The market consensus for 2024 centres around the likelihood of interest rate cuts, following the Federal Reserve’s signalling in December of 75bps reductions to come. That is broadly why bond yields have fallen to the extent that today some U.K. index linked gilts are back in negative yield territory, and valuations of growth equities have made a modest recovery.
The market is not expecting much economic growth — indeed convention is that the inverted yield curve indicates a recession. However, it is expecting inflation to come down further, as without that there cannot be interest rate cuts – at least according to conventional thinking. Which means the consensus is reasonably positive about valuations of risk assets even without much growth.
Interest rate cuts will come in 2024, but not because of lower inflation
At Linchpin we see the connections rather differently. Yes, interest rates will come down, but not as a result of falling inflation. In our view it has more to do with the problems which an inverted yield curve causes within the banking sector, and particularly for secondary banks.
For them taking duration risk is a core strategy to generate profits. However, an inverted yield curve increases the risks, as we saw with Silicon Valley Bank. Indeed FDIC data shows that at June 2023, when interest rates were 3.5%, unrealised losses on the balance sheets of institutions which it insures amounted to $525bn or 25% of the total assets of all U.S. banks (and similar institutions). With the yield curve still inverted, there is plenty of scope for further failures, but in an election year politicians would not be forgiving. Hence the Fed has a strong incentive to reduce interest rates to mitigate the risk of another bank getting into trouble.
We are also less worried than some about the inverted yield curve, as we view the principal cause being financial repression created by artificial demand for safe assets. Collateral for reverse repo markets has been the major source of demand historically, but regulation of insurance companies and banks play its part too. That’s not to say there won’t be a recession, but our central view is that growth will hold up in 2024.
Long bond yields will rise again
In contrast to the consensus, we see longer term bond yields rising to new (post GFC) highs. In our view that will be driven primarily by the tsunami of financing and refinancing which is about to land on markets. First and foremost is the Fed., where about $1.1 trillion of new finance will be required in the next 15 months or so. The Fed. is currently financing about two thirds of its requirements by means of short-term Treasury Bills rather than long-term coupon paying bonds. That helps them un-invert the yield curve (see above) but opens them up to refinancing risk in the future.
However, there is still plenty of new long-term bond supply about to come onto the market and the question is who will be there to buy it? Some long-term traditional buyers, such as China and even Japan, are much less prominent. The size of the Fed.’s reverse repo programme has fallen 70% over the past month as investors factor in lower interest rates in the future, so the demand for safe assets as collateral will be lower. Financial institutions such as banks need the yield curve to un-invert before they take duration risk by investing in long-term bonds. If the Fed. doesn’t wish to see bond yields going to new highs, our conclusion is that it will be forced to buy its own bonds back using short-term paper, much as it did from 2013 onwards under QE.
There is actually little difference between doing this and what the Fed has been doing over the past twelve months or so i.e., relying on short-term Treasury bills as their primary financing tool. Both are a form of QE, but the latter cuts out the process of issuing and buying back the bonds. That is why we have consistently made the point that while the Fed. has with one hand been raising interest rates, with its other it has adopted quite liberal monetary policy since the March 23 bank failures. And as the Linchpin view of the world, heavily influenced by our friends at CrossBorder Capital, sees liquidity as a lead indicator, we draw the conclusion that the U.S. economy at least will be OK in 2024.
China, the world’s other heavyweight, has followed even looser monetary policy but despite this is in a very different place and is flirting with deflation. As it is the world’s manufacturing centre, it is likely to send a deflationary pulse through the globe in 2024. This will help western central banks in the short-term and may cause them to declare victory over inflation.
Monetary debasement is now inevitable
However, in our view that would be highly premature, as the world is now hooked onto the magic money-tree of printing ever more money, and this must then lead to more sustained inflation in the future. Government non-discretionary spending in areas such as health and the military is increasing rapidly; by nature they are less price-sensitive than the private sector when purchasing; and too many western governments lack the fiscal continence to keep their balance sheets under control. That is why the Congressional Budget Office forecasts that U.S. debt will be 250% of GDP by 2047 (compared to 100% in 2022).
Governments cannot finance this using long-term coupon bonds because of the implications on the cost of servicing the debt. It already amounts to 10% of total government spending in the U.K. and 16% in the U.S. So they are being forced, as above, to turn to short-term financing, whether by QE-type Asset Repurchase Programmes or simply by turning to short-term instruments as the U.S has done recently.
The clear implication of this is monetary debasement and a much higher inflation at some point in the future. We do not know exactly when, but if we see any market complacency reflected in the pricing of inflation-mitigating assets such as Index Linked Gilts, we will be keen buyers. But it is not right now.