Risk Assets over Bonds?

Macro Perspectives: Tue 31 Aug 2021

During their respective tenures as Fed Chair, both Bernanke and Yellen said that economic expansions don't die of old age (historically), the Fed tends to murder them - attempting to slow inflation by raising interest rates (tighter money...slower economic activity...higher unemployment...slower economic activity...).

With this in mind, the Fed has now clearly telegraphed an end to emergency policies. It's likely to be a very gradual process, but nonetheless, it's a distinct change in the direction of monetary policy. And it is inflation, which is running hotter than was anticipated by the Fed, that is at the core of their decision to pivot.

But don't expect this pivot to end the economic expansion anytime soon, nor end the bull market for stocks/asset prices. Unlike the history referenced by the two former Fed chairs, this time, the Fed will be moving rates from the ultra-low level of zero, whilst, interest rates adjusted-for-inflation remain deeply negative.

Negative real rates mean that monetary policy, even as the Fed begins to raise rates, will continue to promote spending, not saving, for quite some time.

This dynamic will continue to push money out of the bond market (an almost certain negative return asset class from this point ((chart below for tracking purposes)) and into higher risk, higher returning asset classes. Higher asset prices will continue to support new, higher record household net worth, which will fuel even more consumption, which will result in higher corporate earnings, which means higher asset prices (and so the cycle goes).

Of course, it's all a recipe for higher inflation. With that, we should expect the Fed, once again, to ultimately murder the economic expansion, with a far more aggressive interest rate tightening cycle than is now being anticipated. Given that they are starting from such an ultra-easy level of monetary policy, the economic expansion and asset price boom has plenty of time to continue. Returns will be there. The question is, how much return will be there after adjusting for inflation?

This is why it's important to take the Fed's cue, to pursue higher risk/higher return investments in this environment, as cash and asset class returns are already being eroded by inflation that is running at a near double-digit annual pace (annualising the past four months).