Conversion at Pimco
pimco.com
PM=Paul McCulley at Pimco
here is the relevant piece but some good charts at the end
history says, if the Fed goes on a rampage in hiking cash rates, longer-term rates will rise, too, just by less. So, while the yield curve will flatten as the Fed tightens, long-term rates will still rise.
In the ongoing – but nearly finished! – Fed tightening cycle, that hasn’t happened: long rates – notably the 10-year rate – have fallen slightly as the Fed has been tightening, totally collapsing the yield curve. Or, alternatively, totally collapsing the term risk premium.
This time has been different, regardless of how dangerous those words usually are to the wallet. And trying to figure out why it is different has become an industry: the conundrum-busting brigade.
MLF: So, what’s the answer, Mac? Why is this time different?
PM: There is no single answer, Morgan, which is why it is such fertile ground for investigation. The key question, it seems to me, is whether the fall in long rates versus short rates is a fall in the term risk premium or a fall in the equilibrium real rate. Put differently, are investors demanding less of a yield premium for holding inherently more risky long-dated paper, or are they implicitly projecting a structurally lower real short-term rate in the future?
MLF: Well, which is it?
PM: Bit of both, me thinks, but I lean heavily toward the thesis of a structurally lower real short-term rate in the future. Back when I was a young man, Morgan, the cliché on Wall Street during Fed tightening cycles was that the Fed couldn’t stop too soon, or else long-term rates would rise on the back of un-scotched inflationary expectations. Now, the cliché is that the Fed can’t stop, or else long-term rates will fall, providing inflationary stimulus to aggregate demand.
What a long, strange reversal! To me, that’s a siren signal that secular victory over inflation has been won.
The name of the game now is not forecasting inflation, as it is well-anchored, but forecasting what real rates the Fed will need to impose to keep inflation well-anchored.
MLF: Intriguing. If that’s the case, doesn’t it imply that the ‘flation that matters now is inflation and deflation in asset prices, rather than goods and services inflation?
PM: Right you are, most clever bunny! If Fed-engineered changes in nominal rates no longer reflect changes in long-term inflationary expectations, but rather changes in real rates, then logic suggests that long-dated income-producing assets – bonds, stocks and real estate – will become inherently more prone to bubble and burst.
Accordingly, it seems to me, asset prices inevitably must take on a higher priority in the Fed’s reaction function than during the War Against Inflation. As long as inflation was too high for the Fed’s secular taste, bubbles and their bursting didn’t carry grave harm. They misallocated resources, to be sure, like all good Austrians properly preach. |
