Investment Strategy Brief:
Interest Rates Matter

Below is a transcript of this week’s video.

Hi, this is Mike Reynolds with Investment Strategy at Glenmede.

The decade plus following the Great Financial Crisis of ‘08/’09 was one dominated by ultra-low interest rates and large-scale bond buying by major developed central banks and the Fed was certainly no exception. But that party appears to have come to a close with a new era of higher rates not seen the turn of the millennium. This means, that we are now in an environment with a credible cost of capital after years of easy money.

The party had to end once inflation became unanchored from the Fed’s 2% target, whose significant tightening in support of its price stability mandate appears to have been the informal eulogy for the era of financial repression. The Fed is likely going to have to keep rates high until the inflation genie has been convincingly shoved back into the bottle. It doesn’t appear that the U.S. is at that point yet, as several major sub-groups in the Consumer Price Index are exhibiting annualized 3 month gains that are still above the Fed’s target range.

Another thing the Fed likely has top of mind, is the historical record on major inflation spikes. It is very rare to see inflation spike higher and dip immediately back to longer-term ranges. In fact, aftershocks have been the norm after annual inflation spikes of 6% or more. Prematurely claiming victory during inflation fights runs the risk of near-term accelerations, and a key priority for the Fed is avoiding such an outcome.

The result of that backdrop is an environment in which monetary policy is meaningfully tight and is expected to remain so over the next few years. The Fed’s own projections from its dot plot suggest that rates above neutral are the base case by the end of each of the next three years (including 2023). And to a similar end, the ongoing normalization of the Fed’s balance sheet is likely to continue until pre-pandemic levels of reserves as a share of GDP are reached, which likely won’t occur until 2025 at this pace.

This all contributes to meaningfully tight financial conditions. The Fed maintains a Financial Conditions Impulse metric, which seeks to measure the influence on real GDP growth exerted by financial conditions. It sat at an all-time high in the post-pandemic period when the economy improved from lockdowns and interest rates sat at all-time lows. Since then, financial conditions have tightened considerably.

The absence of a credible cost of capital contributed to some wacky market phenomena. Some of the major asset bubbles in history, such as the Roaring 20’s leading into the Great Depression, the mania around Japanese equities in the 80’s and the Tech Bubble in the late ‘90s took a while to develop and affecting a broad swath of various markets. However, when financial conditions were at their easiest in the post-pandemic period, asset bubbles starting to appear a bit more frequently. For example, explosive price gains in cryptocurrencies like bitcoin, meme stocks and the stay-at-home stocks that benefitted from COVID-era restrictions were, in comparison, more quick, extreme and narrowly focused than past bubbles. If the rates and financial conditions regime is set for a durable shift, this could enact some more discipline on market pricing on a go-forward basis.

In addition, the sustained “higher for longer” interest rate policy from the Fed should eventually bleed through into higher debt costs for corporations. Debt service costs for the S&P 500 have risen a bit from their all-time lows, but remain relatively muted on a historical basis, mostly because all that existing debt has already been issued at low rates. Over time, as new debt is issued and existing debt is rolled into new loans, those debt costs should gradually rise over time, but gradual is the operative word there. A little less than 20% of outstanding corporate debt is scheduled to come due in 2024. Those higher rates should incrementally dig into profit margins, but that’s likely to be a factor that plays out over the next several years.

But at the end of the day, the biggest implication of the new interest rate regime, is that the longer that financial conditions stay tight, the more pressure the broader economy faces. All else equal, rates are at meaningfully tight levels that have historically preceded recession, and they’re expected to remain there for enough time that recession in the U.S. should be the base case heading into 2024.

So to summarize, the era of financial repression appears over. Higher rates means that capital is no longer cheap in the U.S., and it’s likely to remain that way while inflation is still above normal. Ultra-easy interest rate policies may have been at least partially responsible for some of the high profile asset bubbles experienced in the post-pandemic period, but a credit cost of capital should enact some discipline on market pricing going forward. For corporations, this means higher debt costs, but that’s a gradual process that should eat into profit margins over time. And finally, tighter for longer means that recession could be on the horizon heading into 2024.

Thanks for listening! And please don’t hesitate to reach out with any questions.