Not So Fast

Steve Saretsky -

Inflation in the United States surged to 40 year highs in January, with consumer prices growing by 7.5% year-over-year. The last time inflation was rising this quickly the fed funds rate was sitting at 15%, today it sits at zero. This is ramping up calls for aggressive interest rate increases in order to quell inflation, with Goldman Sachs now calling for 7 rate hikes by the end of this year.

It goes without saying that whatever the US does, Canada is essentially forced to follow suit. In other words, housing bears are frothing at the mouth as record high house prices, and massive debt loads collide with rising interest rates.

While there is no doubt interest rates are heading higher, i’d argue it’s a complicated path forward. I would like point to a recent letter from Hirschmann Capital here. The argument that the Fed can halt inflation by hiking interest rates as it did to end the 1970s inflation is somewhat of a ridiculous statement when you unpack things further. Per Hirschmann,

From 1979-81, the Fed hiked the federal funds rate (FFR) by ~1000bps to curtail inflation. In 1979, however, the US Government’s debt to GDP ratio was only 31% of GDP and its budget deficit was only 2% of GDP. Thus the hike’s impact on the US Government’s interest burden was manageable. By 1983, the budget deficit had increased only four percentage points – to 6% of GDP.

Today, a 300bp FFR hike – a fraction of the Fed’s 1979-81 hike – is easily foreseeable. This would still leave the real Fed funds rate lower than it has been for 98% of the last 67 years. Even some members of the perpetually optimistic Federal Open Market Committee are projecting a ~300bp FFR by 2024.

Today, however, the US Governments debt to GDP ratio is ~120% and its budget deficit is forecast to be ~7% of GDP this year. A 300bp hike should increase the budget deficit to ~11% of GDP. Since 1991, all 18 other governments with deficits exceeding 11% of GDP and debt to GDP ratios exceeding 110% defaulted within two years. Thus the Fed could soon be trapped: raising rates could trigger default and not raising them could leave inflation unchecked. 

In simpler terms, meaningfully higher interest rates will likely result in lower asset prices, hampering US Government tax receipts and worsening an already unsustainable debt burden. This suggests any rate hiking cycle may ultimately be short lived.

This debt problem is not exclusive to the Americans, nor the Canadians, although we are pretty bad. Nearly $300 Trillion in global debt needs to be rolled over in the next three years. If interest rates rise by 100bp, global interest payments will rise from $10 trillion to $16 trillion, or from 12% to 15% of global GDP.

The only feasible way to roll this debt is to have inflation run higher than interest rates. This is bullish for hard assets over the medium term, despite any near term volatility coming our way.

Three Things I’m Watching:

1. The last time inflation was this high the fed funds rate was at 15%. (Source: Bloomberg, Lawrence McDonald) 4bc158cc-778c-d10b-e7f6-9d25f5dcc367-4526782

2. As we enter a new rate hiking cycle, here are the countries with the largest share of variable rate mortgages.

3. Canada still the most indebted household sector in the G7. Most of this high indebtedness to no surprise comes on the back of mortgage debt. (Source: Deer Point Macro)

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The Saretsky Report. December 2022