The Blubber

The days of near-zero rates and an expansive balance sheet are behind us, giving way to a new era characterized by prolonged higher rates and 'surgical QE' aimed at supporting financial stability, a concept I'll elucidate.

In this brave new world, equities, following a period where 10-year real returns reached 200%, a rare occurrence in a century, appear to be at risk. Bonds are becoming the favored asset class, as higher rates for longer translate into more attractive fixed-income returns. However, since a growing number of investors are adopting a long-term, index-tracking approach via tax-efficient exchange-traded funds, equities are by no means obsolete. They simply require a stabilizing presence from bonds. In this regard, the traditional 60-40 portfolio comprising equities and bonds may not have breathed its last just yet.

In a sense, particularly from the perspective of interest rates, what we are likely to witness in 2024 and beyond will bear a striking resemblance to the 1980s and 1990s, under the leadership of then-Fed Chair Alan Greenspan. After Paul Volcker, the previous Fed Chair, elevated the Fed funds rate to remarkable levels, Greenspan, who assumed office in 1987, primarily needed to maintain sufficiently high real interest rates to uphold the Fed's credibility in its battle against inflation.

Greenspan commenced with the 10-year Treasury bond providing a yield over 5% above inflation, measured by personal consumption expenditures. Throughout his tenure, his policies ensured that 10-year real rates consistently exceeded inflation by at least 3%, except for a brief two-month period in 1993. It was only when the Internet Bubble burst, leading to the Fed's rate cut to 1%, that real rates deviated from this plateau.

So, when Fed Chair Jerome Powell pledges to permanently lower inflation to 2%, it should not be interpreted as an unyielding commitment to maintaining around 2% inflation over the long term. Rather, it is a signal that the Fed is reviving the kind of vigilance embodied by Greenspan, aiming to prevent the blame for another episode of stagflation. This could imply that inflation will, on average, surpass 2%, much like it did during Greenspan's tenure from 1987 through the 1990s when it averaged 2.8%.

Crucially, the Fed officials are emphasizing higher real interest rates as the linchpin. They view restrictive monetary policy as synonymous with permanently elevated real interest rates, which subsequently translates into enduringly higher nominal interest rates. The era of a zero interest rate policy has officially come to an end. Naturally, this isn't promising news for risk assets, which saw significant appreciation during the period of easy money following the Great Financial Crisis through the pandemic.

Another key element emerging is the Fed's discourse on letting its existing security holdings mature without replacement. This policy of quantitative tightening to reduce the balance sheet is intended to be lasting. We are not reverting to the era of quantitative easing for stimulating economic growth.