Rising rate regime raises real ruction risks

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The long-end bond massacre has been pretty bloody, and, like a really tedious game of Cluedo, everyone has their own favourite contender for the culprit (sorry again).

For what it’s worth, investors belatedly recognising the strength of the US economy and embracing the “higher for longer” narrative — plus some extra term premium and perhaps some levered longs getting smoked — seems the most plausible explanation at Alphaville Towers.

The supply argument just doesn’t seem as convincing. As these charts from DNB’s Ingvild Borgen show, there’s been a pretty sizeable repricing of US interest rate expectations for 2024-25, and that tends to exert a powerful influence over longer term US Treasury yields as well.

The fact that the 10-year Treasury yield tumbled as much as 18 bps to 4.62 per cent after the Fed’s Lorie Logan and Philip Jefferson yesterday suggested that higher bond yields could encourage the Fed to sit quietly in a corner for a bit is more evidence that this isn’t fundamentally a supply story (the Middle East mess might have contributed to the UST rally though).

However, you don’t need to agree on the underlying causes to worry about the implications of the bond rout. While Janet Yellen is right to highlight how the sell-off actually seems to have been pretty orderly, even if things now quieten down (a big if) policy is now de facto significantly tighter than it was not so long ago. Financial conditions etc etc.

Goldman Sachs is sanguine about the direct economic risks, but warned in a note yesterday (full public link here!) that the “move to a higher rate regime poses other risks too”.

Mainly that they chainsaw equity valuations, cause a more widespread cull of (terminally?) unprofitable companies, and/or force the US government to tighten its fiscal belt. Here are their main points:

— Last cycle, the belief that real rates would remain close to zero in the future helped to rationalize a few major economic trends that would otherwise have looked more questionable: elevated valuations of risky assets in financial markets, the surprising survival of persistently unprofitable firms in the corporate sector, and wide deficits that added to an already historically large federal debt in the public sector. We explore what the economic consequences might be if these trends were to begin to unwind.

— In financial markets, the key risk is that valuation measures that are benchmarked to interest rates are now higher for some assets, most importantly stocks. We estimate that if the equity risk premium fell to its 50th historical percentile, the hit to GDP growth over the following year would be 1pp. If it fell to its average level in the pre-GFC years, the hit would be 0.75pp.

— In the corporate sector, investors might hesitate to continue financing unprofitable companies that they hope will pay off well down the road now that the opportunity cost has risen. That could force these companies to close or cut labor costs more aggressively, as they have tended to do when hit with interest rate shocks in the past. A 50% increase in their exit rate would impose a roughly 20k drag on monthly payroll growth and a roughly 0.2pp hit to GDP growth.

— In the public sector, projections of real interest expense and the federal debt-to-GDP ratio look much worse than just a couple of years ago, when the interest rate on government debt (r) was expected to remain well below nominal GDP growth (g). We think it is unlikely that concern about debt sustainability will lead to a deficit reduction agreement anytime soon. But if it does happen eventually, an agreement similar in magnitude to the 1993 fiscal adjustment would imply a hit to GDP growth in the neighborhood of as much as ½pp per year for a number of years.

The conclusion by Goldman’s David Mericle and Ronnie Walker is that unless all these risks are come to pass, they are not large enough individually to trigger a recession. And if they do all occur, then the Fed would quickly start cutting rates to soften the impact.

Maybe. You can read about each of their risks in more detail here. But here we must share a wild chart from the GS report that shows that almost half of all listed US companies are now unprofitable. They only account for a smaller but still meaningful 13 per cent of US employment.

That doesn’t exactly fill us with confidence that the US economy’s remarkable resilience to higher rates can last for ever.