#1002 - Are Higher Rates Here to Stay? | With Bob Elliott

0:09Our higher rates here to stay. Hi, everyone. Welcome to the Real Vision Daily Briefing. With me today is Bob Elliott, co-founder and CEO, CIO of Unlimited Funds. Hi, Bob. It's great to have you back again. Hey, Maggie. Great to see you. So we thought we were going to get a little rebound in stocks today, and they were most of the day, but they kind of faded into the close here, and we ended up with losses, all except the Russell. The Russell looks like they're hanging on. And we had Treasury yields edge lower. It seems like it's going to be one of those weeks where we meander around. We had stronger than expected durable goods, but consumer confidence dipped a little.

0:45We know we've got a PCE reading at the end of the week. So it seems like a good place to just start off and kind of take a look at what you see happening in the economy, since we are getting a little bit of mixed readings. Where do you think the US economy is? Yeah, I mean, I think it's always important to recognize that the economy moves way slower than all of our expectations and certainly anything that's on Twitter on a day-to-day basis. And so what we're seeing with the economy has been seven quarters of above, at or above potential growth. And we're kind of seeing the same thing play out, but we're seeing a little bit of deceleration, I'd say sort of through the quarter here with some of the later data, a little softer than some of the earlier data and the strength that we saw in the second half of last year.

1:34So modest deceleration. And I think the real question is what's going on on that inflation side of things, which is starting to pick up, showing some signs of, at a minimum, not moving durably down to the 2 % or below 2 % threshold. And I think in particular, starting to raise questions with the rebound in oil prices and gasoline prices, starting to raise the question of, is a three handle on inflation kind of where we're going to be at for, you know, through the course of the year. Yeah. And it, you know, energy was a big relief and it seems like whack-a-mole, right? I mean, I think everyone has anecdotal evidence.

2:15In fact, my husband just messaged me. He was in New York City today and just messaged me inflation. It's real. And it was like the smallest cup of yogurt ever for$7. Like that's not unusual for New York, but I mean, even that I was like, wow, wow, okay, you better go hungry. But I mean, it was kind of shocking, but I feel like we all still have instances where sometimes we're like, okay, like I feel a little bit better about this. But a lot of the time we just feel that stickiness of certain things just don't seem to be going down or there's periodic food, depending on what you're buying, get a break on eggs, something else jumps up.

2:52It doesn't feel like we're having this really rapid deceleration. inflation. So, I mean, it still may happen though, right? Inflation lags, doesn't it? Yeah. Well, I think the complicated thing with inflation is that there's a bunch of different moving pieces that are sometimes moving counter to each other. So the initial bout of disinflation coming from the fact that gas prices went from five to three, which then flows into all sorts of different places in the economy. And then also a big shift downward in durable goods as the supply chain issues started to get resolved, started to see a drop in used auto prices in particular, but also imported durable goods.

3:35And so that created a big disinflationary impulse on the economy and brought inflation down considerably. I think the key question, and at the same time, the services side of things, you can look at a lot of different pieces of it, but it's certainly not moving rapidly down. It certainly remains relatively elevated. I think the challenge is, as we look ahead, some of those big disinflationary impulses that existed with oil prices and gas prices falling and having another leg down through the end of the year, but now reversing and up 60, 70 cents, depending on exactly what you look at. And having those durable goods prices that were falling, now starting to rise, I thought it was one of the more interesting pieces of the inflation report was durable goods disinflation started to flip to inflation.

4:25That's not a good sign. At a time when the services side of things just isn't moving down as fast as certainly the Fed would hope, that's not a great combination on a forward-looking basis. And so I think that's when Chairman Powell talks about needing more evidence, that's what he means. It's not like no one is sitting here thinking, oh, inflation is going to go to 5 % or 10 % anytime soon. The question is, are we stabilizing at three or are we stabilizing at two in a compelling way? And I think that's the question that he's got on his mind. And I think there's good evidence to suggest that maybe they shouldn't be confident that it is there, particularly on a forward-looking basis.

5:06Yeah. How do wages plug into this? Because there was a time back in the day, I always remember that being the scariest thing for the Fed because wage inflation is really something that never, or I shouldn't say never, but is typically hard to reverse. Once you get that wage, it's very hard to take it away without inflicting a lot of pain or layoffs and resetting the whole situation. They get baked in for years at a time. Are we seeing that or is the labor market, the labor market's been tricky, right? Because we don't know what's temporary or business cycle. We don't know what's structural. It seems like it's been kind of hard to figure that out.

5:46What are you thinking about in terms of wages? Yeah, I mean, wages are critical. If you just think about like at a very simple level, inflation in the economy can be seen as how much are people earning relative to what their productivity is. And the difference between those two things essentially has to be prices because what they earn, they spend, and what they produce gets bought. It's a little more complicated than that in reality. But that kind of gives you a good benchmark of how to think about wages. And so nominal wages continue to be moderately elevated. They've come down a little bit.

6:18But still, particularly when you look at the wages of high propensity to spend income cohorts, so say your 60th percentile and below or your 80th percentile and below, So those wages continue to grow pretty rapidly on a nominal basis, a couple, let's say 2 % above where they were pre-COVID. The interesting question, the key question is how much productivity are you getting out of those workers? We have seen a pickup in productivity and measured productivity over the course of the last couple of quarters, back to sort of the longer term trend line. If that continues, then we can live with 5 % wage growth and 3 % productivity.

6:57That's an OK outcome. I think the real question is, is that really durable over time? And do we get that nominal wage growth derailed by input costs like gasoline prices going up 20%, 25 %? That's a big deal. If you're in the lower income cohorts with the high propensity to spend, that shift in gas prices from the low threes to the high threes matters for you in the day-to-day basis. Yeah, it does. We used to always think about it as an immediate tax, right? I mean, it's something that hits a pocketbook instantaneously. You really feel it. It's got a really sort of gut visceral response because you've got to open up your wallet every, you know, depending on how often you drive.

7:39And Americans drive a lot. So against that backdrop, does the Fed's plan to cut rates three times seem doable against this backdrop? Well, I think it's a good question. And certainly, when you look at that situation, certainly from the market pricing, a lot of the easy money has been made. When we came into the year, it was six or seven cuts. The economy was growing above potential, and there were inflationary pressures that had yet to be resolved. And the idea that the Fed was going to cut six to seven times was not reasonable, despite the real Raider-type comments that were going on. And we've adjusted significantly now to two to three cuts priced into the market.

8:20From my perspective, I look at that and I say, is that what I do? Probably not. On the margin, will the Fed probably do less than that, given the data that's likely to come out? Probably. But when you're talking about the difference between are they going to cut once or twice, you're kind of like splitting hairs there at that point, certainly from a trading markets perspective. Yeah. In a way that I don't, you know, it's within the cone of plausible. It's also very plausible that zero happened over the course of the year. But, you know, we're in the ballpark of not too much. Easing is likely to occur given the momentum that exists both in inflation and in the economy.

9:02Yeah, which is, as you say, very different from where we came into the year, what we came in thinking. So Jack Burnett gets the gold star today because I think he's asking the question, certainly, that we're all thinking about and that you've been tweeting about. If the long-term rate is closer to 3.5 % to 4 % instead of 2%, first of all, let's start with is that a likely scenario that we need to adjust to? And then I'll ask part two of his question. Hey, everyone. We're going to take a quick break right now to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.

9:38Have you ever wanted to trade Bitcoin but haven't dared try? With Plus500 Futures, you can trade crypto without the hassle of opening a wallet. With just a few clicks, you can register and start practicing with their free and unlimited demo. See a trading opportunity? You'll be able to trade it in just two clicks. Feel ready? You can move to real money with as little as$100 once your account is approved. And the great thing is that in addition to crypto, Plus500 gives you access to a wide range of instruments. S &P 500, NASDAQ, gas, and much more. Explore equity indices, energy, metals, forex, and beyond.

10:10With a simple and intuitive platform, you could trade anytime, anywhere. Experience the fast, accessible futures trading you've been waiting for with Plus500. With over 20 years of experience, Plus500 is your gateway to the markets. Visit us.plus500.com to learn more. Trading in futures involves the risk of loss and is not suitable for everyone. Not all applicants will qualify. Plus500. It's trading with a plus.

10:59Thank you. They have secured more than$1 billion in precious metals for their clients. Gold remains steady when inflation is on the rise and the dollar is in turmoil. Its value doesn't just hold, it increases during inflationary periods. And unlike money, gold can't be printed. It's your shield in times of economic uncertainty. Invest in something you can hold. Go to noblegoldinvestments.com slash vision to get started. Don't wait. That's noblegoldinvestments.com slash vision. Yeah, I think it's a critical question to start to be wrestling with. You know, I remember in this cycle when the short rate was at two and a half percent and Chairman Powell said it was restricted at two and a half percent.

11:55And you looked at it and you're like, I don't think so, man. And he was trying to back away at that. And even at rates at five and a half and in the high fours and through to the mid fives, over the course of basically a year plus, growth has continued to be at or a bit above potential. And so you sort of look at that picture and you say, the overall sensitivity to the economy, to the short rate, to the existing long rate structure, even with interest rates between 4 % and 4.5%, things are OK in the economy. And so what that highlights, I'd say on a tactical, cyclical basis, that really raises the question of whether there's enough tightening that exists on the short end to really slow things down meaningfully or quickly.

12:46I think the question on the longer term, which is, what does that longer term neutral interest rate look like? I think part of it is, first of all, a lot of uncertainty. And there will be seven academics in a room and you'll get seven opinions about it and seven highly quantitative models describing what's going on. So we have to accept the ambiguity of it. But I would say, look, there's a lot of people who talked about a two or two and a half percent rate back during the post-GFC era where we had huge debt overhangs in the private sector and depressed spending and incomes. That sort of story is not really pertinent, that pertinent to today.

13:26A lot of the healing has happened in the private sector in terms of the balance sheets. If anything, we're moving to an era where we're starting to get likely a lot more investment, part of it supported by the government and part of it private sector driven as a part of the deglobalization dynamic. So that's a draw for credit. And at the same time, the global savings glut has really stopped in a way that it had existed right after the GFC, where you had global central banks basically recycling liquidity into US treasuries and into US dollars. Places like China are more concerned with their currency going down than going up these days.

14:04And so you basically have this situation where probably the demand for capital on a forward-looking basis is meaningfully higher than where it was back in the in the post-GFC period. The supply of capital is probably lower. And we've got this inflation issue, which we at least have to acknowledge is more of an issue today than it was 10 years ago when people were more concerned about deflation. You put that all together, and probably the baseline level of interest rates that you're seeing is probably going to be higher certainly than two and a half, which is where we were for the last 15 years.

14:39Which is why this is a big deal. When I saw that tweet, I was like, when we're changing from basically assumptions that we've held for 15 years, that sounds like a big deal. So the other part of Jack's question, I split it into two, but his question is, are there areas of the market that will adjust higher? That's such a great neutral way to put it, Jack, because I'm wondering when I hear that, okay, is the fact that the neutral rate may be closer between four, maybe four and a half, 5 % even, is that in and of itself a bad thing? And then I think his question is, what is that adjustment? If there are areas that have to adjust, what does that look like?

15:18Well, it's a bad thing if you're a bondholder and you've locked in low interest rates for an extended period of time. those people who came to the year buying at 375, if the neutral rate is closer to 4 to 5, and on top of it, you have a circumstance where the term premium is pretty depressed right now as well, that's not a good picture for bondholders. I would emphasize this assumption that the Fed is going to bring interest rates back to 2.5 % or 3 % in this cycle is baked in all of these different models. I'm sure you every once in a while bump into a few interviews on Bloomberg, and you listen to the bond people, and basically every single bond person says, well, the long-term rate is 2.5%, or the Fed will bring interest rates down to 3%.

16:11Imagine those folks, and that's causing them to a bond. To be clear, that's causing them to buy yield at 425. At 425, if your long-term rate is 2.5, it actually looks like a pretty good deal over a cycle timeframe. When those folks start to say, I'm not so sure, maybe I need to pencil in a higher number. And we're actually seeing that in terms of surveys of professional economists and dealers. We're starting to see that long-term rate expectation creep up, when that shifts, that totally changes the valuation picture on bonds. And so bonds, particularly risk-free bonds, treasury bonds serve as the backbone of the whole economy.

16:55We already saw last summer, it doesn't take that big a rise to start to upend the apple cart and create some risk to stocks due to the rising discount rate if those yields rise. So a lot of the rest of the financial system is really dependent upon this continued expectation that interest rates are going to be low for a long time. Yeah. So the argument when you hear that is that even if the Fed will go back to that rate, even if they have to inflict pain to get there, but you're suggesting maybe they don't go back to that. Right. Well, I think I think that's part of the question is if the economy is structurally running hotter with higher productivity, higher demand for capital, lower savings rates, et cetera, you can have an economy that continues at higher inflation.

17:52You can have an economy that continues to be fine. right? You can have your unemployment rate at, let's say, five, which, to be clear, the average unemployment rate is five, not three, not three and a half, not four, it's five. The idea that you could have an unemployment rate just in terms of thinking through things, let's say we had long-end yield move to five, and we had an unemployment rate of five, that seems like a perfectly plausible solution to the macroeconomy. And would that be, That would be undesirable tactically for the Fed. But in a strategic sense, a 5 % unemployment rate would be fine, would be a fine outcome.

18:32Yeah, this is why I asked, is it in itself a bad thing? It sounds like it's just settling where the economy can handle it, right? And as opposed to everyone hating zero interest rates and some of the repercussions that come from that and being worried about deflation, you're in a different regime. The problem in the rub is that the system is built on expectations of it being at two or two and a half. Right. Those expectations, I always like to joke the fact that the bonds are in the stocks, but the bonds are also in the credit and the bonds are in the loans and the bonds are in everything. The bonds are in the houses.

19:09That's the challenge from an asset holder's perspective is the fact that we're moving to a structurally higher rate may not be so bad for the real economy, but it isn't great for asset holders. Now, the question is, does that yield move so fast that it then creates enough of a hit to asset prices to then flow through to the real economy as spending slows and creates that downward dynamic? We saw just a taste of that last summer, although even with rates at 5%, look, big picture, stocks were down 10%, 10%, 15%. you know, stocks go down 10 or 15 % over the course of three or six months. It's like not that big a deal.

19:59And the economy actually accelerated. It didn't actually deteriorate. Now, there are other things going on. I wouldn't necessarily draw that linkage to it. But the idea of saying, like, could the real economy tolerate, you know, an environment of moving back to 5 % interest rates, given all the things that are going on? Yeah, absolutely. Absolutely could. The asset, the financial economy cannot, though. Well, the financial economy has high sensitivity to that sort of dynamic. And obviously, it depends because it depends on essentially the duration sensitivity. There's a lot of assets that are out there that are not that duration sensitive, but there are certainly many assets that are duration sensitive.

20:39And what would have, I think the question that you sort of have to pencil through is, what would stop, if interest rates go to 5 % from where they are today, that's 75, let's say a 75 basis point rise at, I don't know, 15 years of duration, that would get you, again, another 10 % to 15 % hit in stocks. Is that enough to derail the recovery? Or is that just simply annoying for equity holders that we're hoping for YOLO, NASDAQ, go through the roof and never stop going down. My guess is it's more of that ladder, which is that you can have the real economy persist okay and have a moderate hit to asset prices as the interest rates reset.

21:27It's really a question of, does that then beget more concern about interest rates? Does that create bond-vigital empties? Does that start to spook investors who so far are, you know, when the yield rises, they come in and buy, just look at the flows into the TLT. Like it is, you know, typically the way it works is for stocks, when stock prices go up, people buy and when stock prices go down, they sell. For TLT, as that yield rose, people were pouring into TLT, buying the yield, buying the yield, buying the yield, as long as that persists. In the anticipation that it would drop later. In the anticipation that would drop or just like they were looking at and they said a 5 % yield is not a bad yield, all things considered.

22:07And so as long as that dynamic persists, then probably the yields don't rise too much. Certainly, they don't rise to whatever that crazy thing that was said back in October, like yields are going to rise to 17 % or something. That's probably not going to happen. The real question is, do they rise to five in this sort of environment as things reset, or do they rise closer to six? And the difference between stocks getting a drag of 10 % to 15 % versus 20 % to 30%, that's a big difference in terms of what the second order consequences are in the real economy. Yeah. It's a fascinating problem to work through because it doesn't seem like anyone's positioned for that.

22:52We're going to take another quick break to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.

23:21Noble Gold Investments is the gold IRA company that Americans trust. The founders of Noble Gold have more than 20 years of combined experience in buying gold and silver. They've secured more than$1 billion in precious metals for their clients. Whether you're a seasoned investor or new to the game, Noble Gold Investments simplifies and secures your gold investment journey. Choose between a tax-advantaged gold IRA or have physical gold delivered to your door. Noble Gold Investments ensures a seamless and easy transaction. Invest in something you can hold. Go to noblegoldinvestments.com slash vision to get started.

24:02Don't wait. That's noblegoldinvestments.com slash vision. Not many people are positioned for a shift to meaningfully higher rates. And I mean, it makes sense why that is, which is that, you know, in general, asset managers are invested, they're investors, and they are invested. And so in a lot of ways, it's functionally hard for many asset managers to be positioned for that. And what really matters is what the marginal buying pressure is. And I mean, we know that obviously, there's a lot of marginal buying and selling pressure. And from that perspective, I think we know that there's obviously a lot of treasury supply, here as we step into quarter two, net supply of duration is going to be about twice what it was in the first quarter.

24:54And that's up from last summer, where essentially it was very, very, very low given the various TGA, the debt ceiling and the TGA retail, et cetera. And so I think that's a really interesting question. We're going to get a good sense of the sensitivities because it's going to basically ask the question, it's going to give us a good insight into how much do yields need to rise or do they need to rise in order to swallow that duration supply at the current price levels. My guess is we probably will need to see higher interest rates to get those rate-sensitive buyers to come into the market. I should say they're rate-sensitive and yield-sensitive.

25:34So if you're, as a simple example, like Japanese buyers are typically buying in a currency-hedged way, that currency hedge way is essentially a bet on the yield curve. What about households? They're buying TLT. How high do yields need to go in order for them to look good about it? We sort of achieved balance at 5%, which I wrote at the time, actually. At the time, I was like, yeah, 5%, I sort of add up all the buyers, and it kind of looks close to imbalance. It looks reasonable. The question is, as we go to this next round, where maybe the disinflationary forces aren't quite so present, there's some concern on the upside, and where we've extended growth and the level of equity prices, are people going to need something higher than five to come in and swallow that higher total duration supply?

26:20Yeah, which, gosh, could make for a real summer of discontent. So to follow on and stick with Jack's excellent question for a moment, two areas that seem like, because he's sort of saying, basically, where's the pain, right? Where the market adjusts higher. And we were talking about treasury yields. What about commercial real estate? This sounds like this would be the last thing that the commercial real estate market would need. Yeah. I mean, commercial real estate, I think the challenge with commercial real estate is that it's not all that viable at 4 % yields or 5 % yields or 6 % yields. And so I think - So maybe it doesn't matter as much because anything - The question is sort of the marginal impact.

27:03I think probably there is not all that big. You know, I don't want to under it matters whether the yields are four versus six. But, you know, the big problem is that no one's going to the office. Yeah, as evidenced by the idea of extending and pretending if you get those rates down, you know, if they were going to go back down to two percent. Yes, you still have a problem. You still have the distressed guys that have to come in and you have a liquidation that could probably take like savings and loans. someone refers to it, you know, decades to unwind or repurpose. But now the idea that you're in a different rate regime can only make that, you know, I think that situation more difficult.

27:40Yeah, that's right. I think the main thing, the main thing with the CRE world is that it is almost entirely on balance sheet loans. And the one thing that the banking system is really, really good at is extending, pretending, modifying, you know, terming out, restructuring, like that whole world. Like if there's one thing bankers are good at, it's not necessarily making loans, but they're darn good at dealing with bad loans. They have a lot of experience dealing with that. And I think there's a lot of regulatory relief that exists for them to, you know, not necessarily resolve those things immediately.