The Shadow

9 Dec 2021

Something that we (and others) have often noted over the past few months is the risk that the US Federal Reserve might be committing a costly policy error based on the false premise that inflation is pending a normalisation through supply-side adjustment. From our humble perch, the current inflation pressure has also been driven by excess final demand. Moreover, even if goods price inflation eases next year, service sector inflation driven by wages/employment costs (chart 1) and shelter (rents) could contribute to more persistent underlying inflation. In that context, it is probably not appropriate for monetary policy conditions to still be at emergency levels. While the Fed has started the process to taper the asset purchase program, monetary conditions (adjusted for QE) are still exceptionally loose.

Last week we noted that the Funds rate implied by the “Taylor Rule” was around 6%. Even adjusting for challenges with the model, that is an extraordinary gap relative to the current upper bound at 0.25%. Based on the October CPI, the “real” policy rate is -6% or lower than the peak policy error in the 1970s. Clearly, the real policy rate has been deeply negative for some time, but it has likely contributed to potential misallocation of capital underway in US and global capital markets.


A recent example of this error is the decision by CALPERS, the largest US pension fund, to allow leverage to achieve the Fund’s mandated 6.8% return target. Put another way, prospective un-levered expected returns from traditional assets are too low, partly because real interest rates are too low. When rates are too low, that tends to encourage companies and investors to increase debt and potential dislocation when rates eventually do rise.


An alternative way to frame policy conditions is by the Wu-Xia Model which is an estimate of the Fed Funds rate adjusted for the impact of QE asset purchases. While the Fed has not taken the upper bound of the nominal funds rate below 0.25%, the effective rate adjusted for QE is around -1.8% currently (chart 2). The point here is also that ending QE is the equivalent of more than 7 (25 basis point) rate hikes before they even hike the fed funds rate once. That might explain why the 2018 cycle was so challenging for risk assets even though the nominal rate peaked at only 2.5% in December as the starting point was -2% based on the Wu-Xia model (the total change in policy was equivalent to a 1994 style rate cycle). It is similar to -5 degrees Celsius, but -20 with the wind chill factor.

A point we have also noted over the past few weeks is how stable and low expectations have been for the terminal Fed Funds rate. While market pricing for the end of 2022 has generally risen over the course of this year, the yield on the 16th Eurodollar contract has remained below 2% since February, in spite of the highest inflation in decades. From a behavioural perspective this suggests the prevailing market bias is: more rate hikes now require less later. It also suggests that beliefs have not changed on the neutral rate and probably explains why assets influenced by low discount rates appear mispriced on absolute valuation measures.


For now, the markets are still looking through near term inflation pressure. To be fair, odds are that goods/headline price inflation has peaked based on leading indicators like ISM prices paid (chart 3). However, if the Fed accelerates its timetable for policy normalisation (starting next week?) that would likely be troublesome for beneficiaries of low rates and super-abundant liquidity. It is also possible that the reversal of QE feels like 7 rate hikes before the real rate rises even begin. There has been considerable capital allocated and leverage taken on in this cycle on the belief that low terminal rates were a permanent feature of the macro environment. We remain cautious on highly levered entities.