5 reasons why USD interest rates will plunge
And 4 ways to trade it. The line between insanity and genius is thin.
A story on good analysis and poor implementation
In October 2021, I wrote this to a friend who was wondering about the next moves markets would be making from here:
Long term trends are still favorable (innovation cycle, demographics) to be bullish. But in the short and mid term, there are two false narratives that need to be proven wrong before the bull market can continue. These false narratives are:
An expansion of money supply shows consistently and instantly in nominal asset returns.
The pervasive side effects of the Corona measures (massive increase of the share of government spending in the GDP, privatizing profit & socializing risk, mass disincentivizing of productive work and creation of stranded assets due to lockdowns) will not show up in the real economy.
In hindsight, the mechanism with which these two narratives can be destroyed in one stroke is obvious: a real interest rate shock driven by handcuffed central banks and debt addicted governments, which is exactly what happened and still is unfolding.
But at that time, my mind was blocked by greed. Getting to that conclusion would have required me to significantly reduce my asset exposure and even go short against my conviction in long term trends. I was not able to do so. And can you blame me? I rode Tesla from $60 to $1,200 with most of my savings and more. I was invincible!
The next big leg for interest rates is down
So I missed out on benefiting from the big 2022 (real) interest rate shock. It is pointless to regret that. More productive thinking is about what will most likely come next?
One thing I know from investing over the past 15 years is that my greatest calls often (not always) come with a certain degree of embarrassment. If I am afraid from saying out loud what my action are, I am usually onto something. So here is my call:
Interest rates will plummet from here, both in real and in nominal terms. Even if they rise further (anything can happen in the short run), the drop thereafter will be bigger.
It is not just that this expectation is embarrassing to state because it is such an off consensus call. It is not about being contrarian for the sake of being contrarian. The original thesis must stand on its on feet. I have thought a lot about it and shared my reasoning with you.
Here is it summarized in five bullets:
1. Inflation is a monetary phenomenon and USD money supply is shrinking.
“Inflation is always and everywhere a monetary phenomenon.”
The 1930s depression was largely driven by a deflation shock which was the result of a 30% drop in money supply as bank lending fell off a cliff. As of April 2022, the latest data point available, M3 USD money supply has dropped by 0.4% (or -4.4% annualized). M3 is the broadest of all money supply measures and I prefer it over narrower metrics such as the Fed balance sheet for instance because it includes also the impacts of bank lending which is an important liquidity driver. M3 has been published monthly since January 1960. Of all 748 data points, only 20 (!) are negative. There have been only 20 months since 1960 in which money supply has been lower than a month before.
2. A lot of the current CPI spike is cyclical due to an overstimulated economy and subject to oil price shock churning through the system.
I have written about the cyclicality of the current inflation spike in this article:
Much of it is related to the oil price going essentially from $0 to $120 within 18 months, which impacts all goods and services, even in the Core-CPI category. There is some structural scarcity in oil, but comps getting tougher for further CPI impact.
3. Monetary regime and fiscal conditions favouring monetary debasement over recession.
The prevolution was 2001 when Alan Greenspan dropped the Fed Funds Rate to an unprecedented 1.0% following 9/11 and the dotcom bust. And the revolution was in 2008, when Lehman was allowed to fail in a final attempt of policy makers to let markets run their course. Then the flood gates open and when you hear Bernanke, Yellen and Powell speak, you can tell that there is a new monetary paradigm which views the existence of recessions and unemployment spikes - once viewed as healthy shake outs in the economic process - as unethical hardship. The pendulum has swung from free capitalism to a stewarded economic supertanker. I have no doubt political elites will find ways to pump liquidity into the system as soon as the political legitimacy allows it.
4. Positive correlation between real interest rates and inflation uncertainty
The higher inflation is, or more specifically, the more uncertainty there is regarding future monetary debasement, the less investors want to own fixed income securities and the better the real interest rate must be to compensate them for bearing this risk. As inflation expectations come down when the current CPI spike resolves, interest rates will therefore likely fall disproportionately.
5. Innovation supercycle
The Covid measures were a shock to the economy and the financial system, the effects of which we are seeing today by charts going vertical everywhere around us. But this was a temporary event. The disinflationary forces that provided us with the 2010s goldilocks era are still in place. Several disinflationary technologies are hitting prime time. First and foremost battery technology, AI and renewable energy will free up consumer budgets over the coming years and decades which can be used for other consumption or investment. The more investment dollars there are, the lower interest rates go.
How can we trade it then?
So, if the above is right, what are possible ways to benefit from it? By the way, none of what follows is financial advice. Please do your own reasoning. If I can give an impulse here and there, that is great. But you need to have conviction in it yourself. So here are a few ideas. I attempted to rank them from reasonable to bold to cuckoo:
1. Options on TLT
The most direct and straightforward way is to buy call options on the TLT, an ETF consisting of long term (20y+) treasury securities.
Fallacy Alarm @fallacyalarmM3 dropped at an annualized rate of 4.4% in april! remember that the 1930s deflation/depression was caused by a 30% drop in money supply. it may take two years to play out, but i am certain the current inflation spike will be followed by a deflation spike. https://t.co/OHKIMVruzr
It dropped badly, quite the amazing volatility:
An alternative way could be to sell a put option on the TLT, i.e. grant someone the right to sell the TLT to you if it drops further. The beauty of this is that you can collect the time decay which is quite high at the moment. Look at the MOVE Index, which is a measure for the volatility priced into bond market options. A lot of uncertainty here to benefit from.
2. Buy defensive long duration innovation
Obviously, if you believe interest rates will go south, anything Tech related will likely thrive. Companies with large growth runways serving as a buffer to any macroeconomic demand dips. Because one thing is for certain: If interest rates drop sharply, recession will be part of it. The Fed can only make a U-turn if employment goes into the bin providing relief on the CPI issues. Follow this to keep up to date:
3. Bet on a mortgage broker
You can just buy plain defensive long duration growth. Or you can spice it up. How about a mortgage broker with a techy touch? Completely insane, no? Mortgage rates are killing home sales and refinancing demand after all. You can’t buy something deeper in the doldrums if you are looking for a bargain. And if interest rates make a U-Turn, it will add fuel to the housing market.
Here is my deep dive on Rocket Companies, the most successful aggregator of mortgage business in the US. The article also comes with a valuation model where you can come up with your own value by playing with market share and market size assumptions.
4. Swap your fixed rate mortgage to a variable rate mortgage
Your broker might call you crazy and talk you out of it if they are ethical. But if you have a long duration mortgage right now, you might be able to get a great deal if you go variable now since a lot of further interest rate increases are baked into the swaps.
What you you think? Any of these ideas worth anything? Let me know in the comments. And if you enjoyed the read, please consider sharing with others. It helps a lot to build reach for my newsletter.