It is well known that inversions in the yield curve signal bad economic times coming ahead.
Why? Typically credit is extended by financial institutions that make their money by borrowing short and lending long.
When the yield curve is inverted, financial institutions will find it more difficult to make money since the interest spread capture is narrower.
JP Morgan, for example, has announced in their last quarter that they are suspending their share buyback program. Their politically correct wording was: “In order to quickly meet the higher requirements, we have temporarily suspended share buybacks which will allow us maximum flexibility to best serve our customers, clients and community through a broad range of economic environments.”
Just remember, they’re suspending share buybacks for your safety!
Certainly when JPM is deciding to go into capital preservation mode, I get suspicious. Indeed, when I look at the Canadian banks, I think most of them have a good chance of going back to the pre-Covid levels. Second-grade financial institutions (e.g. Equitable, Home Capital, etc.) are offering GIC rates of around 4.4-4.5% for two-year money, which is the highest I’ve seen in a very long time. If they have to pay that much for their short-term capital, good luck on the duration match when they are also charging 4.59% rates for a 5-year mortgage!
Presently, I’m looking at one of the weirdest interest rate outlooks I have ever seen. The markets are predicting an increase on the July 27th Federal Reserve meeting, and another rate increase in September. However, in 2023, rates are expected to drop again, presumptively modelling this economic slowdown and recession nearly everybody and their grandmother is talking about at this point.
It is the oddest recession on the planet where you have low unemployment rates (5.1%, which is about as good as it gets here), commodities are booming, governments are raking in record corporate income taxes, etc, etc.
The Canadian rate curve has a similar trajectory – September 2022 3-month Bankers’ Acceptance Futures are trading at 3.85%, while a year later (September 2023) they are at 3.30%. Right now that rate is at 3.18%.
Since this rise in rates in 2022 and the drop in rates in 2023 is all baked into existing futures pricing, it leads one to the question – where might this actually go?
A few scenarios:
1. We get our recession, but inflation persists – banks likely have to stand pat on a relatively low rate of interest (2-2.5%) and real rates will continue being negative for the foreseeable future.
2. We get a massive recession (e.g. the asset deflation scenario with QT and everything), inflation busts out due to demand evaporation (supply chains normalize, etc.) – banks will crank rates down likely to the zero bound and you can dust off your post-Japan 1989 playbook for another couple lost decades.
3. The economy is actually fine, capital gets invested, etc. – rates will steady and possibly rise even further as this would probably be inflationary in the short-run.
Since a lot of the inflationary phenomena involves psychological expectations, it is very difficult to predict how this is going to resolve itself.
Cash (take a mild amount of duration risk for a net 370bps YTM with TSX: XSB!) might be trash, but it might be less trashy than the alternatives. Perhaps taking the real rate loss and being able to purchase assets for 20-30% of a discount from present is a possible scenario for those that are patient. Quantitative tightening has just barely begun and the typical real world economic impacts of interest rate increases will take a year to permeate – we’re now four months from the initial March 2, 2022 quarter point increase. Perhaps when the collective amounts of all of the Covid handouts have been spent, there will be a significant belt-tightening process. There are many lines of speculation about the future.
In Canada we now see the spread between 5 year variable and fixed mortgage rates closing – it seems to be around 100-150 bps now. Impossible to say for sure, but what do you think would be the cheaper choice for the next 5 year?
The 2023 rate decreases do seem to be priced in, but are they wishful thinking?
Prime minus 1 gives a 3.7% rate currently, Bank of Canada would have to raise 1.25% or so to get to that 5% spot, so one would think variable would still save money.
Another possibility is that current US/Canada CB action works to lower inflation to the target range in the next 12-24 months, causing only a mild to moderate recession.
Markets are probably priced for a case worse than this one.
There is too much uncertainty about the eventual outcome of rate hikes to justify going to serious cash IMO. Further, going into cash is much easier than knowing when to come out and the vast majority of investors (excluding the author of this blog who does have decent track record) do not get this right. Much better for most investors to maintain a diverse portfolio capable of weathering a range of outcomes, while capturing dividends and executing other strategies such as selling liquidity.