Central banks are aggressively raising rates in an attempt to contain inflation that has proven to be far from “transitory,” and financial markets – stocks and bonds – have been tumbling in response. But how much longer might the hiking cycle go on? More to the point, how much more will rates have to rise before central banks succeed in taming runaway inflation? In its spring Market Observer newsletter, which was produced before Canada’s 100 bps rate hike, leading Canadian institutional investment management firm, Canso Investment Counsel Ltd., took a hard look at the past, present and future of the issue. The newsletter looks at the root causes of inflation, the likely impact of the ongoing monetary policy response, and what it all could mean for investors.
To read the full report, please click here.
How we got here
The highest inflation in four decades did not come out of nowhere. As COVID-19 quickly metastasized into a global pandemic in early 2020, central banks around the world opened the floodgates, pumping liquidity into the global economic system by lowering benchmark rates to near zero and buying up bonds in a renewed spasm of quantitative easing. That included funding fiscal programs that effectively paid people not to work (no matter their financial status) and making borrowed money ultra-cheap by ensuring that real interest rates (net of inflation) were at or – in the case of the European Central Bank and the Bank of Japan – below zero. Simply put, monetary policymakers “created far too much money than was necessary for actual economic activity,” the Canso team wrote in their recent newsletter.
The result? It’s simple, as well: more money to buy goods and services means prices of goods and services will rise. And they did. Today, the inflation that central bankers quickly dismissed as a “transitory supply-side issue” has proven to be anything but. And monetary policymakers are closing the floodgates. In the U.S. and Canada, central banks aggressively raised rates three times by mid-June, with the Bank of Canada raising rates again in July. In their rush to “correct their now very obvious mistake” during the pandemic, “they are reining money supply back in, and it is not pretty,” the Canso newsletter noted. “Interest rates are up, and the financial markets have shuddered, shattered and fallen precipitously in price.”
The genie is “going rogue”
Inflation is at its highest rate in 40 years, but the Canso team noted that it shows no signs of slowing down. In fact, they wrote, it seems to be broadening out into consumer and business expectations. The team compared it to the Robin Williams character in the Disney movie Aladdin – the genie who “did not want to go back in the bottle, and it now seems to be the same with inflation!”
The question is, how can central banks get the genie back where it belongs? The straightforward answer is they need to move interest rates above the rate of inflation. Yet, if that is indeed policymakers’ strategy, “there is still a long way to go,” the newsletter noted. The consumer price index (CPI) in Canada rose by 7.7 per cent in May, but the yield on 90-day Government of Canada treasury bills was only about 2 per cent.
Compare that to history, and the inflation/interest rate dynamic today looks dramatically unbalanced. In 2000, when inflation was 3 per cent, T-bill yields were 5 per cent; in 2007, inflation was only 2 per cent, but treasury yields were 4 per cent. Fast-forward to today, and those figures suggest that nominal yields on T-bills should be about 4 per cent to get to real short-term interest rates of 2 per cent – if CPI were to “miraculously” fall to 2 per cent, the Canso team wrote. That, they added, “is not likely to be the case.”
Yes, you can have too much money
To explain why, the Canso team looked at the growth of money supply (M2) in the U.S. In March 2020, before the pandemic, M2 stood at US$16.1 trillion; as of early July, it is US$21.7 trillion dollars, an increase of 35 per cent in just over two years. With so much excess cash in the system, inflation is inevitable – and hard to contain. “If the Fed reduced M2 as quickly as it expanded it,” the newsletter noted, “the economy would implode.” The alternative, however, is a long and grinding war on inflation, as central banks thread the needle of withdrawing liquidity while trying to avoid tipping the economy into a severe recession. “If the Fed decides on a more gradualist approach, as it did in the inflationary 1970s, then we think inflation will stay at higher levels than the market expects,” Canso wrote.
And about those market expectations: despite the apparent pummeling investors have taken this year and a sharp rise in government bond yields, “we have not seen anything close to panic or distress in the credit and stock markets, as their risk premium has only increased moderately,” the Canso team wrote. Specifically in both investment-grade and high-yield bond markets, yield spreads against government bonds are nowhere near those seen in previous periods of distress.
Higher for longer?
Why has the bloodbath not been even bloodier? Perhaps because of rather sanguine views about how effective policymakers will be in fighting inflation. The newsletter noted that the U.S. breakeven spread is 2.6 per cent, meaning that investors think inflation will be at or below that level over the next 10 years. (After Canso completed its recent study, the U.S. CPI for June actually turned out to be 9.1 per cent!)
Meanwhile, bond markets are pricing in short rates of only 3.2 per cent a year from now – still a far cry from the 4% that would be needed to get back to “normal” real interest rates, even assuming inflation falls back to a more placid range. In short, markets seem to expect central bankers “will have things under control [and] will not have to raise rates more aggressively,” the Canso team wrote, “and inflation will fall back towards their stated 2 per cent target over the next year.”
That, they added, is a highly questionable assumption, given the scale and speed of the increase in money supply during the pandemic. If, instead, inflation proves to be more persistent and more severe, then “it looks to us like we could have the worst of all worlds for a bond investor: higher inflation, higher yields and lower bond prices.” In that world, it could take central banks years to mop up the excess liquidity they created, meaning rates could very well stay higher for longer.
Despite signs that some market optimism is returning, this is not the time to embrace risky assets, the Canso team concluded. “We see a lot more potential downside than upside at present,” they wrote, “and prefer to continue keeping our portfolios in higher quality liquid securities.”
For more insights and analysis, see the full Canso Market Observer by clicking here.
The views and information expressed in this publication are for informational purposes only. Information in this publication is not intended to constitute legal, tax, securities or investment advice and is made available on an “as is” basis. Information in this presentation is subject to change without notice and Canso Investment Counsel Ltd. does not assume any duty to update any information herein. Certain information in this publication has been derived or obtained from sources believed to be trustworthy and/or reliable. Canso Investment Counsel Ltd. does not assume responsibility for the accuracy, currency, reliability or correctness of any such information.
This story was created by Canadian Family Offices’ commercial content division, on behalf of Canso Investment Counsel Ltd., which is a member and content provider of this publication.