2022 Grey Swan #11: Real Rates Armageddon: Pensions Are Destroyed
By Karl Massey
(3 min read)
By Karl Massey
(3 min read)
Despite rising debt loads, corporate balance sheets have remained broadly healthy throughout 2020 and 2021, supported by the tsunami of central bank and government actions. However, markets appear to have fully priced this positive backdrop.
The new dynamic is the Fed tapering its bond purchases and planning to hike rates in the face of high inflation. The intent is to tighten monetary conditions. But should we assume this rate-rising cycle will be no more than 50-100bps before the wheels fall off the highly debt-encumbered economy?
In our current inflation-obsessed world, perhaps we should expect the current spike to be transitory indeed. But rather than returning to disinflation, we could progress to a new unfamiliar world with more stubbornly higher inflation, say 2-4%. This would imply real yields go deeper into negative territory and stay there. Combine this with lower growth and we could get a toxic cocktail – growth too ‘low’ to support debt, inflation too ‘high’ to enable loose conditions.
So we encounter the D-word, which must not be spoken – the D-word that is unpriced. It is not disinflation, not disintermediation, and not decarbonisation. It is default.
A sort of soft sovereign default is already being priced…part of the anti-fiat nihilism of crypto. The crypto ‘vote’ is on global central bank credibility. The ‘rise without a trace’ of crypto is just a widespread spoiling of those ‘ballot’ papers.
If the Goldilocks conditions for markets persist, nothing will change for the There Is No Alternative (TINA) agenda. But if we get a significant slowdown with inflation stubbornly persistent above long-term trends, credit must start to incorporate rising default probabilities – all this while US high-yield credit delivers negative real yields. That is the Real Return Ragnarök. Investment returns will become materially asymmetric with real rates as long as they continue to ratchet more negative.
How unreasonable is it to suggest inflation settles back lower from the current spike to higher than previous levels and that growth settles back near the lower level to which we have become accustomed? That is, insufficiently weak to prevent tightening, with a continuation of the lower highs in subsequent rate cycles.
Reasonable assumptions imply two outcomes. We could see more volatile negative real rates with higher inflation and higher overall uncertainty. Or we could see less volatile negative real rates with the lower growth driving an increased probability of rising defaults.
In both those environments, the investment losers are very probably those institutions with significant unhedged real return exposures. Their long-term asset versus liability mismatches would force them to crystallise at the worst possible times, holding, as they do, both excess risk in private credit and lower-quality public fixed-income credit, and excess public and private equity…in a barbell of ‘wrong-way risk’. This would again dash their dreams of countercyclical investment.