Great post, knocked some sense into me. Looks like my only bond exposure will be in i-bonds (now yielding 9.6%!). Quant friend also told me as long as inflation >3%, expect positive stock/bond correlation, which I thought was interesting as well
If the stock bond correlation becomes structurally positive expect risk parity strategies to get absolutely massacred as they are structurally overweight long dated bonds.
Hi Russell, I generally agree with you long term, but how do you think about the sequence? Clearly at least the Fed wants the market to believe that they will do whatever it takes to tame inflation, even if it means recession, job losses and an end to wage increases. Do they actually believe it or just want to slow/manage the process is another question, but I guess what I'm pondering what is the likelihood that they will make a mistake, lose control of the adjustment, and create a sharp deflationary bust in the short to medium term? At which point I don't doubt that they (and governments) would cave, and then inflation would quickly shoot back up, but again I'm just pondering the sequence... Surely it won't be linear. I usually try to avoid being too tactical, but i fear that if they screw up they could screw up big.
I probably need to right a post about it - but one thing I like to do is look for a relationship were correlation will break at some point. I think currently we are seeing Yields Up - Commodities down at the moment, but I think at some point we are going to see commodities up and yields up at some point. At that point central banks will freak out - as they will feel they have lost control of the cycle... I think that comes at some point - but you are right, it might take longer than expected
Totally agree! Think about it for a second, in a world, where G7 is loaded with debt, and still rising Debt/GDP, the high inflation and rising policy rates (which are still major net negative) will have a dramatic effect on interest service costs. Major chunk of US debt is still short dated and roll over costs will be even more cumbersome. In a world, where politicians are heading towards more labor friendly policies will have to foot the bill in the form of high-er commodities and raw material costs. Probably capital flows are still busy adjusting to immediate cash needs of funds, imminent risk of recessions, etc. but they will turn ugly after this adjustment, unless politicians pick recession over inflation, which as you say definitely not the case, for many years to come..
I actually think you will find that rising wages will lead to very strong growth, and as wage income is easier to tax better budget positions. Interest rates will rise because they can, and they will be used to try and keep real wages strong - and rising wages will drive rising commodity prices. Then suddenly, price to income ratios for property etc will look cheap.
I agree, growth can be high with wage growth, but it certainly will bring inflation along with it. So basically inflation will pass through everything we consume, even nore with the wage rises. My understanding is that revenue/GDP (i.e. tax collection) is somewhat at optimal levels at most OECD countries. Inflation and GDP growth will lead high nominal growth in GDP. Say, wage growth will be up in line with this nominal growth, which is doubtful given last few years' of data. If revenue/GDP is around 50%, then, at most, collection increase revenues by 50% of that nominal growth rate. On the interest cost side, it has been roughly around 1 or 1.5% on average, maturity weighted, last 10 years. If this rates go up to say 4 or 5% along with this inflation and fund rates, then, interest service cost will be up more than 200%. Net net is, while it may vary slightly depending on the country, interest cost burden will be very heavy on goverment budgets. Remember most G7 are still fiscal deficit countries.
Russell as you write the exception to this is in East Asia
The Japanese yen has fallen the most of major currencies (even the Euro) as the BOJ keeps ZIRP
Surprisingly the Chinese bond market has held up, China is the only major economy with a lower interest rate now than start of 2022 (Russia is a special case due to war)
How do these two examples factor into your thinking?
Long Chinese bonds and short yen has been a hell of a trade this year!
I think China is the source of inflation - as they are much more further ahead in moving from pro-capital to pro-labour, so are exporting deflation via commodities - but have created asset deflation in their property market.
Great post, knocked some sense into me. Looks like my only bond exposure will be in i-bonds (now yielding 9.6%!). Quant friend also told me as long as inflation >3%, expect positive stock/bond correlation, which I thought was interesting as well
Makes sense - where are you seeing 9.6%? I am looking at LQD and see a yield of 3.4%
https://www.treasurydirect.gov/indiv/research/indepth/ibonds/res_ibonds.htm
Limit is only $10k/calendar year though
If the stock bond correlation becomes structurally positive expect risk parity strategies to get absolutely massacred as they are structurally overweight long dated bonds.
I hope Ray Dalio has changed tack!
Hey Russell, with the flash crash in GBP, could this be a possible harbinger that the GBP/JPY is picking up deflationary trend?
GBP needs a long way to go, or Yen needs to rally to show a deflation trend... or we need to see bond behaviour change...
Hi Russell, I generally agree with you long term, but how do you think about the sequence? Clearly at least the Fed wants the market to believe that they will do whatever it takes to tame inflation, even if it means recession, job losses and an end to wage increases. Do they actually believe it or just want to slow/manage the process is another question, but I guess what I'm pondering what is the likelihood that they will make a mistake, lose control of the adjustment, and create a sharp deflationary bust in the short to medium term? At which point I don't doubt that they (and governments) would cave, and then inflation would quickly shoot back up, but again I'm just pondering the sequence... Surely it won't be linear. I usually try to avoid being too tactical, but i fear that if they screw up they could screw up big.
I probably need to right a post about it - but one thing I like to do is look for a relationship were correlation will break at some point. I think currently we are seeing Yields Up - Commodities down at the moment, but I think at some point we are going to see commodities up and yields up at some point. At that point central banks will freak out - as they will feel they have lost control of the cycle... I think that comes at some point - but you are right, it might take longer than expected
Most interesting indicators!
Totally agree! Think about it for a second, in a world, where G7 is loaded with debt, and still rising Debt/GDP, the high inflation and rising policy rates (which are still major net negative) will have a dramatic effect on interest service costs. Major chunk of US debt is still short dated and roll over costs will be even more cumbersome. In a world, where politicians are heading towards more labor friendly policies will have to foot the bill in the form of high-er commodities and raw material costs. Probably capital flows are still busy adjusting to immediate cash needs of funds, imminent risk of recessions, etc. but they will turn ugly after this adjustment, unless politicians pick recession over inflation, which as you say definitely not the case, for many years to come..
I actually think you will find that rising wages will lead to very strong growth, and as wage income is easier to tax better budget positions. Interest rates will rise because they can, and they will be used to try and keep real wages strong - and rising wages will drive rising commodity prices. Then suddenly, price to income ratios for property etc will look cheap.
I agree, growth can be high with wage growth, but it certainly will bring inflation along with it. So basically inflation will pass through everything we consume, even nore with the wage rises. My understanding is that revenue/GDP (i.e. tax collection) is somewhat at optimal levels at most OECD countries. Inflation and GDP growth will lead high nominal growth in GDP. Say, wage growth will be up in line with this nominal growth, which is doubtful given last few years' of data. If revenue/GDP is around 50%, then, at most, collection increase revenues by 50% of that nominal growth rate. On the interest cost side, it has been roughly around 1 or 1.5% on average, maturity weighted, last 10 years. If this rates go up to say 4 or 5% along with this inflation and fund rates, then, interest service cost will be up more than 200%. Net net is, while it may vary slightly depending on the country, interest cost burden will be very heavy on goverment budgets. Remember most G7 are still fiscal deficit countries.
True
G7 countries have also monetised debt to varying extents already
BOJ holds more than 50% of all JGBs
So the interest expense is passed to the govt directly
What will be interesting is how Central Banks react to inflation when they have negative equity
As the value of their bondholdings decline due to inflation.
Russell as you write the exception to this is in East Asia
The Japanese yen has fallen the most of major currencies (even the Euro) as the BOJ keeps ZIRP
Surprisingly the Chinese bond market has held up, China is the only major economy with a lower interest rate now than start of 2022 (Russia is a special case due to war)
How do these two examples factor into your thinking?
Long Chinese bonds and short yen has been a hell of a trade this year!
I think China is the source of inflation - as they are much more further ahead in moving from pro-capital to pro-labour, so are exporting deflation via commodities - but have created asset deflation in their property market.
Do you mean exporting inflation via commodities?
Yes I did