The Big Long? Challenging the ‘higher-for-longer’ rates narrative

Is it better to be ‘less wrong’ than ‘more right’?

There’s a line in the film ‘The Big Short’: “It ain’t what you know that gets you in trouble. It’s what you know for sure that just ain’t so.”

Ironically, this quote is often misattributed to Mark Twain, but we like the message that investors should concentrate a lot more on what they don't know. They should spend less time thinking about what they think they know that others don't, and spend more time thinking about what others think they know that they can't possibly know for sure*[1].

We think it's much easier to make money by taking the other side of consensus – for which there is little basis – than it is to make money by being right about what's going to happen next in the economy.

Both require in-depth knowledge of economic data and theory (you have to know what’s possible to know) but are very different ways of using that knowledge.

The small trade

For most of this year, the easiest way to get nods from a room of investors was to stand up and say we couldn’t live with high interest rates for long. The consensus appeared to be that interest rates would come down.

If you can stomach the volatility, in our view real rates now look attractive on a long time horizon. We think there's decent evidence that real rates can't live above real GDP for a long period of time.

The big trade

We think that the scale of the consensus around rates created an unstable environment that was compounded by the seemingly widespread expectation that ‘something will blow up soon’.

So far, little has blown up, which appears to have led to a re-assessment of the interest rates we can live with.

Looking forward, the most interesting idea is that we can live with higher rates for longer than we thought, which is seemingly based on little more than the economy not blowing up over the last six months.

However, we think that such a limited sample isn't evidence of much, and in our view there's decent evidence that modern capitalist economies struggle to live with real rates above real GDP for long.

We're always interested in taking the other side when we see widespread confidence in something for which there is little evidence.

Over the past few months we've put together a list of things that would make us convinced that there was widespread conviction in the idea the current rates environment was liveable.

Here are a couple of things that could entice us into increasing our duration exposure:

• Because the US Federal Reserve is under pressure to maintain credibility, we believe Federal Open Market Committee (FOMC) members have a high hurdle rate to change their minds. By the time the FOMC moves its long-term interest rate forecasts higher, we think it's safe to say that most investors are likely to have already moved their estimates of where rates can settle in the long run
• One of the places where we look for evidence that investors have embraced 'higher for longer' is in the performance of interest rate-sensitive equites. Infrastructure and utilities have been the hardest hit in the last few weeks

We're getting close – but we’re not there yet.

[1] The stories told in the book aren't of people who did this. The characters are able to uncover a big fundamental truth about the economy – they understand something about the economy that others didn’t. That's the dream of fundamental research, but it’s extremely rare and very difficult.