In The Trenches: As Good As It Gets

Guest post by Peter Cecchini

In the first installment of In the Trenches on October 29th (A False Sense of Stability), I wrote: “It’s a matter of when rather than if — the Minsky moment is becoming more palpable. The stability caused by a decade of central bank financial suppression has led to the unintended consequence of creating a more fragile global financial system… one more vulnerable to shocks. The next shock is likely to be one of central banks’ own collective design.” The most recent decade of central bank financial suppression covers only the most recent cyclical rates trend. Importantly, this policy cycle was augmented by an almost 40-year secular rates trend towards zero.

Why is this significant? Unlike any cycle in recent memory, the sun is concurrently setting on both trends. A generation of investors has Paul Volcker to thank for almost 40-years of slowly falling rates. This trend contributed to asset appreciation in the housing, credit and equity markets. He handed countless baby-boomers a free 100 points of investing IQ, for which most never thanked him. Is it a coincidence that many of the world’s renowned, cult-status investors began their careers in the late 1970s? For long-term investors, the last 40-years were likely as good as it gets.

Volcker, now 91 and in ill-health, is six-foot seven-inches tall. Even more extraordinary than his stature was the courage he demonstrated in his campaign to quell inflation after the 1970’s oil price shock. U.S. inflation peaked at ~14.8% in March 1980. In response, Volcker raised the federal funds rate, which had averaged 11.2% in 1979, to a peak of 20% in June 1981. A recession ensued, but as a result, by 1983, inflation fell below 3.0%. This courageous action elicited political attacks and widespread protests, as high rates temporarily overwhelmed construction, farming, and industrial sectors. In his recent memoir, Volcker recounts how James Baker, in the President’s library next to the Oval Office, asked him on Reagan’s behalf not to raise interest rates before the 1984 election. At that time, he had no plans to do so. In fact, in 1981 into 1982, the Volcker Fed had already begun to ease, helping lead to a resumption of economic growth and setting the stage for a multi-decade secular slide in rates.

Figure 1 illustrates the secular trend in 10-year yields as well as the cyclicality withinthe trend. These cycles generally occur alongside Fed policy action and always in response to economic or financial conditions. The trend demonstrates that peaks in cyclical long-rates (as denoted by the dotted vertical lines and red circles) correspond to local peaks in equity market prices (bottom panel). It is unlikely a simple coincidence that equity volatility picks up in every instance the 10-year yield rises to the secular trend line. As denoted by the red circle at farthest right, rates approached the secular downtrend line in October 2018. The intersection was almost immediately followed by a risk-off not just in equities but also in the corporate credit markets. This cyclical intersection with the secular trend was exacerbated by the Fed’s “mistake” in its December meeting when Chairman Powell expressed seeming intransigence around balance sheet reduction. The Fed communication added insult to injury as the European Central Bank (ECB) ended quantitative easing (QE) the week before.

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