By outward appearances, the state of the U.S. economy during the first 10 months of 2022 has been neither too hot nor too cold, except for the double-edged sword of the anything-but-tepid employment data. The bellwether measure of job growth has been robust, with the economy adding an average of 420,000 jobs per month, twice the average rate of 194,000 from 2011 to 2019.
Additionally, average hourly earnings for all private-sector employees continued its post-COVID upward trajectory, rising from $28.56 in March 2020 to $32.46 currently. The nominal unemployment rate edged downward to 3.5% from January’s 3.9%. The labor-force participation rate, though in a secular decline since 2000 when it reached 67.3%, is currently 62.3% and inching its way back toward the pre-COVID level of 63.4%.
In addition to low unemployment, the Fed’s dual mandate includes price stability. Even with the latest disquieting CPI (Consumer Price Index) print on October 13, there’s some room for ephemeral hopefulness. In the fall of 2021, the Fed pivoted in telegraphing its assessment of inflation, begrudgingly switching from “transitory” to intransigent and, beginning in March 2022, backing its rhetoric by ratcheting up the Fed funds rate from near zero. The Fed has signaled that it plans to lift its target rate to 4.25%–4.5% before 2022 ends. Thus, the presumption of reduced demand and improved supply should have a salutary effect on the rate of change in consumer prices.
Equity markets seem to be taking their cues from such headlines, having descended without disorderly fanfare. Year to date, the S&P 500 is diminished by a not-insignificant, yet quiescently somber, 23.9% and the NASDAQ 32%. As a popular indication of the orderliness of the decline, the VIX (Chicago Board Options Exchange volatility index) has not risen above 31%, comparatively benign vis-à-vis 83% in March 2020 and 81% in September 2008.
How Long Before the Seismic Faults Are Revealed?
It appears foreordained that today’s economic contraction will not stay “Goldilocks” for long. After all, the excesses that accumulated during the decade-plus monetary policy of cheap and easy credit are subject to the Law of Compensation and cannot simply be willed away. Robbing Peter to pay Paul is, ultimately and inevitably, a fool’s errand.
Could it be that as interest rates began their ascent in 2022, fissures in the ideological armor of the “new era” of low interest rates (which enabled investor gains far above trend growth since 2008) are being exposed? Was the prosperity of the past decade largely an illusion? Will those years of compounding riches be as evanescent as a castle built of paper?
The widespread and long-held belief that interest rates can be managed at permanently low levels could prove to be a miscalculation of epic proportions. Over the last decade, cheap and easy money insidiously seeped into all the cracks. It flooded financial markets and economies around the world with credit that was priced off an ultimately unsustainable risk-free rate of near 0%. When the price of everything is unanchored from the real and palpable cost of real interest rates, wanton risk-taking will tempt even the strongest. The malinvestment spawned by the largess of monetary policy has been nearly ubiquitous.
If the equity market decline of 2022 might be characterized as docile, the losses in the comparatively opaque market for bonds has been a freefall. At the beginning of the year, the 10-year Treasury yield was a humdrum 1.5%, the 30-year Treasury bond 1.9%, and the two-month Treasury bill a mere 0.6%. Today those yields have surged to 4%, 4%, and 3%, respectively. That’s a big deal. Most investors don’t understand the mathematics of bond pricing. Thus far in 2022, the 10-year Treasury bond has slumped -18.1%, and the 30-year Treasury bond a stunning -33.8%. The spike in U.S. Treasury notes and bond yields has decimated the prices of the safest, long-dated, fixed-income securities.
A Canary in the British Coal Mine?
The Brits are discovering just how big a deal rapidly ascending interest rates can be. Years of low rates proved particularly challenging to British defined-benefit pension funds. According to British accounting standards, pension funds reported liabilities increasing as bond yields fell. In response, large pension funds sought to hedge against the prospect of falling rates with a strategy known as liability-driven investment (LDI). The funds would presumably acquire long-dated government bonds whose maturities matched future expected payouts.
The belief was that if interest rates rose, future liabilities would decline in tandem with bond prices, and the pension funds would be largely unaffected. Events have proven pension-fund managers to be too clever by half. Rather than buying gilts (British government bonds), many funds gained much of their exposure through interest-rate swaps. Furthermore, they applied leverage by borrowing against shorter-dated bonds. But as expectations of future interest rates rose quickly, gilt prices cratered. At the end of last month, one inflation-indexed government bond maturing in 2073 was down 85% from its peak just 10 months earlier. The pension funds faced margin calls on their loans, and the bond market seized up as the funds scrambled to raise cash.
Thus, we observe one of the unspoken and principal reasons behind the surprise recent resignation of British Prime Minister Liz Truss, after just 44 days at the helm. Truss-appointed chancellor of the Exchequer, Kwasi Kwarteng, lasted an even shorter 38 days. He was likely blindsided by the nuances of a subterranean market he didn’t understand any more than the reigning U.S. financial poobahs comprehended the machinations that led to the Great Financial Crisis of 2008–09.
The British episode demonstrates how, after years of easy money, the global financial system is acutely sensitive to rate hikes. The great “unknown unknown” is how the broad derivatives market, which has notional positions measured in the hundreds of trillions of dollars and incorporates unfathomable leverage (with the vast majority linked to interest rates), will react as borrowing costs rise from their lowest levels in modern history.
Rather than whimsically sampling the porridge and discovering that baby bear’s is “just right,” today’s Goldilocks may unexpectedly find herself eye-to-eye with a grizzly. “Goldilocks and the Three Bears” is, as Liz Truss’s too-hot predicament reminds us, a British fairy tale. But it also has been an American story, told by the likes of Looney Tunes and MGM Studios. What happened in the UK may be merely a tremor, but the faults are global and run right through the center global markets, the United States included.