Real interest rates and recession | Financial Times

Good morning Netflix reported declining subscribers last night, a big surprise to the market and to me. I'm one of those people who sees Netflix as a basic support/child care tool and couldn't imagine people would stop using iten masse, even as other streaming options proliferate. I was wrong; the stock is crushed like a beetle; Tech investing is difficult. Email us with your thoughts: robert.armstrong@ft.com and ethan.wu@ft.com.

Real interest rates are going through the roof

In the last six weeks, real 10-year Treasury yields have risen by 100 basis points. That's incredibly fast. Here is the diagram:

The move has brought real yields to within a few basis points of positive territory. For many observers, this is a long-awaited return to sanity. The idea that the inflation-adjusted cost of money is negative strikes many people as madness and as evidence of massively distorted central bank policy. For them, real yields are simply rising because these evil policies are finally being reversed. From this perspective, there's not much to explain here, except perhaps why the move took so long. The answer to that question is that no one was entirely sure that the Fed was serious about tightening. Now they are sure.

Still, there's something a little strange here. Start by decomposing the components of real returns, which are nominal Treasury yields and inflation expectations:

As you can see, it is a big move in nominal yields that is driving the rise in real yields. Inflation expectations have remained unchanged since the beginning of March. The mechanics are simple. The Fed pushes rates higher, and those increases ripple down the curve (long rates are a series of short rates plus a premium). The central bank's unwinding of bond purchases reduced buying pressure on long bonds, which also allowed their yields to rise. At the same time, the tightening of Fed policy gives inflation less room to maneuver and keeps inflation expectations in check.

That makes sense. At the same time, however, the wild rise in nominal yields has come just as fears of a recession in 2023 caused by an aggressive Fed have grown. A recession would undoubtedly push nominal yields down quickly. But the long-dated government bond market appears to be ignoring this possibility.

Treasurys are not alone. Risk assets also ignore fears of recession. Stock prices and credit spreads have fluctuated somewhat, but are still very high or very narrow. In other words, corporate financing conditions remain very loose indeed — even as Fed rate hikes have significantly tightened financing conditions elsewhere, as evidenced by a stronger dollar and higher mortgage rates.

The Treasury and risk markets seem to be taking the view that the Fed can raise rates a lot more before it screws up something in the economy or markets and they are forced to back off. The markets may be right. As Edward Al-Hussainy of Columbia Threadneedle likes to remind us, whether they are right depends on the neutral interest rate, which is unobservable and changes over time. We only know we've hit it when a market collapses.

Another possibility: Investors have been living in a dream and are slowly waking up. Unhedged's friend James Athey of Abrdn, speaking about risk assets, put the point this way:

The behavior of risk markets partly reflects years of learned behavior (stocks can never fall/stay, so always be long), the shift in market structure resulting from this previous "Fed-Put" paradigm (the rise in momentum/systematic strategies). and the belief that once inflation inevitably returns to normal, the Fed can return to supporting markets.

Crypto or crypto miner?

Bitcoin mining stocks are in the news for all the wrong reasons. The two largest publicly traded mining stocks, Riot Blockchain and Marathon Digital Holdings, have had a tough time this year. Both are down almost 35 percent in 2022, compared to 11 percent for Bitcoin. Why does anyone buy crypto miners?

Maybe the answer is as simple as that wherever Bitcoin goes, miners follow twice as fast. In other words, these are leveraged bets on Bitcoin. Recent price activity appears to be consistent with this story. Since Bitcoin went parabolic in 2020, Bitcoin miners have gone crazy:

A comparison with gold helps here. Many people think that Bitcoin is digital gold. Both “commodities” are produced by miners using heavy machinery – pumps and explosives for gold, specialized “ASIC” computing equipment for Bitcoin – and both crypto and gold miners sell their production on the open market.

You can imagine that the idea of ​​leveraged bets also applies to gold mining companies, as revenue fluctuates with the gold, but input costs do not, creating operational leverage. The relationship hasn't always held up, but it's certainly looking good during gold's steady rise since 2015:

This all looked a little too neat, so I took a closer look at these stocks' betas, a measure of how risky an asset is compared to the market. The catch here lies in the definition of “market”. Typically, a stock's beta is compared to the S&P 500 or a similar stock index. But to see if Riot Blockchain, for example, works as a leveraged Bitcoin bet, you need to compare it to Bitcoin. Here's what I found (a beta below one means lower volatility than the market):

Over the last five years, while major gold mining stocks have been more volatile than the gold market (the analysis also applies to longer periods), Bitcoin miners have not.

The boring reason is that Bitcoin's huge volatility means mining stocks have a higher bar to clear. But the crypto mining business also depends on the company strategy. Two approaches predominate, as Joe Burnett from Blockware Solutions explained to me. One runs high-quality, large-scale mining rigs. The other concludes contracts with power grids for cheap electricity. Buying these stocks is a bet on execution prowess as well as the price of Bitcoin.

If this isn't really leveraged Bitcoin betting, we're back to the original question: why crypto mining stocks? Difficult question. If you have a mandate that prohibits direct contact with Bitcoin, that's fine. But for anyone making a conviction bet on Bitcoin or crypto, they're probably better off buying the damn coins. (Ethan Wu)

A good read

Here are some great graphics showing the challenges Europe faces if it is serious about weaning itself off Russian gas.