That’s the Neat Part; or, What's the Point of Interest Rates Anyway?

Here’s the scenario. Through a combination of ChatGPT, BloombergGPT, Bing, Bard, and every other large language model you can think of, you’re offered the chance to perfectly forecast one financial metric for the next 18 months.

What do you choose and why is it interest rates?

This is, of course, both fantastical and an over-simplification. In such a scenario you could pick literally any stock, index, Lego set, and I’m sure having such foreknowledge would be highly beneficial to your portfolio. But fundamentally speaking, interest rates are so important because people need to know what capital should cost.

Sidebar: Not only that, but people are also just really bad at predicting rates. This chart (also one of my favourites) has been around for a couple of years now and shows market optimism-slash-wishful thinking at work. The one here from my colleagues in Man AHL show the forward swap rates at that particular point in time (the hairs) while the bold line shows what the rate actually was.

?(G)Rate Expectations...

In the absence of our Magic Rates Predictor (patent pending), we need to interpret the macro signals we're presented with while trying to avoid the rates-optimism above.

Jumping forward to last week, it seems that markets have largely ignored the OPEC oil supply cut with all the enthusiasm of a ‘thanks for the update’ email auto-response. The 8.6% jump to just under $85 dollars a barrel could be an attempt to reverse the decline seen starting last summer but for the fact that:

1. We know that people really notice the price they pay at the pumps. I imagine there's a limit to how close we can get to $100 again - although in real terms, if you applied inflation to 2008 oil highs you'd near $200 today...
2. Investor positioning in commodities is very light. This excellent chart further below from my colleague Henry Neville shows that positioning across four major commodities is down, oil especially so

So why does this matter?

Well for one thing, if commodities start to come back then I imagine some people may be regretting their underweights. The other is of course everyone's favourite topic: inflation. The jump in oil prices is further indication that our inflationary experience owes far more to the prolonged disruption of supply chains across multiple goods than it does to an explosion of demand.

And given that energy is a fairly large component of inflation measures, central banks have somewhat of a dilemma:

1. Pause. It could all just turn out fine, right? If economic data continues to worsen at a slower pace – certainly around wages – then the hit to inflation from slightly higher oil prices doesn’t seem so bad. Consumer purchasing power comes back, win/win. Let's call this the risk-on gambit
2. Plow on through. There's still a lot of easy money out there and people more than willing to buy the dip at the first opportunity. Literal oil on the inflation fire isn't going to help anybody

This is definitely not to say there's a right answer. Policymaking is supposed to be difficult! Trying to manage inflation volatility is the key to managing expectations. Much like investments, most people don't like it when numbers swing wildly from 'pretty good' to 'pretty bad'. Companies and individuals can adapt to 4-5% inflation - just look at Mexico and many other EMs for one - but when volatility gets too high, that's when things seem out of control.

Which brings us back to interest rates and the basic question of what is the point of an interest rate anyway? Do rates reflect a reasonable return, bearing in mind rising prices? When we speak of lenders, it is also worth remembering that the biggest category of lender is always the ordinary person in the street. The interest rate they receive on their bank deposits, pensions and other savings are dictated by their depositary institutions who hold the savings in near cash equivalents such as government bonds. If the answer is no, we can expect them to divert their savings towards consumption. Renewed demand might compound the supply squeeze and option 1 above may be forced to become option 2, whether the Fed likes the idea or not.

The OPEC-induced oil squeeze is just one data point amongst a series of price rises. But as the value of cash is eroded, and with risks rising just as quickly, it feels unlikely that keeping rates steady will be a long-term option in the current climate.

Or: