By Cullen Roche
The key to understanding the COVID-19 recession was in understanding that it was an exogenous shock.
This made it quite different from your standard recession in the sense that a boom did not cause the bust. There was no endogenous buildup of unsustainable forces that led to the decline in output. COVID was much more akin to a natural disaster. This meant that the recession could be deep and painful, but it was unlikely to last very long.
This was crucial to understand (and a key component of my optimism last April) because it meant that the probability of a deflationary (or disinflationary) recovery was unlikely.
For example, the 2008 recession was an inherent credit crisis. Credit expanded too much, and when home prices collapsed that credit had to contract as well. Credit contractions are inherently long and drawn-out processes. Just as the build-up takes years to unfold so too does the contraction.
COVID-19 was completely different. There was no credit event here as evidenced by total lending:
Credit contractions are inherently deflationary because they stifle balance sheet expansion which stifles aggregate demand. We need balance sheets to grow in order for the economy to grow. And boy did the government make sure that that happened, as they threw unprecedented levels of spending at the problem.
As I said last April, this was extremely bullish because, unlike 2008, there was unlikely to be prolonged damage to key parts of the economy. This damage was much more acute and to the extent that it was permanent, it seems to be permanently impairing businesses that were likely to be impaired in the long run anyhow (like commercial real estate, for instance).
Going forward, the three big things that make this recovery so different from 2010 are:
Output was mostly idled, but not destroyed.
Aggregate demand is likely to rebound much faster due to far larger stimulus.
A series of supply-side constraints arising from all of the uncertainty of the pandemic will make it harder to meet that surging demand.
From an interest-rate perspective, all of this is even more magnified because interest rates are lower than they were in 2010. To understand this we have to consider the magnitude of the potential rate of change, not the rate of change alone.
I’ve stated many times since last April that interest-rate risk was unusually high coming out of the pandemic. That’s because the math behind interest-rate risk is simple: when rates /zigman2/quotes/211347051/realtime BX:TMUBMUSD10Y 0.00% are lower you’re exposed to more potential principal risk in bonds because you aren’t earning as much interest to protect your potential principle changes. Therefore, when rates rise by 1% you’re far better off owning a 10% yielding T-Note in 1979 than you are when interest rates rise by 1% in 2021 and you’re earning just 1%. In nerd parlance, your risk-adjusted return is far worse because you have less embedded coupon protection from the bond.
This is the situation bond investors find themselves in today. They want safety and principal security, but they have to accept a potentially huge amount of principal volatility in the case that interest rates rise (ie, if inflation rises).
The kicker with all of this is inflation, of course. If inflation continues to rise then long interest rates will continue to rise and the Fed will become increasingly concerned that they need to raise rates to get ahead of the inflation risk. They’ve clearly communicated that this is not a near-term risk. But if we see core PCE prices at 2.0% like they were in July of 2018, then there’s a very real risk that the Fed will quickly change their tune about the future direction of rates.
Bond traders will try to anticipate these moves so they can properly hedge their interest rate risk going forward. Interest rates will continue to surge higher and bond investors will find themselves playing catch-up waiting for their very low coupons to cover years of lost principal.
So, how worried should we be about that potential outcome? After all, there are corners of the financial world that, much like 2008, are telling us that high inflation and even hyperinflation is a risk. I still think these concerns are overstated, but not nearly as low risk as they were in 2008.
Said differently, I think there’s a high probability that the economy will revert to its pre-COVID levels with similar or higher rates of inflation, but nothing resembling the 1970s or what we generally consider a “high inflation”.