Crypto News: Brave new world where bonds are more attractive than equities

With the Federal Reserve set to hold rates steady for a second straight meeting the first time in this hiking cycle, it's clear we're near the end of the line. But what comes next is not going to be at all like what came before it. After fifteen years of easy money and a swollen balance sheet, expect the Fed to be a permanently changed institution in ways that are more favorable to bonds than risk assets.

It's Fed Day again, with the Fed policy statement coming out at 2PM. And if you disregard the specifics of today's policy statement and think about the broader sweep of what officials have been saying and doing for the past several months, the contours of a new era of monetary policy are now emerging. This regime is going to look nothing like what came before it. Out are the days of zero rates and a huge balance sheet. In are the days of higher for longer and 'surgical QE' to support financial stability, a concept I'll explain.

The upshot of this brave new world is that equities, coming off a period when 10-year real returns hit 200% for only the fourth time in 100 years, look vulnerable. Bonds are the new asset class du jour because higher for longer means better fixed-income returns. But since more and more investors are tracking indexes for the long haul via tax-efficient exchange-traded funds, equities certainly aren't passé. They just need the stabilizing hand from bonds. In that sense, the 60-40 portfolio of equities and bonds might not be dead quite yet.

In one sense — from the rates perspective at least — what we're likely to see in 2024 and beyond is a lot more like what we saw in the 1980s and 1990s under then-Fed Chair Alan Greenspan. After the previous Fed Chair Volcker took the Fed funds rate to nose bleed levels, Greenspan, taking over in 1987, just needed to keep real interest rates high enough to help the Fed maintain inflation-fighting credibility.

Greenspan started with the 10-year Treasury bond over 5% above inflation measured by personal consumption expenditures. And his policies kept 10-year real rates at least 3% above inflation the entire period through to the year 2000, except for two brief months in 1993. It was only after the Internet Bubble burst and the Fed cut to 1% that real rates fell from that plateau.

So, when Fed Chair Jerome Powell promises to get inflation back down to 2% permanently, don't take him literally in the sense the Fed won't relent until we are around 2% for the long haul. Think of the Fed as re-instituting a Greenspan-like vigilance for fear that it will get blamed for another bout of stagflation. That could mean inflation that averages well above 2% as it did from when Greenspan took office in 1987 through the 1990s. Back then it averaged 2.8% and that was good enough.

The key, though, if you listen to Fed officials is higher real interest rates. For them restrictive monetary policy means permanently higher real interest rates, which in turns means permanently higher nominal interest rates. Zero interest rate policy is officially dead. Of course, that's not good news for risk assets after a run-up during the easy money era after the Great Financial Crisis through the pandemic.

Another kernel is now emerging if you listen to the Fed talk about how they let their existing security holdings mature without replacing them. This quantitative tightening to shrink the balance sheet is permanent. We are not going back to the era of quantitative easing to juice the economy.

If you recall, when QE was first used back in the GFC, it was purely a vehicle to add liquidity to a market that was effectively frozen as mortgage-backed securities became toxic. The Fed took these assets onto its balance sheet, effectively acting as buyer of last resort and protecting the financial system. It was only later when the economy threatened recession again that the Fed — having run out of interest rate cuts -- came back for more QE with the explicit goal of boosting the economy.

In retrospect, this QE to boost the economy move is one many Fed officials likely regret. It took the Fed's balance sheet from $900 billion in September 2008 to nearly $9 trillion at its peak in 2022. That's a swelling of ten times in 14 years, a truly extraordinary expansion of size and scope of the Fed's impact on the US (and global) economy.

The biggest clue that the balance sheet shrinkage is permanent was the Silicon Valley Bank crisis. When the markets dislocated as a result of SVB's failure, the Fed didn't indiscriminately buy up financial assets as it had done during the pandemic, even after inflation had taken hold. Instead it created a specific targeted program that allowed banks to get loans at par for safe Treasury bond assets, effectively acting as a lender of last resort. Meanwhile, it kept QT going in the background, rolling off its balance sheet once the immediate dangers had disappeared.

That tells you that the Fed is fully invested in the so-called separation principle whereby it uses rate policy to tighten financial conditions and it uses its balance sheet — not to affect financial conditions — but to ensure financial stability when bad things happen — what I'll call surgical QE. As long as those bad things don't happen, the Fed is perfectly happy shrinking its balance sheet even further.

$7.933 trillion

- The size of the Fed's balance sheet as of Oct 18, 2023

How far will the Fed let its balance sheet shrink?

Well not back to where it was before certainly. The Treasury market is much bigger now. So the Fed's balance sheet needs to be correspondingly bigger. And if the Fed wants to have ammunition to impact financial stability it needs an even bigger balance sheet if the outstanding Treasury debt was $10 trillion in 2008 and it's $33 trillion now. You could easily see a $3 trillion Fed balance sheet. Throw in higher regulatory capital requirements requiring higher reserve balances and a buffer for fighting crisis and you could get to $4 or 5 trillion.

That's not the $7.9 trillion we currently see. But it's a lot bigger than before the Great Financial Crisis. So while rate policy may be going back to the 1980s and 1990s, the balance sheet is not. Likely, if you listen to what the Fed officials say they want to achieve, we're going to see a bigger balance sheet in perpetuity.

One corollary here is that it reinforces the concept the Fed isn't going back to zero. The Fed won't need to cut to zero if it uses its balance sheet for financial stability. Imagine a world where the Fed cuts rates from 6% to 3% in a recession and mops up any financial instability concerns with special targeted programs using its balance sheet. That way real interest rates act as friction against higher inflation after the recent stagflationary scare, scarred as we now are.

Gone are the days of massive rate cuts to near zero that began in the 2000s and huge Fed buying that began in the late 2000s. Savers will continue getting 3% interest, mortgage rates won't drop to 3%, and the discount rates for stocks will remain elevated. That's a lot different than the past 15, even 25 years.

All of that sounds a lot more like the Fed of William McChesney Martin, who led the institution from 1951 until 1970 and famously quipped that the Fed's job was "to take away the punch bowl just as the party gets going." So forget the Fed put and get ready for a less forgiving safety net for investors.

Even so, if you listen to the way Powell and others speak, there has been a sea change in how they think about monetary policy's influence on the more economically vulnerable and less wealthy. Time and again Powell talks about raising rates to quell inflation in order to help exactly those members of society who are most impacted by inflation. He also stresses the balancing act they have in not overdoing it and causing a recession that throws those same people out of work. After all, having a paycheck but dealing with inflation is a lot better than having no paycheck at all.

I don't think this is just lip service. The Fed really wants to thread the needle. And that means the days of NAIRU — the non-accelerating inflation rate of unemployment — driving the Fed to hike lest a too, too low unemployment rate cause inflation to spiral out of control are over. The Fed now believes we can have our cake and eat it too, keeping inflation and unemployment low as long as real interest rates are permanently restrictive. Their hope is it means the end of boom bust, which most benefits those that get onto the employment ladder last in any business cycle.

On Wednesday afternoon I expect to hear the contours of this policy framework in what Powell has to say as he speaks after the rate decision at 2 PM. A lot of it is the a repeat of what we saw before, but with key differences on the balance sheet and thinking about the Phillips Curve pitting unemployment against inflation.

Bonds are going to love this. It's not the bond market rally we saw as the 10-year Treasury yield came down from over 15% in 1981. But it does ensure bond investors can safely clip coupons once we reach the plateau the Fed thinks is restrictive enough to keep tightening policy. I think there is a non-zero chance the Fed is forced to go to 6% in 2024 if the US economy remains hot and inflation stays above 3%. So we're talking about the period just afterward.

Even so, some investors already feel near 5% yields are good enough. They're moving out of cash and further out the curve. Stan Druckenmiller even recently said he's very bullish on 2-year Treasuries. And the bond market math behind so-called convexity says it's not much harder to inflict further huge losses on Treasury investors.

If there is a recession, you can see the Fed cutting rates and giving enough rate relief to debtors that it buoys the economy without the Fed needing to get to zero rates. If mortgage rates fall from 8% to 5%, how many people with 4% mortgages would be willing to move? A lot. All you need is to get into the ballpark of where their existing rate is and suddenly people are willing to make different decisions.

That's not a 'Fed Put' though. So those people who overweighted risky equities instead of hugging the index via ETFs are not going to find a lot of rate relief to help them as recession takes hold. AMC is nearly 88% down from its 52-week high, for example. A few Fed cuts isn't going to get you anywhere close to those previous levels.

For equities overall though, let's remember that we only recently came off the 4th ever period of 200% real returns over a decade. That's a headwind for future returns since long-term equity returns tend to overshoot to the downside after such magnificent run-ups. And it's the real yield that will do it. Back in August I wrote "the peak in US equities was probably in July." Stocks have since had an official 10% correction from that July peak — and for the reasons I outlined then, rising real yields. And as the Fed wants higher real yields permanently, this is a permanent headwind for equities from that high base. Mind you, stocks can continue to rally as long as we avoid recession. But that rally is capped by a higher discount rate and competition from bonds. A 60-40 portfolio, in that context, doesn't seem so bad.

I want to end this on a bright note. Since increasingly people are thinking about getting exposure to different asset classes via ETFs, they can tax-efficiently mimic the indexes and outperform active management with lower fees. We see that with equities and the same trend is coming for bonds. That will keep people liking a 60-40 portfolio as long as equities don't crater. One asset class to also think about in that context is crypto. If crypto gets an ETF, it's a game changer. From a compliance perspective, suddenly you have a whole host of asset gatherers who have no problem getting into crypto. And that's going to help keep interest in the asset class going. Something to think about if you consider ETFs and the diversification benefits they will bring as they start to dominate the investment landscape.

"It takes a lot larger increase now to wipe out total return over a 12-month horizon because you're getting yield."

Stephen Bartolini

Fixed-income portfolio manager, T. Rowe Price

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