Upside Down CAPM, Part 4: The Fed Rate Cut

I have previously written about how I think about interest rates. (Parts 1, 2, 3, & 3A)

I divide capital markets into two markets:

1. At-risk investments, like diversified stock market holdings. The expected return on this capital is always approximately 6% plus inflation. But, the realized return is all over the place.

2. Risk-free investments, like Treasuries. The expected return on this capital is all over the place, but once you invest, your realized return is nearly guaranteed. In this market, the investor is the consumer. They are buying deferred consumption, which they receive because of the guaranteed returns. The price they have to pay for deferred consumption is the difference between the yield on risk-free bonds and the expected return on at-risk investments.
   The supplier is anyone with a stable source of cash flows that can credibly promise a guaranteed return - the taxing power of the state, owners of assets like real estate, corporations with stable profits, etc.

The interest rate on risk-free debt mostly fluctuates because of changing demand for deferred consumption, which is affected by demographics, cyclical concerns, long-term growth expectations, etc. The supply of risk-free debt is relatively stable because the asset base that guarantees it usually changes very slowly.

This is one reason why the Great Recession was so bad. Suddenly a bunch of real estate was considered unworthy as a guarantee. Demand for deferred consumption (rather than at-risk investment) was increasing leading up to 2008, pushing the neutral interest rate down. Meanwhile, the supply of low-risk assets to serve as collateral was declining (because investors didn’t trust real estate collateral and fewer buyers were willing to take the equity position in homes), which was also pushing the neutral interest rate down. All those late-cycle debt products you see in “The Big Short” were desperate attempts at engineering some safe assets to supply the demand for deferred consumption.

The Fed was holding their target interest rate high while the natural rate was plunging. By late 2007, their stance was very tight, and in 2008 they were just chasing the neutral rate down. That’s why they basically didn’t have to print any cash during the period where they were cutting rates. They were cutting rates from being very hawkish to being less hawkish. Finally, by September 2008, when they held the rate at 2% the day after Lehman Brothers failed, their target rate was so far above the neutral rate, no amount of cash destruction would have hit the target. As Bernanke wrote in his memoir, they would have had to sell every Treasury they owned trying to hit the 2% target.

Basically, instead of building yield models from the bottom up, build them from the top down. Currently, the real 10-year Treasury yield is about 1.5%. But, you should think of it as a premium of 4.5% savers must pay for guaranteed deferred consumption instead of the highly uncertain 6% return on at-risk investments like stocks.

In 2021, the real 10-year yield was -1%. Savers were willing to pay a 7% premium for guaranteed deferred consumption.

The rise in yields in 2022 wasn’t the result of Fed tightening. It was the result of a bullish turn as savers decided it was safe to take risk again, and demand for deferred consumption declined.

This means that most economic discourse is confused.

• A change in the Fed target rate isn’t necessarily hawkish or dovish. Frequently they are chasing the neutral rate under changing conditions.

• Long-term interest rates are not a function of Fed policy changes. In other words, rising long-term rates are not simply an accumulation of expected Fed hawkish rate hikes. The recent spike in interest rates is useful for debunking that idea.

• Low rates aren’t stimulus for at-risk investment or economic growth. Low rates mean that asset owners can earn a higher premium for owning old, safe collateral than they can earn by taking risks on investments with less certainty.

Before 2008, after Bernanke and Greenspan raised the target rate, long-term rates stayed low. They thought that was stimulative, but it actually meant that they had been too hawkish the whole time. Then, by the time the Fed started to cut the target rate, markets were so panicked, they were just chasing the neutral rate to zero.

Most post-WW II recessions have been associated with the neutral rate (the market premium for deferred consumption) falling more quickly than the Fed was cutting. In 2017-2019, JPow! was doing better than average. The Fed was chasing the neutral rate down, but they weren’t too far behind.

Then, he got even better. In 2022, the Fed followed the neutral rate higher. Staying dovish during the transitory inflation helped improve sentiment that had desperately needed improving, and long-term rates started to rise before the Fed started to hike its target rate. (The conventional wisdom, of course, attributes that to expectations of future Fed hikes. Or, if long-term rates rise after the Fed hikes, it is “long and variable lags”. Economists have created an unfalsifiable model, which, unfortunately, sows confusion and stress.)

That brings us to yesterday. Long term interest rates have been somewhat soft for about a year. That is bearish. The confused conventional wisdom treats those declining long-term rates as financial stimulus. The Fed has been a bit on the high side - a bit hawkish, staying at 5.25%-5.5%. That’s ok. It was probably appropriate.

Yesterday, the market wasn’t sure if the Fed would cut 25 points or 50 points, and the Fed surprised us with a 50 point cut. What happened? Long-term bond yields went up. Mortgage rates were up for the day.

What does that mean? The Fed isn’t chasing the neutral rate down. Yesterday the rate cut was relatively neutral. Real long-term rates bumped up slightly and expected inflation remained pretty level. Since the cut was neutral, the Fed isn’t behind the curve. They are just right. And since expected inflation is low, future cuts are also probably pretty safe because it would be fine if expected inflation moves up a little bit. And, it looks like real GDP growth remains strong, so that nominal GDP growth will continue to trend around 5%. JPow! is the master.

Mortgage rates might decline a bit more than the 10-year rate does over the next year because the weird bump in the yield curve increases prepayment risk. As short term rates decline, the spread between Treasuries and mortgage rates should tighten. But, if JPow! keeps us winning, mortgage rates will not decline much, even as they cut the Fed target rate to 4% or less. And housing construction will stay strong.

When long-term rates remain relatively high, don’t think of it as a drag on housing. Think of it as a decline in demand for deferred consumption, as savers choose risk over safety. And, one way they will choose that is by buying the equity position in real estate.