2023-01-02

The future of interest rates

“The Fed is gonna pivot!” Yeah, well it will eventually, but J Powell wants to be Volker’s second coming, not the hapless Arthur Burns. Even though, at the time, citizens were burning effigies of Volker, he has ascended to the pantheon of central bankers, and that’s where Powell and Kuroda want to end up (the latter a lot sooner than the former). What this means for bonds and rates is anyone’s guess, but I’ll have a go.

The biggest thing to happen last year, in macro terms, is that inflation is back, baby. It’s like 1973 all over again, and it has freaked out governments and investors alike, the former because tightening will cause govt. debt service to rocket, the latter because, well, discount rates will go up, which means that asset prices will go down.

In terms of killing inflation, somehow higher rates have to translate into reduced demand. The two main channels for this are the housing market: rents and mortgage repayments get dearer, and FX: pushing up the interest rate pushes up the currency. The problem is that no country wants to have another country “export its inflation” to it, so interest rate rises end up being coordinated, muting the FX channel, and piling all the misery onto the housing market and other capital-intensive activities (like infrastructure).

Sometimes governments actively undo the best efforts of central bankers, by just spending money to compensate those who lose from tight monetary policy.

Japan, Europe, and emerging markets like Brazil and Mexico have problems which are different from each other, and different from the USA. At the very least, I think this is going to finally make FX markets exciting again.

From what I read, the most likely outcome, at least for the US, is a recession this year, maybe Q1 or Q2, a swift pivot, followed by a tsunami of inflation in 2024, with the US trailing a long way behind Brazil and Mexico (and maybe other EMs). How to play this? Go long Dec 24 Eurodollar futures. NOT INVESTMENT ADVICE.