Here's What's Being Bailed Out Next
- Normalizing interest rates to the 5% level will slash corporate profits by 1/3 and lead to an insolvent corporate bond market.
- Capping rates through yield curve control will ensure that pension systems do not meet their 7.5% return requirement.
- I believe yield curve control and a pension bailout are more likely.
- The only guarantee from this untenable situation is that the purchasing power of the dollar will fall relative to scarce assets.
In a free market economy, interest rates are determined by the interaction between borrowers and savers. Too much savings decreases the interest rate to incentivize borrowing and vice versa. For decades, Central Banks have slashed the Federal Funds rate to counter the negative impacts of the business cycle and maintain high employment. Keeping the borrowing cost well below its free market rate for forty years has created a gaping structural inefficiency. We have so much consumer, corporate, and sovereign debt that we cannot allow rates to rise in any meaningful way without creating a wave of defaults.
Nothing demonstrates this dynamic more than the chart below - the Federal Funds rate since 1980. For nearly the past half century, we have solved economic weakness through lower rates that allows indebted companies to refinance and double down on debt to create growth. Remember that too much debt was the problem in the first place. With more debt following each recession, rates can never reach their previous cycle high, hence the forty-year march to zero in the Fed Funds rate.
Investors oftentimes forget that repo markets nearly imploded once rates reached 2.4% in 2019. This led the Federal Reserve to a $500 billion bailout program and the infamous "Powell pivot." Investors also forget that before the coronavirus, we had record levels of corporate debt with over 50% rated BBB, or one level above junk. Once the recession occurred in March 2020, the Fed expanded its mandate to purchase corporate bonds down to the junk level. As the corporate debt chart below shows, we continued with the same playbook of lower rates and more debt.
Between a Rock and a Hard Place
The Fed cannot normalize without breaking something. In a recent Real Vision Interview, Chris Cole of Artemis Capital Management put it this way: "Corporate profits will drop 1/3 if rates go back and corporate borrowing rates go back to where they were in the late 2000s... [if] rates go back to where they were in the 1970s… the entirety of corporate profits would be wiped out." This is due to increased interest expenses from floating interest rates common with large corporations. Rate normalization will break the back of the corporate bond market and arguably equity markets.
The Fed also cannot normalize interest rates without hampering government spending. In 2020, the U.S. paid $522 billion in interest expenses. According to Erik Voorhees of ShapeShift.io, a 1% interest rate increase would raise government interest expenses by roughly $280 billion, or 50% of total interest on debt paid in 2020. I believe this plays into Fed calculus despite their official mandate of being independent.
If rates rise and corporate profits lower, I believe the Fed will have to bail out the corporate debt market. They also might get a "cease and desist" order from the government wishing to continue stimulus and infrastructure spending. However, if they enact yield curve control to save corporate debt, they run into a different issue altogether.
Leaving Pension Systems Hanging
Chris Cole continued his analysis with a look at returns for the past 150 years. Taking out the last forty years of returns in the debt based growth dynamic, the average return drops to 5%. Pension systems have a 7.5% growth mandate. Though he uses a 70/30 equities and debt profile for the average pension system, some studies suggest that the average pension system fixed income holding is 50%.
He suggests that with 5% returns and a 70/30 portfolio over time, "1/3 of the state and local pension system would be insolvent," or under their 33% funding ratio. Pension portfolios are overweight fixed income. If the Fed caps fixed income returns to make debt service payments manageable for the government and corporations, it will need to bail out the pension system. We have already seen signs of this as the March COVID relief bill contained an $86 billion pension bailout plan. The corporate bond market is estimated to be $100 trillion. The U.S. pension system is estimated to be $32 trillion. I believe it is obvious which side the Fed will choose.
What it means for investors
Here is a summary of the Fed dilemma: if the Fed normalizes rates, corporate profits shrivel. If the Fed implements yield curve control to keep debt service payments low, the pension system will need to be bailed out. If investors flee bonds due to inflation fears, as bond vigilantes have always suggested, the Fed will need to step in to keep interest payments manageable.
How do you play this dilemma from an investor perspective? For one, all semblance of price discovery has been lost in credit markets. It seems that arguments for going long or short credit markets depends on how confident investors are in the Fed's ability to manage the situation. The best thing the Fed can do is create and maintain 3-4% CPI inflation and let it run hot for years with negative real rates in an attempt to reduce the debt burden. Generally, this is bad for fixed income.
For me, all roads lead to scarce assets. The only guarantee is that the Fed will need to print money and the purchasing power of the dollar will be diminished relative to any scarce asset. This is also the macro case for Bitcoin, which constitutes the most scarce and liquid asset that exists. However, one can also make a case for commodities and real estate.
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