Interest rates are the penalty you pay for purchasing something today instead of postponing consumption until tomorrow. They are also the reward you receive for saving and engaging in delayed gratification.
I don’t mean to get all philosophical in The 10th Man, but one thing I’ve noticed about interest rates is that people have all kinds of theories as to what makes them go up or down. The theories are more or less meaningless. Rates went down for 35 years. Did they go down for 35 years because economic growth slowed? Did they go down for 35 years because inflation moderated? Did they go down for 35 years because money velocity slowed? Productivity? Energy prices? Risk premia? Does any of this stuff matter?
I find that theories such as these (like a lot of things in finance) are explanatory rather than predictive. Ex-post, you can look back and say, “Okay, interest rates went up because of inflation or this or that,” but these sorts of things don’t really help people predict the direction of interest rates. In my experience, not a lot of people have had success in forecasting interest rates. Interest rates have made fools out of all forecasters. Unless you look at the flows.
For me, a flow model for forecasting interest rates is much more helpful because, at the end of the day, interest rates are a function of the supply and demand for government bonds. If China sells $50 billion of government bonds, interest rates will go up. If the Fed buys $50 billion of government bonds, interest rates will go down.
Currently, interest rates are going up, and some people are using the flow model to explain the price action. We have a lot of Treasury issuance because we are running giant deficits. China is selling. Still, people have a very static view of the flows, as if these conditions will exist from now until the future.
Demand
People were using the flow model 15 years ago as well. I don’t know if you remember what it was like in 2008–2009, but there were some prominent hedge fund managers who were predicting skyrocketing interest rates, which never came to pass. They had observed that issuance was very high back then, too, with the government running $1.8 trillion deficits, but what they didn’t take into account was that demand would rise to meet supply.
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The stock market was crashing, and people were de-risking, fleeing to the safety of government bonds. Those auctions were very much oversubscribed. The lesson here is that while it may be tempting to look at the deficit situation as intractable, things can change.
At the moment, it seems unlikely that interest rates could ever come down. The Fed is paranoid about inflation, even after it has fallen significantly from the highs. The economy refuses to slow down. Payroll reports come in stronger than ever. There isn’t a lot to fall back on here because the last time interest rates peaked, it was 40 years ago. But back then, people were calling Treasury bonds “certificates of confiscation.” To think that you could have had a 10-year note with a 14% yield. That would have been pretty attractive.
But Bonds Are Attractive Now
The odd thing is that Treasury bonds are pretty attractive these days, on an objective basis. Stocks are objectively overvalued. Bonds are not. You’re getting positive real rates for the first time in years, and those real rates will grow as inflation continues to fall.
It’s funny—everyone wanted bonds at 1% yields in the 2010s, but nobody wants them at 4.5% yields in 2023. And there is probably no yield that would ever make them attractive. In fact, the higher yields go, the more unattractive they become as the narrative that we’re in an inflationary debt spiral continues. Things may look very different a year from now.
I’m a trader, so I try to get scientific about entry and exit points, but most of you aren’t. Most of you are presented with the problem of how to allocate assets in your 401(k). All I’m saying is that current conditions argue toward a higher allocation to fixed income and a lower allocation to equities. If you currently have a 60/40 portfolio, maybe it’s time to make it 40/60. Small changes in asset allocation can make a big difference. Also, shorting bonds is becoming an expensive proposition.
I will also add that mortgage rates are inching closer to 8%. I have a quote: “That which is unsustainable cannot be sustained.” At 8%, there will be a policy response of some sort. Use your imagination. Maybe Powell gets a phone call on the bat phone from the White House. It is an election year, after all.
Jared Dillian, MFA
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