How high, and for how long?

0:06Pushkin. As regular listeners to Unhedged will know, the Federal Reserve, the US Central Bank has been doing this shtick for a while where they say, we're going to keep interest rates higher for longer. And the market has been very slow to believe that. But the Fed keeps saying, don't believe me, just watch. And finally, markets are coming around. Today on the show, we ask, if interest rates are going to be higher for longer, what does that mean for the world that we're living in? This is Unhedge, the markets and finance show from the Financial Times and Pushkin. I am reporter Ethan Wu, here once again in the London studio, joined at long last by Marcus editor Tommy Stubbington.

0:44Hi there, Ethan. How are you enjoying your time in London? I'm really loving it. I talked about this with Katie on Tuesday. I'm very easily impressed by London, but there's a lot to be impressed by, I think. Well, the thing that's impressed me is your incredible interest in British meat pies and your quest to buy one while you're in London, and your constant asking for pub recommendations so that you can find somewhere to get a nice steak and ale pie, which I think you've been unsuccessful so far until yesterday. Yeah. The FT Canteen came to the rescue and delivered the goods. They came through.

1:14For the American listeners and, you know, for myself, like one week ago, the British pies are like, you know, it's kind of like a flaky crust in which like, you know, meat and seasoning and gravy is baked. That's right. It's usually some chopped up beef and gravy and onions and things underneath some pastry. Delicious. So now I've got like truly too many recommendations to go to in London before I leave in just a couple of days. Well, thank you to the FT London markets team for a warm welcome. And it's an interesting time to be here on the markets team because there is a really big market story happening right now.

1:45I think undoubtedly the big story markets right now is higher for longer. And, you know, I alluded to this a little bit on the top that markets are reacting strongly. But I want to just give you some numbers, Tommy, to sort of sum up where we are. And this is from the excellent story on the front page of the FT today. The S &P 500 is down 5%. Yeah, it's about 5 % for the month. The 10-year treasury yield is the highest it's been since 2007. The market estimate of where the Fed's interest rates will be in 2024 has gone up from 4.2 % to 4.8%, pretty significant increase in just a month. And the yield on junk bonds, which is effectively what a risky, you know, worse balance sheet company has to pay to borrow, has gone up this month from 8.5 % to 9%.

2:30You know, this is all a picture of rates have gone up, so people are a little bit less happy about owning risk assets. But, you know, something that's really remarkable is, you know, the 5 % drop in stocks has been mitigated by how big big tech is in America. Right. I mean, if you look at an equal weighted version of the S &P 500, i.e. one that kind of cuts out that heavy weighting towards big tech, it's down for the year. I mean, this is a year when stocks had this unexpected huge rally in the first half, but it was all the kind of hype around artificial intelligence. It was all a few tech stocks that were propping up the market.

3:07If you look behind that, things look a lot less healthy, particularly now. Yeah. And just to unpack that, the S &P 500, as a standard for most stock market indices, it's market cap weighted, meaning that the bigger the company is relative to all other companies, the bigger its moves show up in the overall index. So like if Apple moves 5%, that has a huge impact on the S &P 500 because it's a massive company. It's like 10 % of the index or something like that. What the Equal Weight Index does is Apple's not 10%. It's 1 500th of the index. And it assigns each company just 1 500th of the impact, irrespective of what size they are.

3:45And that lets you capture kind of what the broad market is doing if you look past the moves of just a couple of really, really big technology stocks that dominate the market. Right. That's right. I mean, it basically tells you what's happening to the average company rather than what's happening to the entire market, which, as you say, is dominated by Apple, by Alphabet, by Meta, by Amazon, by a few very, very large stocks. Yeah. And so that's what's going on. And so I just want to step back and try to stitch together these facts because I think it is a bit of like an overwhelming and confusing picture in general when stocks go down.

4:18It's because the economy is weakened and we're worried about growth and recession and so forth. And that's when interest rates are cut. Now we're having this kind of strange picture where the economy is strong and stocks are falling while interest rates are rising. It's just all a little bit weird. Tommy, what's been changing? What explains where we're at? Well, as you say, stocks falling is often associated with a weak economy. But the reason stocks are falling now is because bonds are falling too. So people don't want to own risky stuff. They don't want to own safe stuff either. And that's because the prospect of a period of high interest rates for a long, long time makes owning a fixed income asset like a treasury bond less attractive.

5:00So kind of mechanically lowers the prices. And then if yields on treasury bonds are higher, that makes things like stocks look less attractive by comparison. So it tends to kind of crush all asset prices. And what do you think has changed in the past month to sort of drive these market moves? Well, I mean, it's always difficult to pin down exactly why a market is waking up to something now. I mean, as you already said, you know, the Fed has been at pains for months at least to say, listen, you know, once we finish raising rates, they're staying high. They are not coming back down quickly. I think what's happened now is that the, you know, the penny has dropped, as somebody said in our story this morning.

5:35But I think we can pinpoint, you know, a couple of things that would maybe explain the timing here. One is that, you know, markets are typically only good at focusing on one thing at a time. Yeah. And so the obsession for the last 18 months has been the interest rate hiking cycle, right? How quickly are rates rising? Where are they going to top out? How much longer is this going on for? Only now that we can see the finish line, people are suddenly thinking, well, what comes next? And that's why they're waking up now to the fact that what comes next isn't a swift cycle of interest rate cuts. It's that rates maybe stay high for quite a while.

6:12And that's an uncomfortable backdrop for investors who kind of over the last 10, 15 years that the period after the financial crisis have been almost kind of trained to believe that as soon as something slightly bad happens, the Fed rides to the rescue, slashes rates down to zero and everything is fine. Yeah. And this is the idea of like the Fed put so-called. And that was when, you know, markets tend to go up for the most part. But in times past, when they've gone down, the Fed has come in and build out the market, not explicitly for the market's sake, not because they like traders or like investors, but often because the market was slowing because of some kind of fundamental economic issue.

6:51And the Fed wanted to help improve that economic issue with looser credit conditions and looser monetary policy. That's right. And the big question mark now is, is that something the Fed can do when it's still worried about inflation. Bear in mind that the rhetoric of Jay Powell and Fed policymakers in general has not been, well, we've won this battle and we can relax now. The higher for longer is because they're telling us it's going to take time to bring inflation back down to target. Yeah. And there's two things that have changed recently that have kind of reinforced that Fed message and in some ways made it more credible.

7:23And that's the strength of the economy and the oil price. I mean, maybe you can talk through the two of these. Yeah, absolutely. The US labour market has been very, very strong. I think the strength of consumers in general has kind of surprised people in the face of this incredibly large rise in borrowing costs. I think people would have expected that to weaken the economy more. It's strong. That adds to inflationary pressures at the margin, less reason to cut rates. And then, as you say, the oil price, we have had an absolutely huge rally. We're approaching$100 a barrel. And it was like 60 in June.

7:55Right. It's a massive move. It's a massive move. And This is about Saudi Arabia and Russia and their production cuts and their kind of very deliberate policy of trying to drive the oil price back up because it's such an important part of both governments' revenues. And again, that's something that adds to inflation, makes it slightly less easy for the Fed and other central banks to turn around and say, we've won this battle with inflation. We can relax now. Yeah, yeah. So the market's single-mindedness, the strength of the economy, a fast-rising oil price, I think this helps us get some sense of why the market has been changing so much recently.

8:28But I want to just zoom out one level broader and ask about the world we live in. If the market is right, which it may not be, but if it is right that interest rates are going to be higher for longer, how does that change the world? I mean, we've already seen in the 18 months or two years that interest rates have been rising pretty profound changes to certain industries. Like, you know, my friends in the tech sector think we're still in a recession, you know, because there was this really quite brutal consolidation among a certain segment of tech companies that had overbuilt, overhired, overbought commercial property during, you know, the tech boom and the low interest rates of the 2010s.

9:03Right. I mean, there are a lot of things that make sense when money is free. Yeah. That no longer do when interest rates are, you know, 5%. Yeah. And I mean, one place you've definitely seen huge changes is the housing market. Absolutely. Yes. You know, the housing market is, I suppose, it's a key way central banks are very deliberately using to feed their monetary policy changes through to real people, to the real economy, to, you know, to what you and I have available to spend. And that feeds through via mortgage rates. And again, I think the housing market has been remarkably resilient to that.

9:35But, you know, hire for longer raises this question. How long can the housing market stay resilient without buckling under the pressure, you know, if people can't get new mortgages? One of the weird facts in the US, and you'll have to tell me if this is true of the UK too, is on a relative basis, it has not for a long time been more attractive to rent than it is right now in the sense that monthly payments on like an average US rent are lower than like an average mortgage payment if you took out a new mortgage right now. Those spreads, the difference between the rental price and the monthly mortgage price are really large.

10:08And yet rents are really high. So it's this kind of catch-22 for people that would like to live in America, which is that you want to get a house? Well, it's unaffordable. You want to rent somewhere? It's unaffordable. Yeah, I mean, that's not entirely different to the situation in the UK. I mean, certainly the rental situation in London at the moment is being described as a crisis because, you know, there's so much competition for every property that becomes available. Some of this, by the way, linked to the rising interest rates here, which means that a lot of people that were landlords and had mortgages to buy second homes and then let them out, they can't afford to do that anymore.

10:43The mortgage costs are too high, so they've sold up. and the market hasn't yet adjusted so that the supply isn't there, but people still want to come to London and work. So yeah, the rental market at the moment is a complete mess. Yeah. Well, let's go even broader though, because there are domestic implications, of course, and we've seen those and I think on the show, I've talked a lot about them. Something we don't talk about as much is the kind of international implications, especially for the developing world from high interest rates in the US. I mean, the Federal Reserve is described often as the global central bank.

11:11It sets the tempo for every central bank. Because the dollar is so important to the global financial system, any country's central bank, no matter how far they are from New York or DC, has to keep a really close eye on what the Fed is doing. Absolutely. And a key reason for that is a lot of developing economies will tend to borrow in foreign currency. And that basically means you borrow in the dollar. Therefore, your interest rates are based on whatever the Fed's doing. I mean, you will clearly pay some extra spread on top of, you know, what the US pays to borrow, but that kind of sets a baseline for borrowing for governments around the world.

11:45And so if interest rates and treasury yields go up very, very sharply, as they have, that's very painful for developing countries that have borrowed heavily in dollars. They need to keep rolling that borrowing over as it falls due. And, you know, some of them are finding that the costs now are too punitive, they're locked out of markets. And that's why over the last couple of years, we've seen so many sovereign defaults, so many, So many countries saying, you know, we can no longer carry on servicing our debt. The likes of Sri Lanka and Zambia. These are not countries that are in great shape to begin with.

12:17And now they're facing like a really significant debt crisis that further kind of imperils the standard of living there. Absolutely. And, you know, not being able to restructure your debt, you know, means it's hard to get the public finances back on a sound footing and kind of carry on with life. But I mean, sadly, I think what higher for longer potentially means is that you see more bankruptcy on a kind of nation state level. Yeah. Because, again, as you say, it's particularly those countries that are kind of maybe at the less developed end of emerging markets tend to be the ones that are more reliant on international borrowing in dollars.

12:53If you're talking about the big emerging markets, India and China and Brazil and so forth, you know, they'll tend to have a better developed domestic borrowing market. they can borrow more heavily in their own currencies. But it's those that have relied upon dollar debt that have run into trouble. Yeah. And just to wrap up, one potentially positive thing that we are seeing and could continue to see from this higher rates world is just an increasing focus on the real economy. What lower rates did is it made financial engineering a lot more possible in the sense that money was free. So your incentive was to just borrow money at 0 % or very low interest rates and go do God knows what with it.

13:35What higher interest rates have done for a lot of parts of corporate America is made them focus on efficiency and on real economy investment. So we've seen a really strong uptick over the past couple of years in US companies' capital expenditure. They're spending on factories and machines and stuff like that. And there are analysts that think that we could be on the boom of a so-called CapEx super cycle, a five to 10-year wave of companies focusing hard on investment. This is driven by other things like climate change and deglobalization. But the change in interest rate environments means you need to be a lot more strategic about where you put your money to, because borrowing is not free anymore.

14:17So when you borrow, you want it to really count. Absolutely. All right, let's leave it there. We'll be back in a moment with Long Short.

14:36Welcome back. This is Long Short, the part of the show where we go long a thing we love, shorter thing we hate. Continuing in my second London-based Long of the Week, I'm Long Sainsbury, this delightful grocery store chain in London. They kind of have everything. It's like half convenience store, half grocery store. I was impressed by the stock going into this. I mean, this is all on the theme of me being easily impressed by London, but... Ethan, all I can say is, if you like Sainsbury's that much, wait until you see Tesco. I do like Whole Foods, but American grocers could learn a thing or two.

15:05We know how to do cheap food in Britain, yeah. That's right. Tommy, are you short something? I am short something. I am short US small cap stocks. I've heard of these. Now, the reason for this is I edited an excellent story about why they're having such a bad time written by an excellent new FT reporter called Ethan Wu. And I found his arguments very convincing. So I'm shorting US small caps. You're too kind. You know, my struggle writing a news story, you know, we do so much commentary here that I just the commentary muscle wants to emerge and, you know, no, fair and balanced. Keep it short. Yeah, keep it short.

15:38Factual. Yeah, yeah, yeah. No rambling, no opinion. All right, Tommy, thanks so much for being here. We'll have you back soon. And listeners, we'll be back in your feed on Tuesday when I'm back in New York. Catch you then. Unhedged is produced by Jake Harper and edited by Brian Erstad. Our executive producer is Jacob Goldstein. We had additional help from Topher Forges. Cheryl Brumley is the FT's global head of audio. Special thanks to Laura Clark, Alistair Mackey, Jacob Weisberg, and Jess Trulia. FT Premium subscribers can get the Unhedged newsletter for free. A 30-day free trial is available to everyone else.

16:14Just go to ft.com slash unhedged offer. I'm Ethan Wu. Thanks for listening.