Meet on the Corner of Main and Bond
I promised to talk about interest rates and bonds from a slightly more scientific standpoint last week, and the real world couldn't wait to discuss them either.
So, for those of you following the game from home, here is what happened this week on this front.
Jerome Powell, Chair of the US Fed, came out and said that the Fed Funds Rate (the policy rate off which most other interest rates in the economy are keyed) would stay where it is for now, but we should expect more rate hikes this year and then stay there for a while. The first part people expected, the second part was a bit more of an attention-grabber. Yes, inflation is off the lava-hot boil from just a few months ago, but it’s still high and the economy is way more resilient than most everyone expected, making taming inflation harder than we thought (A serious case of “good news, bad news”).
In Europe, Christine Lagarde, President of the European Central Bank (ECB), raised Powell’s ante by upping the ECB policy rate and making it clear there is more to come. This is huge given that Europe had super low rates for a very long time, and that a near-4% ECB rate is now a believable number (which would have been unfathomable not so long ago).
All of this takes us to bonds (though it could easily have taken us to currencies…). Next stop, the corner of Main St. and Bond St. in Nerdville. Tchoo-Tchoo!
In the simplest sense, bonds represent a loan by a lender (the investor) to a borrower (the issuer). Assume the borrower is the US government, so we can set aside credit risk for now, at least until the next time the dreaded Debt Ceiling monster comes out of his cave. The interest rate on a bond is the compensation received by the investor for lending for a while, foregoing immediate consumption or investing in other assets:
The former is key because investing is all about eventually using resources to consume in some way, shape, or form;
The latter is also key because it highlights how all assets are interconnected, i.e., at any given point in time, the “sophisticated” investor weighs the pros and cons of all sorts of assets against one another, and that’s how you get things like “global tactic asset allocation.”
Onto the science bit! Finance was nearly 100% experience, apprenticeship, and trial and error until a bunch of math whiz types hit the scene starting in the 1950s. Now we have science, though some of those scientists could use — you know — some real-world experience, apprenticeship, and the kind of humility you only earn from the error end of trial and error, but I digress. The first “models” came as an intellectual pair called “mean-variance optimization” (which made Harry Markowitz a Nobel-Prize winner) and the “Capital Asset Pricing Model” (or CAPM, which made Bill Sharpe a Nobel-Prize winner). The whole crux was to provide a framework for making rational decisions as an investor based on risk and expected returns (Markowitz) and then derive market implications on how assets should be priced relative to one another (Sharpe) if — and this is a big if — investing is a one-time deal (i.e., you invest, you wait, you consume).
Then Bob Merton came along in 1973 and gave us the Intertemporal CAPM, or ICAPM (Bob eventually got a Nobel Prize too, but for another paper he produced in 1973… So, 1973 was a good year for him and for us as well, as a result). Intertemporal means “more than one period” and that’s kind of a giant leap when you think about the real world, which is more like “invest, wait, make more investment decisions, wait, some more investing, wait, and then eventually consume.” The ICAPM produces the notion of holding an asset for its hedging qualities, not just run-of-the-mill risk-and-return profile. What is “hedging demand,” you ask? It means that you would want to own an asset (not exclusively) because it makes you money when things aren’t so great for the economy and for markets. Think of it like prepaid unemployment insurance. The economy goes bust, you lose your job, but fortunately this asset goes up in value, so you can consume that windfall while you look for another job. Or markets make it tougher to earn a good future rate of return, but this asset has already gone up in value, so you’re not so desperate to make money in this new crummy market environment. That’s an asset with “good” hedging properties.
What could such an asset be, you ask? (Lots of questions, everyone!) The answer tends to be bonds, precisely for the reasons that Jay Powell laid out this week. Interest rates will stay high as long as the economy is strong, was his basic message. The part of the story that goes unspoken is that interest rates can be expected to come down if the economy goes bust (and we’ll know that’s happening when jobs are lost, the stock market drops, and so on and so forth). When interest rates decline, the value of bonds will rise. That windfall if you own bonds is the hedging component of those bonds’ returns. Given all of this, a healthy bond allocation could make sense, the ICAPM says. And the experienced market apprentice tends to agree, as I noted last week. The reason is simple, bonds could be a good hedge for future trouble, and given what bonds yield now, the cost of that hedge may be very reasonable indeed.