BC: Given those risks, are you surprised to see 10-year real yields below -1%? What would it take to see positive real rates again?
SD: If we were to see unexpected and persistent inflation, we would expect to see real rates lead nominal rates higher. That’s not our base case.
One thing we look at very carefully is where the Fed terminal rate is priced. The market is currently pricing in something like the 1.5% area, which is really low. We understand why, but if they go to 1.5% and have a target of 2% on inflation, that implies -0.5% real rates. That’s lower than it has been historically, but it has been trending lower, so it’s not outside the realm of possibility. But the debate around r-star is a challenging one.
BC: Is it possible for governments and corporations to unwind the leverage they’ve taken on since the 2008 financial crisis? If not, what are the consequences? What’s the endgame?
SD: The incentives created by economic and financial conditions over the past several years have yielded a backdrop whereby the cost of debt is really low. For years, cost of issuance for a sector like utilities was 13% to 14% for AA senior-secured debt. That created less incentive to issue new debt. Nowadays, the incentives are completely reversed. Corporations could unwind the leverage, but the cost of debt on an after-tax basis is so extremely low that there’s no incentive to do so.
When you think about a country and their fiscal space, it’s not just a function of how high the debt-GDP ratio is, it also depends on the relationship between the cost of debt and economic growth. At the highest level, developed-market debt loads are sustainable over the medium term. We don’t foresee them driving large changes in fiscal policy. If they were large and persistent—say, running at 5% over a longer period of time—it would need to be addressed or risk damage to economic and financial-market stabilization.
BC: When will the Fed start tapering and raise rates for the first time?
SD: Our base case for a taper announcement is the November meeting, with the potential to start tapering as early as December. They’ve done a pretty good job telegraphing it, and they don’t want to surprise the market. They weren’t even thinking about tapering, then they were talking about talking about tapering, now they’ve talked about it.
In terms of the pace, they want to be very predictable and orderly. Our expectations are $15 billion a meeting, $10 billion in Treasuries, $5 billion in mortgages. We don’t see any incentive to go in any other proportion than that.
We expect the first hike to occur in mid-2023. If the Fed starts tapering in December or January, they’ll complete it by late 2022 and at that point they’ll look where inflation and employment stand. At Jackson Hole, Powell went out of his way to decouple tapering from hikes. It’s hard to predict where inflation will be that far forward, but based on our outlook, we see mid-2023, with some risk of sooner should inflation prove less than transitory.