The esteemed author and researcher on whether inflation will stick, the likelihood of recession, monetary policy’s proper role, and more.
Our guest this week is Jim Grant. Jim is the founder and editor of Grant's Interest Rate Observer, a twice-monthly newsletter on financial markets with a focus on bonds. He is the author of numerous books and has made frequent appearances in the financial press where his views on markets and the macroeconomy are much sought after. Before founding Grant's Interest Rate Observer, Jim did stints as a journalist, first as a reporter at The Baltimore Sun, and later at Barron's. He received his bachelor's degree from Indiana University and his master's in international relations from Columbia University.
Grant’s Interest Rate Observer
The Forgotten Depression: 1921: The Crash That Cured Itself
Mr. Market Miscalculates: The Bubble Years and Beyond
Money of the Mind
Bagehot: The Life and Times of the Greatest Victorian
Inflation and Interest Rates
“Jim Grant: The Fed Cannot Control Inflation,” by Robert Huebscher, advisorperspectives.com, May 4, 2021.
“Jim Grant: The Trouble With Treasuries,” by James Grant, barrons.com, Oct. 11, 2019.
“The High Cost of Low Interest Rates,” by James Grant, wsj.com, April 1, 2020.
“Happy Birthday, Federal Reserve! Have Some Punch (Before the Bowl Gets Taken Away),” by Paul Vigna, wsj.com, Dec. 23, 2013.
“The Inflation Headshake,” by Eric Cinnamond, palmvalleycapital.com, March 9, 2022.
Horizon Kinetics Inflation Beneficiaries ETF
Murray Stahl bio
“Jim Grant: The Endgame for the Bull Market in Bonds,” by James Grant, barrons.com, Sept. 13, 2019.
“Jim Grant: Low Interest Rates Forever? Don’t Get Used to That Idea,” by James Grant, barrons.com, June 7, 2019.
“James Grant: Bitcoin and Other Bubbles,” Wealthtrack podcast, youtube.com, Feb. 26, 2021.
“Jim Grant: The Big Flaw in Ph.D-conomics,” by James Grant, barrons.com, July 19, 2019.
What Is the Taylor Rule?
A History of Interest Rates, by Sidney Homer
Recession and Macroeconomic Forecast
“The Difficult Art of Conjuring Up Yield From Mortgage-Backed Securities,” by James Grant, barrons.com, March 15, 2019.
“The Fed Is Well Behind the Curve: Jim Grant,” cnbc.com interview, youtube.com, Feb. 25, 2022.
Jeff Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak, chief ratings officer for Morningstar Research Services.
Christine Benz: And I'm Christine Benz, director of personal finance and retirement planning for Morningstar.
Ptak: Our guest this week is Jim Grant. Jim is the founder and editor of Grant's Interest Rate Observer, a twice-monthly newsletter on financial markets with a focus on bonds. He is the author of numerous books and has made frequent appearances in the financial press where his views on markets and the macroeconomy are much sought after. Before founding Grant's Interest Rate Observer, Jim did stints as a journalist, first as a reporter at The Baltimore Sun, and later at Barron's. He received his bachelor's degree from Indiana University and his master's in international relations from Columbia University.
Jim, welcome to The Long View.
James Grant: Well, it is nice to be on The Long View. Thank you, Jeff.
Ptak: It's our pleasure to have you. Thanks again for joining us. We wanted to start with, I think, what's a pretty obvious and timely topic, which is inflation. We finally got inflation after what seems like a very long wait. Do you think it's transitory and in Fed parlance, fleeting or not?
Grant: Well, all things in this life are transitory. I think that's not exactly what Jay Powell meant a year ago. The inflation we see has been with us for more than a year and at levels that attract people's notice. And so, it has not been transitory, nor do I expect that it will be over shortly.
Benz: Why with all of the stimulus thrown at the system did it take so long for inflation to arrive?
Grant: The inflation on Wall Street was, of course, clear and present, at least I would characterize what has been going on, on Wall Street since about 2010 or '11 as a kind of inflation. But inflation at the checkout counter was for many, many years a no-show, paradoxically so as it seem, because after all, the Fed had its hand on the printing press, and it did not stint. And yet, despite warning some people, like me, inflation at the checkout counter was quiescent.
But lo and behold, come the pandemic, our public policymakers were emboldened by the preceding record, and laid it on with a trowel. To recall, I guess, few of us can forget the stymies of 2020-21, the immense production of new credit and money balances by the Fed. Nothing before like that seen. And still people in Washington were relatively sanguine about the outcome because after all, they had done QE 1, QE 2—QE being the term for quantitative easing—QE 1, QE 2, QE 3, and no really bad inflationary outcomes. But yet, they want to preach too far.
Now, as to why previous episodes of monetary exuberance didn't create the kind of inflation we see now? I think there is one reason that is foremost, and that is that the Fed by dint of paying interest on excessive balances that the banks carry was able to keep that money bottled up in deposit accounts at the Federal Reserve itself, rather than having it do a mischief in the workaday world. And what changed during the pandemic was that cash and the Treasury cash the Fed directly infused the bank accounts of people who spent it, at the same time as supply was constrained, at the same time, subsequently, as war broke out. So, there are many factors contributed to this inflationary outbreak. But the question before the house, of course, is what happens next?
Ptak: What does happen next?
Grant: I don't know. I have no idea. I thought I would at least ask a rhetorical question.
Ptak: That's fair enough.
Grant: I want to take a quick U-turn into recent financial history to illustrate what might happen next and what precedence might be relevant for the present day. So, people talk about the inflation of the ‘70s while not acknowledging that it began in the ‘60s. So, inflation during the first five years of the decade of the ‘60s was absolutely flat on its back. There was none to speak of. In fact, it was kind of 1% per year on the CPI—one-half of 1%, scarcely 2%, levels at which today's Fed would have been sieged with anxiety that they were not creating enough inflation as if that were a thing to fear. But lo and behold, around 1965, the CPI poked its head above 3% and then went to 4%, as the ‘60s wore on. And as early as 1967, the final meeting of the Federal Open Market Committee, 1967, the then Fed Chairman William McChesney Martin declared, more or less quote, “that the horse of inflation is bolted the barn, and the best we can do is to keep it from running too far and too fast.”
So, the inflation of the ‘70s got a running start in the mid-60s and persisted until about the year 1980-81. And to scroll back to the present day, I think, people who are prepared to say, “Next month's CPI is to be slightly lower, therefore it's peaked, therefore we're in the clear,”—I think that is way premature. I think, well, no one can know the future. We can at least observe the past. And we can make allowances for the risk, that something that is unwelcome, will nonetheless overstay that welcome. And that's more or less where I stand.
Ptak: That's helpful. Thanks for elaborating a little bit. We probably have an entire generation of listeners who are unacquainted with inflation in any real sense. And so, for them, it might not be immediately understandable why inflation is so difficult to combat and can last as long as you just described. And so, can you talk about the mechanics of that and maybe why you're pessimistic that this is a fire that the Fed would be able to douse anytime soon?
Grant: Well, the Fed has actually been part of the accelerant. Let's not forget the Fed persisted in its stimulating ways—they say stimulus—I'm not sure how stimulating it's been. But the Fed persisted in quantitative easing. I should perhaps take a moment to describe what this QE mystery thing is. The Fed goes out and buys bonds in the market with money that it creates for that very purpose. That is called quantitative easing. You might also call it, money creation or money printing or credit creation. But it is the materialization of new purchasing power with the smallest of efforts. The Fed types it on a computer keypad and boom, there's another $100 billion.
So, the Fed persisted in quantitative easing to March last month—we speak in April—to last month, when the CPI was already galloping along at rates of, what, 8%. The Fed was still infusing the system with new cash balances. Such is its overblown confidence in its capacity to change course. So, not only was it running QE until about 15 minutes ago, so it continued to suppress very short-term money market rates of interest at approximately zero during the first year of what may or may not turn out to be a very persistent and unwelcome inflation.
So, the Fed was not only a party to this but was very much a part of the causation of this. I'm not sure that it caused it. There was a confluence of things that came together. So, we haven't seen this in a long time. We haven't seen anything like an 8% rate. What does it mean? Why is it bad? Well, it's the destruction of purchasing power. We ran a cartoon in Grant's—we have a cartoon on Page 1 that is meant to lighten the mood and to amuse the subscribers. And the cartoon recently was a child addressing her mother who gazed back at the child with a knowing somewhat forlorn look, and the child is saying, “But mommy, my allowance is getting smaller and smaller.” So, what inflation does is to shrink purchasing power. And the trouble is that you never get it back. And the aforementioned William McChesney Martin, Fed Chairman from 1951 to 1970, at one point gave a speech—this was the mid-1950s when there was really no inflation. In fact, 1955 when the CPI was actually declining, but Martin said, the purchasing power lost to inflation is never recovered. And that's the problem.
There are many other problems. Inflation is unfair. It's like a certain bug we know. It attacks vulnerable people. It distorts things; it distorts the value we attach to money. It poisons relationships between classes, between employers and employees. It institutes jealousy and envy of those who have somehow managed to sidestep it by the part of those who have not. It empowers clever and cunning people as against the trusting souls who save. It's a social plight, as well as the financial one. A friend of mine recently observed—there is something in the supermarket he patronizes called the inflation headshake. And that's what you see when someone stops in front of a counter to confront the familiar array of goods and can't believe the new prices. So, he/she shakes his/her head in disbelief, in sorrow and in some cases, in anger at what has befallen. Now, the system that we once knew as seemingly stable.
So, all those things are wrong with inflation. The Fed has been on this mission. Not just the Fed—the European Central Bank, the Bank of Japan especially, has been on a mission to make more inflation. They say we have to have a little bit and in their overblown self-regard, they say we will make sure that it doesn't get too far. But I've been doing what I do for 50 years or so. And what I have seen in that time is that sometimes people who think they're in charge of events are actually not and events, rather, are in charge of them. And I think that is what the Fed will now confront.
Benz: We're hoping you can talk about what you see as the biggest contributors to this latest bout of inflation. You clearly think that stimulus has been important and key, but do you think it was the directness of payments to people that pushed inflation into high gear recently that supply chain issues have been in the mix, too?
Grant: It's kind of everything. I am not going to debase the quality of this interview by uttering the phrase “perfect storm.” It is a cliche that we must avoid at all costs. But if I were to invoke that once… Let me try this way. I'm going to you a baseball story because it's baseball season. The year is 1968. And Bob Gibson, the formidable, regal pitcher was going to go on to amass one of the greatest records in the history of Major League Baseball pitch was sitting at one end of the bench and Ducky Schofield, the light-hitting infielder, was at bat. Now Ducky had a lifetime 230 batting average, which, Jeff and Christine, is not good. Ducky struck out, as was his want sometimes. He was a great athlete but not a good hitter. So, he stalks back to the bench, slams down his bat, his batting helmet, cusses up a blue streak, smashes the watercooler, and Gibson, no longer willing to tolerate this, summons him over to the end of the bench and says, pointing to his batting average, he says, “Ducky, what did you expect?” And I almost think that that describes the alignment of the inflationary stars at the beginning of 2021.
You had supply constrained, you had demand stimulated, you had the Fed doing what it had never done before with respect to the creation of new credits in new ways, you had a vast and in peacetime, I think, unprecedented growth, resulting growth, in the money supply, and you had a government that was running as it had run under administrations, both Democratic and Republican, in preceding years. Administration was running massive deficits. So, what did you expect? So, it seemed to be rather obvious. But muscle memory plays an important part in how we perceive things in finance, especially so on the interest rates. Interest rates peaked, bond prices bottomed, the same thing. Interest rates peaked in 1981 and went down, persistently, not constantly, but they persistently declined for the next 40 years. Now, that becomes a trend. People are prepared to believe that at the end of 40 years, you had to have had at least 1.5 Wall Street careers to see a bond bear market. So, people now are confronting for the first time a major inflation, they're confronting for the first time the interest rates actually going up. Up! How does that work? And naturally, there's a lot of confusion and a lot of hope. And I think after certain amount of denial that things are as they are.
Ptak: That's a good segue to the next topic that we wanted to take up with you, which is interest rates. Bond yields are rising as you just mentioned. Bond investors are staring at losses. Do you think this is just the beginning?
Grant: I'm one of the world's leading authorities on when the next bond bear market cycle will begin. I began looking for it some time ago. But I do think it's upon us now. Something to know about the history of the bond market, something to know of use in thinking about the present and the future is that in the past, bond yields have trended in generation-length periods. So, it's a characteristic that you don't see in other financial assets. You don't see it in stocks. Real estate is another financial asset type—you don't see it there. But interest rates, they declined for the final 35 or so years, the 19th century, that is the 1865 to 1900 or thereabouts. They went up for the next 20 years to about 1920, declined till 1946, rose from 1946 to ‘81, and declined, as I say, for 40 years subsequently.
So, it is a thing—as the young folks say, it is a thing in the bond market for a trend once established to persist. And it might just be that we are embarked on an upcycle in interest rates and bond yields with all that implies for valuations and mortgage rates and house prices, and so on and so on. It's an intriguing time. It's, as we say, in the journalism trades, great copy. But it's also a time pregnant with risk and of course, opportunity, being two sides of the same coin. But I do think that this wonderfully, or frighteningly powerful, updraft in interest rates is the start of something, and to me, it has the feel of a reversal in trend.
Benz: Bonds have been reliable stabilizers in diversified portfolios, at least over the past 30, 40 years. They've diversified stocks. Can they continue to fulfill that role, even amid rising interest rates? And if not, what are the alternatives?
Grant: Well, if rates rise, and of course, it matters a great deal how fast they rise. But if rates continue to rise at a bounding pace, the 60/40 portfolio, that is 60% stocks and 40% bonds, that standby of the bull markets of the ‘80s and the ‘90s and the odds that portfolio standby is not going to work. Now, it's not all bad news for the bondholder when rates rise because you can reinvest coupon income at ever higher rates of return. That's OK. But you look at your statement of mark to market base and the price of that security, of that bond is going down. And especially, do bond prices go down when the coupons at which they were purchased are trifling. And that characterizes a great deal of bonds over many, many recent years.
You bought securities at 1.5%, at 2% or 3%. That explains why you've been reading that the first quarter saw the most violent destruction of asset value in the bond market since at least the ‘70s or the ‘80s not because rates went up so much to such a high level, but rather because the rates at which prices began to fall were so low. So, a 1.5% coupon on a long-dated security can fall a lot when that 1.5% becomes 3%. And that's kind of what happened in the first quarter. And can it continue? Yes. Would it be welcome? No.
One final word on precedent. The bond bear market that began in 1946, the one that lasted 35 years from 1946 to ‘81, that began as a tortoise would begin its race with a hare. The yield at which that bear market in bonds began in 1946 was about 2.25%. And it was not until 10 years passed that the same duration bond yielded 3.25%—10 years to get the next 100 basis points in yield higher, one percentage point higher in yield. So, history, if it were only more predictable, would empower and enrich the historians. As it is most historians don't have two nickels to rub together. So, one must take precedent with many grains of salt. But for whatever it's worth, the violence of this upsurge in yields is unprecedented. In the few bear market sightings we have had, there aren't that many statistical observations, certainly not enough to make hard and fast laws. But this has been some light show on the bond market.
Ptak: So, maybe turning back to portfolio strategy, if you will, given the fact that it sounds like you're a bit pessimistic on the 60/40…
Grant: I wouldn't say pessimistic. I'm trying to be clear-sighted. People who are optimistic, because they're wrong are no more helpful than those of us who are pessimistic and wrong. That was a word from the pulpit. But carry on, Jeff.
Ptak: Clear-eyed and sober might have been a better way to describe it. But when you think about alternatives to the 60/40—there are different steps that one could take, for instance, adding commodities, more TIPS, perhaps it's expanding the sleeve of equities that have a modicum of pricing power or maybe throw off dividends. Are there particular tactics that you think that an allocator would want to keep in mind knowing that there's the possibility that rates would rise?
Grant: Yes, you've mentioned some. Here's a good idea. I think people ought to go and visit the website of a firm called Horizon Kinetics. Horizon Kinetics is a sponsor of an ETF called the Inflation Beneficiaries Equity ETF. Now, I'm not saying to buy it. But I'm saying for an exercise in investing imagination, go to the website and look at the portfolio holdings of this ETF. Because what Murray Stahl, the very capable and successful investor who designed this, what he tries to do is to pick the stocks of companies that are good companies that will do well in almost any economic environment but are particularly suited to a time of rising prices because they exhibit the business characteristics of companies that have pricing power. And the ETF has been an OK performer. It has done certainly better than the S&P. It hasn’t knocked the cover off the ball. But it has been more than OK performer. And as I say, it affords you a free education in what one very good investor looks for in the way of inflation-resistant equities. It's the kind of distinction you make with a wristwatch. Is it waterproof or water resistant? There's a difference. Before you step in the bath—there's a difference. And I would say that the Inflation Beneficiaries ETF is inflation resistant.
There are other thoughts. I'm a gold guy. I believe that to the extent the world has gotten away from a gold basis or a precious metals basis in currencies, to that extent it has done itself no favors. But, again, for what it's worth, I'm not here to sell stocks, nor would I desire to, but gold-mining shares have been the dogs of dogs. And if the inflation is to persist, and if the Fed is to lose prestige in the eyes of the world, people will look for alternatives to dollars, and they might take a fancy to gold. If so, they might conceivably, likewise, fancy mining stocks, which are near record cheap with respect to the underlying element itself, that is to gold.
So, there are some income vehicles too. You can look at a well-managed business development company that underwrites credits carefully and conservatively and pays out a good dividend. But the blunt and hard truth, Christine and Jeff, is that rising interest rates are the kryptonite of financial assets; they are basically unhelpful. Again, it's important to qualify that by the speed at which rates rise, but if we are talking about a persistent inflation, and if we are talking about a new long-term bond bear market, we are talking about a difficult time for financial assets generally, there's no getting around that.
Benz: Thinking about rates rising in the future, will debt service in the public and private sectors become the story of the next decade, given what a headwind that would create for those entities?
Grant: I think it will become a story. It always becomes a story, credit does. Money is the thing itself, and credit is the promise to pay money. And the way credit is priced or ought to be priced is with an eagle's eye on the capacity of the borrower to service debt in bad times as well as good times. But the trouble with good times, the trouble with prosperity is that you begin to think it's permanent. It's a high-grade problem to be sure, prosperity. Prosperity is a very high-grade problem. But we have had a long run of a growing GDP and a worldview that says the Fed can solve most any financial problem through the liberal dispensation of dollar bills or the suppression of interest rates. So, the Fed has been rather predictably on the spot of financial accidents to lower rates and to ease access to credit. And the people who run corporations have not failed to notice. And they have loaded debt on private equity. Portfolio companies, for example, those are the companies that private equity promoters take private, paying a lot of money for them, and loading them up with a lot of debt. And as this bull market in bonds has run on, the terms and conditions of lending have become ever more liberal, and the fine print that is meant to protect a lender in a time of impairment or default, that fine print has become sparser and less rigorous. So, what long-trending markets do is condition us to think the wrong things at the wrong time, the wrong time being the inflection point. By the time the cycle turns after a long run in one direction, people are inclined to believe that what has happened will continue to happen. And that's the rub. That's what makes life interesting. That's what keeps journalists in business. Things simply don't cooperate. Thankfully. Where would I be if they did?
Ptak: Why don't we shift to—we've referenced it at different points in the conversation—but the topic of policymaking and the implications that rising inflation could have on fiscal and monetary policymaking? As you mentioned before, it's been very accommodative, very freewheeling by many measures. Do you think in view of the fact that we've experienced inflation like we have, fiscal and monetary policymakers will be more gun-shy and pull back from here? Obviously, we have the Fed poised to raise rates. But do you think that some of the accommodation that they would have formerly provided they will be much more reluctant to provide in the future?
Grant: Many good questions in that one question, Jeff. Let's start with the Fed. The Fed has probably lost $500 billion in the first quarter, $500 billion. Its capital is $41 billion. So, if we were talking about a GAAP-compliant and law-abiding banking institution, the Fed will be broke. It's not broke. Why is it not broke? Because it has a little discussed, little acknowledged credit line to the Treasury. So, the Fed operates as if it were an arm of the Treasury, which in effect, it is. The Fed has no financial independence. It's no more independent than the Forest Service. It is a codependent. The Treasury and the Fed are like a couple of drunks. Ah, that sounds rather harsh. They were like a couple of drunks when the Treasury's spending was gone full blast, and the Fed was creating record amounts of credit. Now, I think both of these former over-imbibers are somewhat chastened.
The Fed has gone from transitory to stop. The Fed governors remind me of starlings on a power line. One flies off, they all fly off, and they suddenly change their minds. And now, yes, they are resolved to do what it takes to stop inflation. We will see if they have what it takes to do what it takes when things get tough. I'm not talking about bare-chested Vladimir Putin kind of machismo as unappealing is that invariably. I'm talking about the balancing of risk and reward and the nexus between fear and duty that will overcome them when/if the stock market is down 25%— private equity companies find, some of them, find they can't service their fixed-income obligations. And when employment starts ticking up, and suddenly people will throw back in the face of the Fed their speeches about equity and fairness, the burden of unemployment falling unequally. And so, what then does the Fed do? Well, it's possible the Fed reverses course and decides that inflation is a problem that must be subordinated to the social dislocations it finds occurring in the midst of a rising unemployment rate. That's a possibility. So, you asked me whether our policymakers are going to tighten? They have tightened. The budget deficit this year is looking to be smaller. Certainly, rates of interest are much higher. So, one could say, yes, they have tightened. The unknown is whether they will continue to do so in the face of unwelcome macroeconomic data. And we should not forget there's an election coming up.
Benz: So, what do you think is the correct policy response? And was the Fed too late in acting to raise interest rates?
Grant: Well, I could answer the second part of the question first, because there is no getting around the fact that the Fed has been very late. There is a rule of thumb in Fed policymaking. It's called the Taylor Rule. John Taylor is the eponym, the creator, self-naming creator of that rule and the Taylor Rule holds that if you look at the inflation rate and the operating level of the economy, you can create a rule of thumb that will tell you where the ideal Fed funds target ought to be, where the Fed's policy rate ought to be set. And when the Fed was talking about maybe raising its little, tiny federal funds rate from 0% to 1% or 2% this year, the Taylor Rule said it ought to have gone to 9%.
Now, John Taylor is the name spoken second-most frequently in the deliberations of the Federal Open Market Committee. You can see that it's second only to Mr. Chairman or Ms. Chairman. Those are the words that the other members toss out to try to get recognized to say their piece. But Taylor is the name always invoked to these meetings almost reverentially. And yet, the Fed was carrying this 0% funds rate through 2021 into 2022 when the inflation rate was cresting to whatever it crested to, 8% plus. So, yeah, the Fed was late.
Now, what should the Fed do? It ought to raise rates, it ought to do what it's doing, it ought not to have had to do what it's doing because it ought to have been not so blinded by the obvious as it was. People say, “Well, what will you do if you're the Fed chair?” And my invariable impulse, if not response, is to say, “I'd resign.” They've got themselves into a terrible bind. So, they ought to keep doing what they're doing. And we should all pray for them on the weekends.
Ptak: I wanted to go back to interest rates if I could. I know there's different rules of thumb for thinking about what the natural level of interest rates are, whether it's nominal GDP growth, or real yields—I think 2% maybe is a number that's sometimes thrown around. Interest rates are nowhere near that by either of those measures. How do you think about interest-rate equilibrium? And as people are trying to set expectations for the future about what's a normal level of interest rates, how do you think they should think about that?
Grant: Well, just as you say, Jeff, there are rules of thumb that interest rates ought to be 2 full percentage points above the inflation rate. That gives creditors a fair return. They ought to have some relation to the nominal growth in GDP. But those are nothing more than expressions of common sense ideas. That's where they ought to be. We have A History of Interest Rates, the book is by Sidney Homer, the first edition was, and interest rates from 3,000 BC. So, we have about 4,000 years of interest-rate history, which is probably more than enough. But you are hard-pressed examining or just glancing at that history to come up with where rates ought to be. Rates have spent a long time being where they ought not to be based upon the commonsensical rules that you described, Jeff.
So, Grant's Interest Rate Observer is on record of saying that the 10-year note ought to be yielding 5%. That's about 2 percentage points above the 3% that it almost but didn't quite touch the other day. And let's say that inflation subsides from the current white-hot Ukraine war, exaggerated supply chain, distorted levels… Let's say it goes down to 4% or 3%. That's not where the Fed wants to be. The Fed says it wants to be at 2%. Let's say it goes down to 4%. We will meet the bond bulls halfway. We'll say if it's at 4% that the 10-year note ought to be at 5% because that gives the creditors a little bit of something besides the losses they have borne recently. So, that's my guess. But there's no telling when that might happen, or indeed, if it might happen.
Benz: One thing we haven't talked about yet is recession. Will the economy tip into a recession and…?
Benz: …Do you have any thoughts? Yes? OK, eventually. But what will cause it, this next recession?
Grant: Well, the cause of recession is typically the excesses and the expansion that preceded it. So, people say that business cycle expansions don't die of old age. No, they do die of bad behavior. They die of excesses that are typically the product of misplaced or mispriced credit. So, if you suppress interest rates, as the Fed has been doing, say aye, the Fed has held them down artificially for 10 years or more. But if you can see that, you are prepared to acknowledge that the consequence of suppressed interest rates is excessive borrowing and misdirected capital investment. And it is the congestion of these white elephants, of the things that ought not to have been built but were built on the encouragement, as it were, of interest rates priced too low. It's the congestion of all these errors, these errors of the preceding upcycle that will lead us into the next slump.
So, how do you know when a recession is upon you? People have been talking about the yield curve a long time. The yield curve, of course, is the alignment of the structure of interest rates over time. So, a yield curve describes rates prevailing at various intervals beginning at, say, three months or overnight, say, overnight to, say, 30 years. Why does this matter? Well, it matters because you ought—again, you ought, this is a normative thing—you ought to earn a higher rate of return by taking the risk of investing for more years, because for one thing, you might encounter inflation during the out years and the value of the money you invested would decline or your counterparty might run into credit troubles. There are a lot of imponderables as you look out in the future. And uncertainty ought to have its cost or, in the eyes of the investor, its reward. So, yield curves are typically upward sloping, meaning that longer-dated securities yield a higher return than do short-dated ones. Treasury bills priced to yield less than long-dated bonds. All right, that's the norm.
What happens on the eve of a recession, typically a year, a year-and-a-half, little less maybe, is that the yield curve inverts such that short-dated yields rise above long ones. Now, the great debate on Wall Street is what short-dated yield—people have focused on the two-year note. But I think a much better and rather more rigorous approach to this is to insist that you see a short-dated yield like the Fed funds rate, or the three-month bill rate, go above long-dated yields. And that's nowhere near happening, nowhere near happening. So, that is kind of a green light, at worst an amber light, on the recession prognosis. I would say that if you're looking for the fruits of mispriced capital, meaning a lot of companies that shouldn't have come into existence or whose lives should not have been extended through easy credit. We have that already. But what we do not have is a traditionally inverted curve, traditionally meaning three months to 30 years. And so, I think recession is not the next thing to happen to us.
Ptak: And so, you alluded to it, but where do you see those imbalances being most pronounced? Parts of the economy that maybe have been over-supplied or where there's been tons of capital that's been poured into them under loose underwriting standards? Obviously, we know that there are excesses in places like tech, you mentioned private equity. Are there other sorts of industries or categories that you think really…?
Grant: All the things that have done really well. Meme stocks, SPACs, crypto, trillion-plus market cap, or was it 2 trillion at one point for crypto? I think Dogecoin, the former joke, now $30 billion serious cryptocurrency. I think you don’t have to look far to see the manifestations of money that was essentially free to those who could avail themselves at the very short end of the yield curve. For professionals who could raise money near the fund's rate, money was sensibly free for many years. And free money does many things but does not promote a sound and conservative judgment and investment decision-making. Walter Bagehot, who was the great muse of central banking, and he lived in the 19th century, and he was one of the earlier editors of The Economist. And Walter Bagehot who was a very observant editor and financier, and he observed that very low rates of interest promoted very, very aggressive speculation, which invariably ended with a financial problem, typically a crash. And he coined the aphorism, the adage that—this is alluding now to the national symbol of Britain, because Bagehot was an Englishman. Bagehot said that John Bull can stand anything, but he can't stand 2%, meaning rates of interest pitched at 2% or below, with a certain incitement of the kind of speculation in his day, it took the form of railroads that went nowhere, or of emerging-markets bonds, very low interest rates. People had to earn income. They wouldn't settle for 2%. Therefore, they went to Argentina, or they went to the newest railroad being floated in the London Stock Exchange. We can certainly see that action today. We have seen it for years. Nifty's and meme stocks, they didn't come from nowhere. They came, in part, from the human inclination to take a gamble and to have some fun. There's a lot of fun involved in these things. But they also came, I think, more fundamentally speaking, from monetary policy that was way too loose for way too long.
Benz: I wanted to ask about residential real estate. It's been on fire over the past several years, but it might be starting to slow in part because of rising interest rates. Do you think a slowdown will cause disruption like we saw in the global financial crisis?
Grant: House prices are very fancy these days. And by some measures, they have outdone even the excesses of 2005 and ‘06. I think the underwriting standards have improved. I think that people have not totally forgotten what happened to them in the years ‘07, ‘08, and ‘09, and every cycle is a little bit different. So, I'm not sure that residential real estate is going to be the nexus of the next big financial crash. You always have to look for exceptions to the rule. And the great stock-picker, my colleague, Evan Lorenz, here at Grant's is always looking around for things that don't quite fit the accepted narrative. So, within the realm of housing, you can find parts of the universe, of builders, or of refurbishment companies that exhibited above-trend growth during the pandemic because the pandemic pulled forward future demand, and there are others that exhibited no such temporary, false growth that makes their shares much more attractive now. So, the generalizations only carry so far. So, yes, house prices are up. Yes, mortgage rates are now well above 5%. And yes, people who took one of these beautiful 2% or 3% mortgages are not going to be in any hurry to refinance. So, a lot of what made housing tick is going to stop ticking itself. But there are nooks and crannies, I'm sure, within the residential housing market that will still deliver the imaginative and diligent securities analyst opportunities.
Ptak: I wanted to widen out with our last question and ask you about forecasting. As you know, macroeconomic forecasts…
Grant: Don't do it.
Ptak: Macro forecasts, they're tough to get right, and it can be even harder to translate a good macro call into a successful investment. So, for those out there who are listening, maybe they're putting together portfolios for themselves or for clients, what role do you think macro ought to play in their process the way they assemble portfolios and pick securities based on your experience?
Grant: At one level, macroeconomic forecasting and discussion, as a friend of mine says, resembles sports talk radio. Just bloviate about stuff. “Yeah, yeah, yeah, they're going to do well this year. Yeah, look at that guy, he got a fabulous night.” No, no, that's not helpful. That's a waste of time. I think where macroeconomic thinking comes into play is to lead the investor into constructive thought about potential risks. Now, where the Fed went wrong—it ought to be in the business of macroeconomic forecasting. In fact, it is in that business, and it is almost invariably bad at it. And the trouble is, the Fed in its self-conceit is prepared to rule out plausible outcomes. It ruled out a virulent inflation one year ago when it ought to have been at least hedging its bets on it.
So, where does macroeconomic forecasting come? It comes in to remind us of the rule, don't be so sure, to diversify, and to don't rule out things that have happened in the past and could happen in the future, and if they did happen, would be a problem. So, practically speaking, what does this mean? It means, well, think about what the end of the 60/40 portfolio might mean for your portfolio; think about what are the alternatives to 40% of your portfolio being in bonds or 60% being in equities. What did people do in the ‘60s and the ‘70s? What did the successful people do? That is a mixed micro and macro prescription on my part. But I think the successful investors are really the ones who exhibit not only shrewdness and great numeracy and great nerve, but also can deploy an imagination. And imagine or thinking about macro can at least help you avoid avoidable errors.
Ptak: Well, Jim, this has been a treat. Thanks so much for sharing your time and insights with us. We really appreciate it.
Grant: Oh, you're welcome, Jeff and Christine. Thank you for having me.
Benz: Thank you so much, Jim.
Ptak: Thanks for joining us on The Long View. If you could, please take a minute to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.
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Benz: And @Christine_Benz.
Ptak: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.
Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.
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