Commentary: Great transition — from low rates to high anxiety

After nearly two generations of declining interest rates, a great transition is underway. Inflation uncertainty is forcing bond yields to transition from manipulated consistent lows to trending higher accompanied by market-driven volatility. We think the great transition is in early innings with a long way to go. Bond yields, while up, underestimate further upside risk, ignoring mounting evidence like proverbial ostriches with their heads in the sand. Federal Reserve Chairman Jerome Powell recently said the great transition will "bring some pain to households and businesses." He should have included investors in his list of sufferers.

Take each transition in turn, with inflation first. Inflation is disruptively high and alarmingly broad. Every major category of inflation is running above 4% — twice the Fed's target. Every OECD country (besides Japan and Switzerland) is running inflation above 4%. Wages are growing at 5.5% and inflation is broad-based with virtually all worker categories earning pay increases of 4% or more. If that's not a "wage price spiral," we don't know what it is. Despite Wall Street predictions of inflation moderating, uncomfortable levels are here to stay.

What's more, the risk of future inflation spikes is high thanks to new constraints on labor and commodities. For the past generation, globalization allowed wealthy consumers access to a bounty of goods produced by an abundant global workforce. Similarly, commodities used to feel abundant due to cheap shipping as well as shale technology. Globalization was reversing pre-COVID-19, but COVID lockdowns highlighted the failures of complex global supply chains. More recently, the nobility of "going green" constrained investment in the infrastructure to extract commodities. The risk is laid bare as Russia weaponizes commodity prices in its war on Ukraine, spiking prices on goods ranging from Kenyan maize to German electricity.

Add to this that the pipe dream of modern monetary theory without inflation is over. The current inflation level constrains continued quantitative easing, releasing interest rates to rise. Since 2008, Congress has run up $16 trillion of cumulative debt-funded deficits. But rates didn't rise because the Federal Reserve bought half the issuance and foreigners bought a further third.

Now, the supply/demand balance flips. Congress no longer has the Fed as a partner willing to monetize the debt. The Fed's long-awaited "balance sheet normalization" is underway. Foreigners' appetite for U.S. Treasuries is also shrinking due to smaller trade surpluses, QE to quantitative tightening reversals from the European Central Bank, their own views of U.S. inflation, and existential fears around the dollar payment system following the banishment of Russia.

It's reasonable to expect U.S. bond yields much higher than 4% in the near future. Through a fundamental lens, that would be consistent with inflation gradually falling toward 2% with occasional 5% spikes and a 1% real interest rate linked to population growth and trend productivity gains. Through a historical lens, long-term bond yields averaged 4.5% since 1871 and 4.9% if we exclude the two major periods of Fed manipulation (around World War II and since 2008). Through a yield curve lens, 5% bond yields would be consistent with a 4% fed funds rate and the Fed's reiterated conviction to bring inflation back down to 2%. Unlike some, we don't doubt the Fed's conviction — but the Fed will have to be even more aggressive than normal since low leverage across banks and consumers reduces economic sensitivity to rate hikes.

Even with mounting evidence to the contrary, derivative markets price a mere 8% chance of 10-year yields being above 5% one year from now. The market's ostrich-like behavior could be dreaming of a "soft landing," a stale belief that labor and commodity supply constraints will be "transitory," or simply the fact that major transitions take time. In our experience, when there is a conflict between market pricing and mounting evidence (pointing to higher rates in this case), side with the evidence. Six months ago, post the Russian invasion, markets only priced a 9% chance of yields rising above today's 3%. Oops.

Finally, virtually all asset classes — from property to private equity — benefited from falling bond yields and the low cost of capital. Most worrisome, the impact of higher yields is correlated across most holdings, overwhelming any delusion that diversification (or an algorithm) is sufficient defense against the great transition. Even the most seasoned investors have yet to experience generational interest rate changes, especially in the context of today's market structure. There are very few assets that truly hedge inflation risk. Investors will need to transition from complacent thinking to active protection and reallocation if they are to thrive through this great transition.

Sander Gerber is CEO and CIO, and Jason Cuttler is a senior strategist at Hudson Bay Capital Management LP. This content represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.