I was filling in for David Bahnsen this week on DC Today, and I was reminded how much I enjoy the Ask David section. This is where readers send in questions, and David addresses one question a day on this published public platform.
I remember an old teacher always used to encourage our class, “Ask, please ask all the questions you have. If you have a question on your mind, surely that same question is on the mind of a few others.” It was our civic duty to ask questions; it was for the greater good of the class. Our teacher actually used to give us [the class] an ultimatum – either ask questions for the entire period of the class, or he’d tee up a boring lecture. That’s right, an entire class, an entire semester, of just our questions. Sounds odd, right? But this professor knew the subject well, and our inquiries were based on the assigned reading, so it was our actual questions that made up the tapestry of his lecture. Yet, because we were the inquirers, we were much more engaged. Participation was a large portion of your grade, so it was also a motivator to complete the daily reading and be prepared for the discussion. It was quite a genius approach to teaching.
In that vein, I should probably be better about sharing the questions that I get from clients, friends, and readers. Why? Because surely these questions are on the minds of many others.
One Good Question Deserves Another
With that said, here is a question I got this week:
Where will short term interest rates be two years from now?
I am confident that you know that I can’t answer this question with the utmost certainty. If you come across someone that said they could provide an exact answer to this question, then you came across a liar.
Although we don’t have perfect clarity about the future, we can make educated estimates based on history, the current economic landscape, and other relevant factors.
To tackle this question, I first want to start by tackling a few other questions regarding interest rates:
(1) How did we get here?
(2) Where are we going?
(3) When will we be there?
How Did We Get Here?
On Monday (July 17th) David provided the following chart in DC Today:
The segmentation of this chart helps to tell much of the story. Just as we use BC and AD to delineate time around the most crucial moment in history – the birth of Christ – we can use 2008, the financial crisis, as a critical turning point in modern financial history. In approximate terms, the 10-year treasury was always above 4% pre-crisis and has lived mostly below 4% post-crisis.
Coming out of the financial crisis, our central bank, The Federal Reserve, would conduct one of the greatest financial experiments of all time. The goal was to stimulate the economy and bring life to what was seen as a dying patient. No medication, method, or support was held back. A result of this accommodative posture was artificially low-interest rates for a very long time.
Our next memorable notch on the timeline was the COVID moment of 2020. If the financial crisis led to the greatest financial experiment of all time, the COVID crisis led to the greatest social experiment of all time. The entire population was asked to isolate, businesses were forced to hit the pause button, and again our central bank and government sought to make accommodations. What did we learn? When businesses are placed on hold, they shrink inventories, and supply chains get messy. When people are in isolation, their desire to spend on things and activities becomes like a volcano, ready to erupt. The extra (excess) government funding just adds fuel to this fire. And then, when the entire system gets turned back on like a light switch, you’ve got an imbalance of demand and supply. Too much money chasing too few goods, AKA inflation.
How does an accommodative central bank react to inflation? They tighten the belt. The Federal Reserve has a dual mandate – stable prices and maximum employment. The tool they use to combat inflation? Raising the federal reserve rate.
So, how did we get here? We shut down the world, and then we turned it back on. This shocked the system, and prices rose. When prices rose, interest rates rose. That’s how we got here.
Where Are We Going?
This seems like a question we shouldn’t be able to answer, right? It seems too predictive. In finance, though, we can often get a general sense of direction. It’s timing that becomes difficult/impossible to foretell (see next section).
Above, I explained that inflation led to a reaction from the Federal Reserve – they raised the federal funds rate – which then led to a reaction from the bond market, a rise in interest rates across the curve. So, it would be fair to conclude that a rise in inflation leads to a rise in interest rates. It would be equally fair to assume that a fall in inflation leads to a fall in interest rates.
Let’s take the riddle one step further, can we get an idea of where inflation is going? We can. We can not only use the published data that reflects a softening in inflation, we can also use the implied inflation rates embedded in TIPS (Treasury Inflation-Protected Securities) spreads. Those expectations over the next two years are currently reflecting estimates in the 2% range.
We can conclude that inflation is coming down, which means we can conclude that interest rates are indeed coming down.
When Will We Be There?
This is a difficult question for me to even type. Why? Because as I type the question, I can hear the voice of my four-year-old. We’ve been on two summer trips recently – one to Kauai and one to celebrate grandpas birthday in Northern California. One a long flight, one a long drive. The prevailing question of the trip? Are we there yet? When will we be there?
Regardless of GPS and all the technology available, I can’t predict down to the minute our arrival time for these long journeys. Turbulence, traffic, potty breaks, weather delays, and a number of other variables make these things impossible to predict.
It’s not much different in finance. Many educated men and women are made to be fools in the arena of finance when they try to predict the exact timing of a particular event or action.
Again, you can be confident about direction based on the evidence available to you, but I encourage you to be humble when considering the timing of it all.
“Markets can remain irrational longer than you can remain solvent”
― John Maynard Keynes
“The main purpose of the stock market is to make fools of as many men as possible.”
― Bernard M. Baruch
When I am referencing the timing as being impossible to predict, I am really saying that these specific pivot points in markets are only obvious in hindsight. With markets seeming to have the desire to fool the most and frustrate all, they don’t operate in a linear fashion. Something may feel like it’s pivoting at the moment, and that momentum can quickly dwindle. I often refer to markets as a two-steps-forward-one-step-backward sort of system. So, the journey to lower rates will be chock-full of little upticks that will most likely surprise you, confuse you, and have you second-guess your conclusions.
For this reason, I encourage you to ground your hypothesis in reason. I also encourage you to be humble in your beliefs and to hold your conclusions loosely. Markets are complex systems, and it is best to digest all the available information to help refine and evolve your perspective. Convictions are good, and they are needed to have success as an investor; otherwise, anything and everything will knock you off your saddle. Just be careful not to mistake stubbornness for convictions.
With that said, I invite you to send in your questions (firstname.lastname@example.org); otherwise, you will have to continue to read my boring lectures 🙂