Old Capital | Ep. 245

Where are interest rates going? LoanBoss Founder and CEO JP Conklin joins Paul Peebles and Michael Becker to discuss where interest rates are today and where they're going.

Hosting the show is Paul Peebles, the National Underwriter for Old Capital Lending, and Michael Becker, Principal at SPI Advisory and Old Capital's Senior Director.

Their guest star is LoanBoss Founder and CEO, JP Conklin with his "crystal ball" to shed light on the future of the economy and interest rates. JP spent his entire career in interest rate derivatives and it's important to have some inside information about where interest rates are going, not just today, but in the future too.

There is this threat right now that the front end will go negative at some point here in the near future. There's actually too much cash chasing too few Treasurys. So, it's just become a very distorted market and now you're seeing on the front end, the curve, particularly interest rates, dive toward zero.

What happens if the front of that curve go negative? Is that something you think the Fed'll actually let happen?  

I think they don't want to give the perception that they've lost control of that part of the curve. That's the part of the curve that they're supposed to be able to control. And I think that they will take steps if necessary to avoid that happening. If the front end goes negative it's because Jay Powell wants it to go negative. I don't think that they view this as a huge problem in the grand scheme of things. I think it's mostly a problem with optics. Unlike September 2019, too much cash is better than not enough cash.

What can they do, if we start giving them this pressure, what tools are in the toolbox to solve this problem?

• The most likely candidate is that they'll just increase the interest that they pay on excess reserves. Basically banks are required to keep a certain amount of deposits on the balance sheet at the Fed, and then you can have excess reserves there. And I think that they could increase the rate that they pay on that and that would divert funds away from repo over to this excess interest. It would just make sense for a Treasury to switch their money over there and get paid a little bit more interest.
• They could actually taper. The tapering is what's causing this sort of bloated balance sheet because the Fed is putting $120 billion of cash into the system every single month. And it is simultaneously withdrawing 120 billion in bonds, 80 billion in Treasurys, and about 40 billion in mortgage backed securities. That simultaneous effect is causing this issue in the reverse repo market, so they could start to taper those purchases. The problem there is that comes with a threat to credibility in the sense that they just told us they're going to be on this schedule through year end. 
• They could also actively sell front end holdings. It's a little bit of a surprise to people, but they don't actually purchase a ton of 10-30 year bonds. Most of the stuff that they buy is sort of four and a half years in, and if they chose to, they could just sell some of their front end holdings and that would put upward pressure on interest rates.
• They could re-institute that exemption that probably caused some of this at the beginning, but it primarily only affects the biggest banks.
• And the last thing they could do is increase the daily limit. They increased it from 30 billion to 80 billion back in March, and that's proven to not be enough. They could raise it again. You know, they could sort of say like either there is no ceiling or it's 150 billion a day, or whatever that number looks like in order to encourage people to keep coming to them.

And so they have tools. I just don't know that this is a huge deal to them.

We're seeing the flood of cash put downward pressure on the front of the curve. We're getting a little bit more range-bound on the 10 year, the longer end of the curve, we've been in the 1.5 to 1.7 range for the better part of last year. We're starting to see all these headlines about inflation and the Fed keeps saying it's transitory, we're measuring these inflation rates off of a very depressed base from 12 months ago.

What's your crystal ball here? Talk inflation and interest rates for the remainder of this year, going into '22.

As much as I wish I was in the camp of inflation is going to take off, I'm firmly in the camp that this is transitory; that we will see inflation spike, we're already seeing it happen. I believe that it's real, but I don't think it's going to persist forever. I think this past reading is just measuring off of such a sharp contraction from a year ago. And that as we work our way through the stimulus money and enhanced unemployment rolling off and people trying to find jobs, that things are going to cool off substantially by the end of this year.

I do think it's going to be a pretty hot run for a while, maybe like six months. But at this time, next year, we will not be concerned that inflation is running away from us. So I think basically what we've done is pull forward consumption, and we're seeing that in prices, but it will eventually settle down. 

I think that the Fed knows if we had to, we could hike interest rates overnight and squash all of this. And so they will err on the side of caution and allow the economy to run hot because they learned after the financial crisis, it is challenging to create sustained 2% inflation right now.

I think we can acknowledge that something has changed structurally and all the measures that the Fed is doing today are the same measures they were doing post financial crisis. Nothing's new. This has all been done before and we couldn't get inflation. I don't know why this time will be different.

So my crystal ball for inflation is yes, it's going to spike. It'll feel hot for a while. Sit tight. We'll do a podcast a year from now. And we won't be worried about rampant inflation at that time.

What about the long end of the curve? Where do you see that going?
I think it's got a lid on it. I know everybody thought that the 10-year Treasury was run up to 2% or north. I think everything is priced in the reason, the ten-year ramped to 1.62 and that's a really key level for your listeners; 1.62 is a very key level of 10 year Treasury. It's either the ceiling or the floor, depending on what side.

That number, that price is in almost perfect recovery. Perfect rollout of vaccinations, a perfect reopening of the economy, tons of steam. So I think that will probably be range-bound. I don't think it should be below 1%. I also don't think it should be above 2%.

I think that this reopening is going to be very uneven and it's going to be very disjointed and we're going to have a lot of crazy strong months and then some weird months where things just seem like they tanked, but it's just because we have such a mismatch between employers and employees and trying to put those people back together, reconnect all those people.

I wrote in this week's newsletter that 37% of the workforce is not at the company that they were at in February 2020, which is just mind blowing to me. And so there's going to be that sort of disconnect as we try to come out of this, get people back into the right jobs. And it's just going to take a while, we still have 8 million Americans, we've got to get back to work. That's not going to happen overnight.

What's a black Swan event that would make interest rates go up versus a black Swan event that made interest rates go down?

Probably has to be Fed inspired if the Fed does something like a misstep or some sort of version of a taper tantrum. The market's prepared for that, so that won't be the black Swan this time around. The Fed is so artificially making up the market that I think any sort of distortion will come from a misstep by the Fed. I don't think data right now can have that kind of effect. I think it would be, the Fed does something wrong.

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