Bilal’s Macroscope: How High Rates Cause Inflation!

Surely, higher interest rates reduce inflation. That must be a cast-iron rule of economics. But it follows that lower interest rates increase inflation? If so, then why did we not get higher inflation after the global financial crisis in 2008? After all, the Fed cut rates to zero and engaged in QE, so inflation should have shot higher. Instead, US PCE inflation averaged 1.6% from 2009 to 2019. So why did low rates not cause inflation?

One reason is that both household and bank balance sheets were impaired. So, lower rates did not result in much extra credit creation. Instead, both households and banks spent their time cleaning up their balance sheets and building up buffers for the next crisis.

But a less discussed reason is that leverage was built, not by households or banks, but by equity investors. These investors borrowed at low rates and invested in companies that benefited from low rates. These investments were focused on so-called ‘tech’ companies, that lose money today to gain a large network, which could be monetised in the far future. In essence, ‘tech’ companies were offering products priced below costs thanks to the largesse of equity investors. This allowed prices, and hence inflation, to fall. So, the transmission went from low rates to leverage in equities to ‘tech’ companies lowering prices below cost.

Take three high-profile examples:

1. DoorDash (similar to Deliveroo in the UK). They call themselves ‘a technology company that connects consumers with their favourite local businesses’. In reality, it is a food delivery service that makes $3.87 per order but spends $4.55 to get the order to people’s houses. The biggest investors in this loss-making business include Sequoia and Softbank.
2. Uber. They say they ‘reimagine the way the world moves for the better’. In reality, it is a taxi/mini-cab and food delivery service that makes $4.27 per ride but spends $4.89 per ride. Its early investors included Menlo Ventures, Jeff Bezos, the Saudi sovereign wealth fund and Softbank. Today, most of its stock is held by index trackers such as Vanguard and Fidelity.
3. Disney+. The company has been wracked with politics of late with CEO Bob Chapek recently booted out for former CEO Bob Iger. The proximate trigger was the $1.5bn quarterly loss by Disney’s streaming service Disney+.  The service is haemorrhaging cash. Disney+ makes $3.91 per user per month, but the service costs Disney $20.71 per user per month. How is Disney funding these losses? It is redirecting profits from other divisions like Theme Parks. Disney’s debt load has also increased sharply from around $15bn in 2018 to $45bn today. Admittedly some of this is due to Disney’s acquisition of Fox.

These are all examples of how low rates allowed companies to offer services at below cost, thus reducing prices and inflation.

But now that rates are rising, such behaviour will not be tolerated by markets. Disney has lost its CEO as a result. Share prices are also tumbling. The S&P500 is down 16% this year, but Disney is down 37%, Uber is down 33% and DoorDash is down 63%. In terms of equity factors, value and profitability have far outperformed growth and volatile stocks. But at the macro level, we have a mechanism for higher rates to cause prices to rise as loss-making services are forced to raise prices to survive.

Our Current Discretionary Trades

Our US rates flattener has continued to perform well. It has recently broken lower and trades at the lowest levels since early 1981. A year earlier (1980) it fell as far as -200bps. And on FX, we are closing our short GBP/CHF trade – note to follow. Elsewhere, our EM trades are unchanged. Currently, our trades consist of:

• US rates flattener: sell 2Y, buy 10Y
• Higher euro yields: short German 10Y
• EM FX crosses: long THB/TWD, long SGD/CNH
• China bounce: short USD/CLP, long HSI
• EM rates rally: receive 1s5s MYR IRS

What Are Models Signalling?

We track a range of models which can help understand where the market is in pain:

• CFTC positioning revealed that hedge funds are paring their USD net-shorts. Meanwhile, their net-US 2Y positioning stands in contrast to that for real money with both in extremes, too.
• Our FX carry models rebounded over the past week following a sharp downturn. While they remain up over the past three months, they may struggle into year-end.
• Momentum models were flat over the past week; gains in equity momentum models were offset by rates and FX momentum models. There are few models with consensus signals – just net-bullish Nikkei, FTSE-100 and EUR/NOK.

Recent Questions from Clients

• Why will the Fed still hike to 8%?
• Why won’t the ECB hike as much as the Fed?
• Which G10 central banks are overpriced?
• Can the FTX/Genesis blow-up become systemic?
• Can crypto survive if it gets regulated?
• Are banks safe?

What I Am Reading and Watching

• I finished the TV show ‘Your Honor’. It is excellent. I am looking forward to season 2.
• This interactive map is cool – shows noise levels for New York, London and Paris.
• The White House needs a copy editor.
• Tyler Cowen’s favourite non-fiction books of the year.
• 3D for everyone? Nvidia’s Magic3D can generate 3D models from text.
• ‘SuperGPS’ Technology Accurately Pinpoints Your Position Within Inches. Good or bad?!
• For friends who get migraines: Mysterious Changes Identified in The Brains of People Who Get Migraines.

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)