Hudson Bay CEO sees inflation, interest rates higher for longer

Hedge fund manager Sander Gerber wrote in September 2022 that he expected U.S. bond yields to move much higher than 4%, inflation gradually falling toward 2% with occasional spikes and a 1% real interest rate.

His predictions turned out to be prescient.

In this follow-up interview, Pensions & Investments caught up with Gerber for his current thoughts: what he believes the Federal Reserve will do in terms of interest rates, where equity markets are in the cycle, and whether a credit event is still in early innings. His $20 billion multistrategy hedge fund invests in credit, convertibles, merger arbitrage, equity long-short and volatility strategies. Hudson Bay Fund LP is up 5.89% year to date through early December, while the firm's new Special Opportunities Fund has raised more than $500 million with a lockup of four to six years. Neither Gerber nor the firm would comment on returns or on the fund, but he did share his thoughts on the markets. Questions and answers have been edited for style, clarity and conciseness.

A: Paradigms are shifting, (from) lower inflation to higher, and to higher interest rates. That's a whole recalibration of the investing world. So much of the investing world has changed to "what's your cost of capital?" That's what private credit's all about, and that's bled into (collateralized loan obligations), insurance company balance sheets. That demands recalibration when rates go up.

Meanwhile, inflation has prevented the Fed from buying up more debt issuance, because if they buy more bonds, they pump more money into the system and that causes more inflation. Modern monetary theory postulates – if you believe it – that you can buy debt, essentially printing money. They're the same. But when you buy your own debt, you're injecting more money into the economy, which is the same thing as printing money. You can print or buy debt until there's inflation – and then you have to stop.

A: We're not macro traders. But we're macro aware. As we saw the rates rising, that made us much more cautious and hedged on rates and credit. We're structured as 30 portfolio teams. We're not ring-fenced pods like other multistrategy funds. We focus on collaboration and to drive persistent outperformance you must have the ability to opportunistically invest. Don't invest all the time; use patience. As rates rose, that meant it becomes more risky. The banking crisis happened, we lost a handful of banks. Overall the bank sector lost about 20% of its equity. That's before any credit event unfolding. We're now beginning to see defaults in commercial real estate, just at the beginning.

A: We're in the second or third inning. It's a slow-motion credit cycle. This isn't a shock. The financial system has been ring-fenced. In response to the rate rise, the government insured the depository base of the United States! That's a huge deal. That prevented a financial shock like 2008.

Now, the cost of capital is higher, which affects you when you need to refinance. The debt is termed out. It hasn't hit yet. It will hit more in 2025 and 2026. The banking system is pulling back from commercial real estate because they don't want to term out their capital and take losses.

A: It's now down around 4.45%. I think we're still going to see higher yields in the 10-year.

Historically from 1871, the average 10-year yielded 4.5%, excluding World War II and 2008. If you exclude those two periods, then the average is 4.9%.

Let's look at the components of the 10-year. First, we have inflation: the Fed says it wants (inflation) to be 2%, and it's now running at 3%. The reason why they say 2% is they want inflation to be "imperceptible." That why they settle on 2%. If it's over 3% its thought to be "perceptible." They state 2%, but I don't see it going to 2%. They could raise it to 3%, but then it's too close to perceptible. So they keep it at 2%. We're currently at 3.5%-4.5% inflation.

There's also a real rate of interest, after inflation. There should be a value to capital. What should that real rate of interest be? On average it's north of 1% a year. And it's been up to 2% over history.

Lately the real rate of interest has been 2%. That's measuring 10-year inflation vs. the 10-year bond, and that difference gets you what the real rate of interest. But these statistics are nebulous. Let's deconstruct where rates should be: the real rate should be between 1% and 2%.

The last component is term premium. That value of holding money over time should be between 50 basis points and 150 basis points for 10-year money.

So if you add all those, you get a minimum of 5%. And I see that going over time. For as long as we have 3% inflation with a real rate of 1% to 1.5% and term premium of 50-150 basis points, we're looking at 4.9% or higher for an extended period of time.Whereas economic actors were hoping rates would go back down and refinance cheaper in commercial real estate, especially, there's recognition that rates aren't going back down.

A: Yes, and there's going to be a recalibration in the equity market. Enterprise value equals debt plus equity. When it's more expensive to refinance debt, then equity has less value. This is going to cause companies to balance sheet restructure. The credit break hasn't happened yet. That's what I thought would happen earlier, but because debt has been termed out so it hasn't come due yet. More debt is maturing in 2025 and 2026, because companies took out a lot of five-year debt in 2020 and 2021.

A: I don't see inflation below 3% unless we have a much higher unemployment. The strength of labor is much stronger than I've seen in my lifetime. Across both U.S. and European economies, labor strikes are at much higher levels than I ever remember. That strength of labor pushes wages higher, that pushes inflation higher. A lot of it is because the cost of food has gone up. When cost of food goes up, you're obligated to demand higher wages.

The cost of food is a global phenomenon.

The wave of free trade is being reversed now. We're "onshoring" or "friendshoring" and that means a realignment of major commodity producers vs. the U.S. We can't rely on prior supply chains, and increased global conflict. All these things raise the prices of commodities.

There's not a systematic way of pricing geopolitical risk. I'm worried about the Middle East situation, specifically whether or not the conflict will result in much higher oil prices. The Iranian-led "axis of resistance" vs the Sunni Gulf states might lead to conflict over oil supplies and shipping routes over there. Oil is a major input to commodity production and food production and transportation.

The conflict between Iran and its proxies vs. the West will become more heated. Whether that leads to outright war or attacks on oil infrastructure, there's a strong possibility, not a certainty.