Reality finally started to dawn in financial markets last Wednesday. Interest rates weren’t likely to tumble by Christmas, or even during 2024. Instead, traders finally began to realise they were going to be ‘higher for longer’.
The catalyst was the US Federal Reserve’s press conference. Markets had confidently expected at least a pause after rates had risen 5.25% since March last year:
- The S&P 500 opened up in the morning and only dipped slightly ahead of the press conference
- Previous press conferences had then seen it surge ahead when Fed Chair, Jay Powell spoke
- He normally focused on calming the markets by suggesting rates would soon go lower
- He gave the same message on Wednesday, but instead the market sold off quite sharply
The issue was simply that traders finally began to realise that Powell isn’t in control of events. Crucially, he even admitted the Fed’s models don’t actually predict the future:
“The models that we use, ultimately you only know when you get there and by the way the economy reacts…I would say you know sufficiently restrictive only when you see it. It’s not something you can arrive at with confidence in a model or in various estimates, you know.”
Clearly, the market didn’t like this concept at all. What, after all, is the point of spending $mns on building computer models, and employing 400 PhDs to run them, if they don’t actually tell you anything about the future?
It seems the Fed is now starting to agree with ECB President, Christine Lagarde, who warned last year:
“There are things that the models don’t capture. Sometimes the unexpected happens. So we have to pay attention to traditional indicators while also monitoring empirical data and what we expect to happen in terms of geopolitics, energy price developments and demographics.”
We therefore seem to have reached “The End of the Beginning” of the bond market downturn. The two charts tell the story in terms of recent market action:
- Interest rates began to move higher, and are now back to levels last seen before the 2008 Crisis
- The US$ Index versus other major Western currencies is back at levels last seen before 2003
In other words, the stimulus experiment is coming to an unhappy end. As the chart shows, central banks have lent $73tn dollars in the belief that their models could predict real-world events, and enable them to manage the global economy.
But in reality, it makes no sense at all to think that 12 men and women in Washington could somehow control a global economy of 8bn people. Especially as all they can do is raise or lower interest rates, and print money.
Instead, they have distorted financial markets by destroying their key role of price discovery. A whole generation has been brought up to believe that interest rates are always around 0%. As a result:
- Individuals have bid up house prices to levels that are now unaffordable
- Stock markets have been bid up to extraordinary levels of valuation
- Companies have added vast amounts of new capacity to meet demand that doesn’t exist
Now, this vast bubble is starting to burst. And whilst bubbles take time to reach their peak – they usually burst fairly quickly.
As discussed here recently, it isn’t hard to spot the forces that will burst the bubbles.
- Energy markets are already heading into a new crisis with Brent close to $100/bbl
- Food prices are also pushing up inflation as fertilizer markets continue to tighten
- Plus, there is the growing risk of a major Asian Debt Crisis
The chart highlights the likely end result in terms of future interest rates.
300+ years of Bank of England data shows that interest rates are typically inflation plus 2.5%. At today’s level, this would imply:
- US rates would be 3.7% + 2.5% = 6.2%: Japan would be 3.2% + 2.5% = 5.7%
- Eurozone rates would be 5.3% + 2.5% = 7.8%; UK rates would be 6.7% + 2.5% = 9.2%
This highlights the risks ahead. And it may even underestimate them. As famed market guru Bob Farell has warned:
“Markets do not usually correct by going sideways.”
Risk management seems likely to be key to survival over the next few months, as the bubbles continue to burst.