Epic fail....

The consequences of policymaker stasis could prove very ugly for the global economy, but investors could profit from this, as long as they protect their portfolios....

At last week’s March meeting, The Bank of England voted 8-1 to keep interest rates unchanged at 4.5%, with policymakers emphasizing the need for a “gradual and cautious approach” to any further easing of monetary policy. BoE Governor Andrew Bailey, with whom I have clashed horns on various aspects of policy in the five years since his appointment justified this with reference to “a lot of economic uncertainty at the moment”.

This is the point where, in my eyes, any last remaining shreds of Bailey’s credibility disappeared. 4.5% is a highly constrictive policy rate. Therefore, Bailey’s comments translate as ‘we have no idea what will happen so we will maintain an excessively tight interest rate policy at a time when the economy is slowing to stall speed because we’re (always) much more worried about inflation than we are about slowdown and recession’.

How close is the UK economy to stall speed? The last 2 quarters have produced 0.0% and 0.1% GDP growth respectively and 2024 as a whole saw the Uk economy grow by 0.8% (around 50% lower than ex-ante official forecasts, which foresee a similar, ‘sluggish’ rate of growth in 2025).

Why are policymakers so terrified of inflation that they will crash their economies to make sure that they avoid it? There are multiple reasons for this (mainly to do with historic incidents of inflation) but essentially the last half century or so has seen policy makers broadly develop a more sophisticated but still empirically weak understanding of inflation.

At MBMG we broadly divide inflation into 3 main types:

· Asset price inflation (e.g. increases in the price of property, capital market assets and speculative assets significantly in excess of increases in the intrinsic value of such assets)

· Consumer price inflation (also known as CPI e.g. increases in everyone’s weekly shopping basket but also rent or mortgage payments)

· Unit labour cost inflation (e.g. wage increases that outstrip productivity increases)

Each of these is a complex area and the interrelationship between them is massively complex and, despite what classical economic textbook theories and formulae tell us is not fixed. In fact, the financial ‘miracle’ of the first decade of this millennium saw policymakers take plaudits for having engineered high levels of asset price inflation while CPI and labour costs remained subdued.

However, during the great lockdown, asset prices initially tanked until monetary and fiscal policy put a floor under them, with policymakers cutting rates to zero and engaging on unprecedented direct to consumer fiscal stimulus. The problem with lockdown is that, largely fuelled by second and third rounds of stimmies in economies such as USA, demand recovered more quickly than supply was able to. This sparked short-term ‘supply-shock-driven’ inflationary pressures. Policymakers failed to identify these and unleashed a short-term bout of inflation –

In the chart below, the solid blue line is 30-year breakeven inflation (i.e. the level that the markets have priced inflation at for the next 30 years) – this is pretty slow moving but as you can see has been fairly solidly in a range of 1.5% to 2.5%.

The line of blue dots and dashes is the monthly recorded change in the actual inflation (CPI) rate – as you can see, this fell apart during the shock of lockdown, falling to zero but fiscal policy mistakes then created a surge or spike in inflation which briefly exceeded 9%.

The green dotted line is the 30-year treasury yield, which has, throughout this time, reflected Fed and Treasury policy. When it dips below inflation expectations – which it was for most of 2020 after the Q1 and early Q2 recession, this is potentially expansionary/inflationary.

At the point where the monthly CPI reading started to recover and broke above the 30-year yield in late Q3 and in Q4 of 2020, fiscal policy should have reacted and monetary policy should have been adjusted because of the constraints on the supply chain, rendering it incapable of satisfying the increased levels of demand. Instead, Trump 1.0 threw more fiscal stimuli at the US economy on its way out of the White House doors and the incoming Biden administration ramped this up as soon as they placed themselves in the seats of power. Having determined that easy fiscal policy and tight monetary policy could create conditions supportive of asset prices, policymakers ensured that the 30-year yield remained at 2% for all of 2021 and into 2022, only breaking back above the pre-lockdown levels in mid-2022, by which time inflation was well over 8% and closing in on the peak rate of 9.1% in June 2022. In other words, in 2 ½ years, inflation ran away from below 2% to over 9% and the Fed’s belated reaction saw 30-year rates move up from 2.3% at the start of 2020 to 3.2% in June 2022. Having missed the boat on hiking rates, and seeing the inflation genie escape the bottle (these two things not being as directly or causally linked as neo-classical economic models reflect), interest rates, as we have seen, only peaked some 16 months after inflation peaked and started to recede. Once again, the Fed were asleep in the economic wheelhouse. The extent to which inflation is an outlier is apparent on longer-term charts:

Essentially, inflation was a fiscal policy error, which policymakers were far too slow to address, with the disastrous consequences, in terms of inflation that are evident in the 2 charts above. Subsequently, the Fed has been equally late to the party in terms of cutting interest rates. Inflation has now fallen from just over 9% to just below 3% and the Fed’s response has seen 30-year rates remain at 4.9% at the start of this year and fall back only to 4.6% today. Even a move back to the June 2022 level of 3.2% would see a more than 50% increase in the current price of the highest Beta form of unleveraged treasury exposure, zero coupons such as $ZROZ. A move back to levels of 5 years ago, when both yields and inflation were below 2% as shown in the chart below would see a gain of between 100-150%. Using options and upside participation structures this becomes a potential upside of 140-210%.

The consequences of policymaker stasis (exacerbated by the mutual distrust between the Trump administration and the FOMC [the policymaking arm of the Fed], which echoes that between policymakers and the administration of DC outsider, Herbert Hoover from 1928-32) could prove very ugly for the US economy. Investors needn’t be so exposed to this, as long as they protect their portfolios, especially with high Beta treasury exposures such as ZROZ or structured enhanced Beta versions of this. In fact, the chance to make over 200% from treasury exposures in the coming years is without precedent in my 40 years in finance.

Recognising the immeasurable degree of uncertainty that prevails right now, our most deeply held conviction is that investment strategy in 2025 should continue to be built around exploiting this unprecedented opportunity (while also being aware that the risk of unknown unknowns may be greater than ever and that something entirely unexpected could happen). Options pricing is creating opportunities. We are continuing to monitor these and expect to update our clients on strategies and opportunities in the bond markets in the coming weeks.

From a technical perspective, the fact that retests of the bond price lows/interest rate highs have held above/below the Q4 2023 levels, indicates that the worst is now over. If so, the only question is how long before the slight pain trade finally turns into a major gain trade. we’re already seeing this with our balanced portfolios showing gains of 6-7% YTD and in double digits over 12 months, whereas riskier investments of even blue-chip stocks, such as the S&P 500 are down around 4% YTD and only exhibiting single figure gains over the last 12 months.

MBMG Investment Advisory is licensed by the Securities and Exchange Commission of Thailand as an Investment Advisor under licence number Dor 06-0055-21.

For more information and to speak with our advisor, please contact us at info@mbmg-investment.com or call on +66 2 665 2534.

About the Author:
Paul Gambles is licensed by the SEC as both a Securities Fundamental Investment Analyst and an Investment Planner.

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