interest rates – that economies are vulnerable to long-term higher rates, and will be unable to withstand the transition pain. A combination of corporate slowdown, unemployment and consumer debt could trigger a deflationary spiral. Where governments are scrabbling to rebuild infrastructure and social assets, the rising cost of government debt will trigger rising tax demands to simply pay the higher debt service costs – triggering a deflationary death spiral.

It’s a risk – but a worst case one. Remember Blain’s Market Mantra No 2: “Things are never as bad as you fear, but seldom as good as you hope!” Entrepreneurial animal spirits, government subsidy and the new tech economy could overcome the deflationary trend. Yet, deflation is a major risk – especially if it morphs in deflationary-stagflation if inflation rises.

3. Renewed Interest Rate Distortions –

The risks raised by the cost of higher interest rates will push policy makers to make a deliberate choice to resume the policies of the QE/ZIRP (Zero Interest Rate Policy) era to avoid financial armageddon. They fear recessionary deflation and unsustainable debt loads as higher rates mean rising debt servicing costs crowd out all other Governments spending. (We are seeing a variation of this in the UK as a number of major regional and city councils declare themselves bankrupt as falling revenue from governments mean they have to slash services.)

Debt costs is a topic prone to hyperbole – I’ve been shocked by journalists assuming that because the latest 5year bond funded at 5%, therefore the cost of a government’s total borrowing is $50 bln on a Trillion! Not so.. the cost of the bulk of government borrowing incurred during the pandemic is close to zero! Financially sovereign nations don’t go bust – they print more money (albeit with consequences on their currency and economy!) Its countries that borrow in other nations currencies that suffer.

(Also, I am not convinced Central Banks need to worry about QT- quantitative tightening; selling the bond they bought back into markets. Why? Any inflationary effect is already in the economy – why not make them “disappear”? See my comment on the “Zonk” – a solution to reduce the UK’s debt burden by 30% : How much Time and Money does the UK need?)

Should nations revert to interest distortion – thus triggering renewed asset bubbles, and rising inequality – the consequences will be dire and become ingrained. Yet, many portfolio managers I speak to are anticipating some central banks will intervene to avoid recession next year as the lagging effects of debt (corporate and household), supply chain disruption, and defaults (plus maybe yet more banking crises) occur. Many anticipate the ECB will find its inner “do-whatever-it-takes” mojo and intervene dramatically once more to force down rates, creating an economic lifeboat for Europe’s battered economy.

However, as the QE experience from 2008-22 shows, a lifeboat is not an economic ship underway. It will work for some nations – recently I wrote about the Greek recovery on the back of stable government and EU support. More generally, what would happen if low growth, recessionary Europe is running at zero interest rate, while the US economy continues to run at its current pelt with normalised interest rates. Europe in recession and the US in growth? Where would you invest? It would be great news for the dollar, Treasuries and US stocks!

Long-term interest rate distortion in Europe would become an economic addiction… At some stage Europe will need the cold turkey of a serious interest rate shock.

The next 4 months are going to be fascinating as all the lagging effects of normalising interest rates kick-in: we will see this in rising corporate defaults and a wave of downsizing (I think the City of London is particularly vulnerable). Will Central Banks are Governments hold firm as we navigate the transition by avoiding the temptation to cut rates too quickly? They know to do so would be a short-term puff of ganga rather than an economic solution.

No time for 5 things – got to catch a train! Out of time…

Bill Blain

Strategist – Author of the Morning Porridge