Larry Berman

Berman's Call

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George Soros famously said, “Markets are constantly in a state of uncertainty and flux, and money is made by discounting the obvious and betting on the unexpected.”

Let’s have a look at what is priced into the bond market, then think about what is likely to happen in 2024 and why.

INTEREST RATES

Money markets are pricing in six rate cuts through January 2025. In Canada, it’s 4.5 rate cuts by December.  The Canadian economy is in worse shape than the U.S., and we will likely see the Bank of Canada cut first and more than the U.S. Federal Open Market Committee. Keep in mind, rates in Canada are already a bit lower than in the U.S. across the yield curve.

There are two main factors out of many that central banks consider when setting interest rates, primarily the interaction or balance of growth and inflation dynamics. These are direct drivers to equilibrium non-inflationary full employment. We believe market and financial models are largely still working on the old regime, where inflation is considered transitory, and the longer-term trends are largely disinflationary. While many of these historic influences like technology driving productivity are still very much disinflationary drivers, we believe demographics and a reversal in the globalization trend and the peace dividend that accrued with the fall of the Berlin Wall are now likely working to lift the base (or core) inflation rate.

AGING POPULATIONS

Global demographics are very different than they were in the post-Second World War period. Many countries’ populations are aging rapidly while birth rates are declining.

The supply of labour is growing mostly in parts of emerging market countries like India (where the average age is early 20s), while former giants like China and even Brazil are facing poor demographic growth outlooks with populations that are closer to 40 years old on average, with low reproduction rates.

Western societies are only growing mostly through liberal immigration patterns (especially Canada). The Japanese economy has been stagnating in this way for close to 20 years with very low birth rates and no real net immigration. The economy has struggled to grow and disinflation is strong. Real economic growth is defined as population (read: workforce) and productivity. In recent decades and at an increasing rate, growth is coming from credit creation, which makes it more vulnerable.

GROWING DEBT

Deficits funding growth are getting worse in most counties. Debt-to-GDP ratios are becoming unstable in many economies. Weakening credit outlooks are disinflationary. The cost of funding the debt is a fiscal drag.

Most of the inflation we exhibited post-COVID was supply-side driven in its origin, ignited by massive fiscal stimulus. History shows that once inflation ignites, there is likely some stickiness to it. They call this a “wage-price spiral.” Looking at inflation trends from the 1960 and 1970s, we saw strong evidence of this type of cycle.

To us, the changing dynamics of the global economy suggest higher risk that this current inflation cycles will persist. We need to monitor sticky inflation trends and wage trends to see if this will materialize. I think the market is not factoring this risk correctly.

BOND MARKET MOVES

The bond market has started to price in a return to the pre-COVID period regarding inflation expectations. While it appears we are mean reverting back to pre-COVID levels, the question is how likely is that, with several of the factors that drove disinflation for the past few decades changing dramatically.  

We are focusing on the U.S. bond market because of its sheer size and reserve currency status over focusing on trends in Canada’s bond market, though they are similar.

The U.S. 10-year rate briefly touched five per cent in the fourth quarter of 2023 following the lifting of the debt ceiling and refunding on the Treasury General Account. The bond market rallied largely because U.S. Treasury Secretary Janet Yellen chose to fund most of the new debt in the fourth quarter with T-Bills, sucking up the excess reserves on the Fed’s balance sheet. The massive fiscal deficits and management of the Fed’s balance sheet are huge factors that could drive a much higher cost of money compared to the past decade. The equity market is priced for close to zero interest rates again over 20-times forward earnings. We do not see bond yields falling back to post-2008 levels. The fiscal dynamics likely demand a much higher-term premium than we’ve seen in the past 15 years.

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