raymondparson

Michael Avery

Time for ‘The Week That Was’ with Warwick Lucas, Private Clients Portfolio Manager at Vunani, and Professor Raymond Parsons from the Northwest University Business School and the University of the Western Cape.

Last week we asked whether $100 oil, rising inflation, and climbing bond yields were beginning to change the global interest rate ‘story’. And we found our answer this week.: The US Fed is now raising rates for the first time since 2023, and American 10-year yields are pushing through 5%. The Bank of England has just resisted calls to follow suit for now. And we now see the Bank of Japan hiking, but the yen weakened on the back of that. Very interesting as well.

In the bond market, we spent a lot of time talking about this over the last few weeks. Now that the Fed has actually moved, is this still principally an inflation story, or has the global ‘cost-of-capital’ regime shifted again?

Warwick Lucas

Hi, Michael. It’s still an inflation story, but it’s not just an inflation story. The Fed raised rates because inflation is too high, energy prices are feeding into the outlook, and it needs to reassert credibility.

But that bond market, as you hinted at, has actually done quite a lot of tightening already. A 10-year yield around 5% is quite a lot of tightening on its own, and it affects US mortgage and corporate borrowing and valuations. It would affect the private equity market, which is much bigger these days, infrastructure financing, and emerging market capital flows.

So the bigger message is that the cost-of-capital regime is shifting again. We’re not in a world where central banks can hold short rates close to zero and long yields will obediently stay low. It’s just not going to happen. You can only use ‘financial repression’ for any length of time in wartime conditions. Otherwise, it just doesn’t work out well in the end.

Michael Avery

It’s quite interesting on that point, Warwick, because a lot of people are comparing this to the period post the global financial crisis, where interest rates were abnormally low at zero and negative in some instances. Before the global financial crisis, was a tenure of 5% or 4.5% to 5% all that unusual?

Warwick Lucas

Not particularly. It was a level that kept a bit of sanity in place in terms of finance and capital allocation. But the period since then with your zero interest rates has had two potential problems. First, you’ve had a long period of potential capital misallocation.

And secondly, you created a low base from which now you’re getting a rebound where rates are going higher.

But the problem is that you also have some expectations of momentum in those rates. You know, obviously in the back of minds now is, well, is this a stop? Are we at the right level yet or not? So, are we there yet then becomes a question, and it doesn’t get answered for quite a long time.

Michael Avery

And Raymond – Warwick’s touched on a very important point; it raises a bigger political economy question here because governments became accustomed to borrowing very cheaply. And again, that probably led to a misallocation of spending at a government level as well. So what changes when bond investors once again demand a meaningful real return for financing the state?

Raymond Parsons

Hi Michael. Well, as has been pointed out by Warwick, it’s certainly a real paradigm shift in the US as far as the markets are concerned. And also, as far as wanting a real return on money in an economic phase in which we see that inflation is, in fact, resurging – the markets do want some real return on that.

And quite clearly, this also creates a lot of pressure, not only on central banks like the Fed, but on the politicians in the US who want to show that, of course, with these US midterm elections coming, there’s better news on the inflation front. So clearly we’re in a paradigm shift here, and the chips haven’t yet completely settled.

But everyone in the US and globally nevertheless has to reset their expectations to a greater or lesser extent to what’s now happening as a result of the latest Fed decision, including emerging markets who don’t have much fiscal space.

Michael Avery

Yes. And obviously not just the Fed as well. We’ve seen the Bank of Japan hike, the Bank of England held, but three of its nine policymakers wanted to hike because of the inflation risks from higher energy prices. So it’s fair to say the global easing cycle is ‘on ice’ for now as well.

But Raymond, there’s another institutional story to all of this, because we know President Trump wants materially lower interest rates, while the Fed has just moved in the opposite direction.

How important is it, particularly at a moment like this, ahead of the midterm elections, that markets really believe monetary policy is being set independently of the political cycle?

Raymond Parsons

Michael, I suggest that by now one can say that the politicians have may have ‘barked’, but that ‘the US Fed caravan has moved on’. And the hawkish stance they’ve taken seems justified for all the reasons outlined earlier and which have already been well-aired.

The most important institutional message, though, is that the Fed and its new Chair have also asserted their independence. That’s been tremendously important in this decision: that Chairman Walsh has shown that, with a unanimous board behind him, he’s been willing to strongly show the independence and reinforce the credibility of the Fed. And even President Trump, although he has criticized the Fed’s decision, didn’t single out Warsh. Trump said Warsh was outvoted. That was Trump’s claim.

So it’s been a good week for the Fed for now. And we’ve got to accept, though, that the US monetary metrics will now change as a result of this, because we’re looking for now at a different political economy context in the US, as a result of this Fed decision and its broader ramifications.

Michael Avery

Well, our debates around the future and its broader ramifications may all become moot, if you believe some in Silicon Valley about AI potentially wiping out all of humanity.

And Warwick, I look at that, and I’ve got to say the skeptic in me looks at it. I look at the timing, just ahead of these IPOs. I look at these frontier labs, and they’re just burning through cash at the moment. And they need to raise a bit of ‘hype’ before the IPOs. And what better way to do it than saying, oh, look, this technology is going to wipe out humanity. Am I being too cynical?

Warwick Lucas

Well, it’s an alternative approach there. You know, these are certainly not ‘outsider’ critics. I mean, they’re people in the thick of building the systems and competing for talent, chips, market share, and so on.

What I can say is that whenever I’ve seen markets, and I suppose here I’m talking specifically about equity markets or similar kinds of instruments – whether you’re talking shares or oil or gold or tulip bulbs, whenever you have development or price gains, with a complete throwing out of any moral hazard or guardrails. You better look out for some kind of ‘fallout’.

And what’s being flagged here is that these big players are saying ‘this car is rocking quite hard on the rails’. And we actually want a ‘rulebook’ – we want a framework that will ultimately allow society to accommodate AI.

Because the one thing that you get clear when you read the warning notes that Bill Gates put out on AI is how unready society, but even worse, governments, are for the consequences of AI as it gets smarter and smarter. And if we persist in sitting back and watching it until it suddenly becomes very, very powerful, we will probably regret our languor.

Michael Avery

I mean, make no mistake. The risk of AI ‘breaking out’ and potentially destroying and wiping out the internet, making the internet, the World Wide Web, unusable, is quite high. Does that wipe out the human race? It’ll have huge economic consequences, catastrophic even. Human-ending, epoch-ending, I’m not so sure.

But, you know, Raymond, the obvious problem with a voluntary slowdown that the heads of the AI labs are asking for is the prisoner’s dilemma. Why would an American company slow down if its competitor, or China, doesn’t?

Raymond Parsons

Michael, may I remind you here of a minor but illustrative piece of innovation history in transport?

In the second half of the 19th century, in the United Kingdom, there was what was called the Red Flag Act. It required all self-propelled vehicles on the road to then be preceded by a pedestrian about 100 meters ahead, holding a red flag to warn horse riders and drivers. That persisted until ‘rules of the road’ were developed for new vehicles.

So, that’s in a way where you are with AI, until you have effective ‘rules of the road’. That’s where we are now. And it’s clear that, because of the magnitude of the transformation that could take place, AI needs ‘guardrails’ to ensure that it remains more of a smart indispensable servant, than becomes the dangerous master. So there are tremendously important issues here in what is, because of its overwhelming nature, huge uncharted territory.

It is indeed uncharted territory, and we need to urgently explore and now identify what are the guardrail options. The fact that it’s uncharted territory also means one cannot be dogmatic about what the guardrails should be. That’s part of the current debate. But it’s clearly an urgent debate, an important debate, and we need to know what ‘’trade-offs’ this new challenge is now presenting to national economies, and the world economy, including the competitiveness question.

Michael Avery

And I would side with the precautionary approach here. Much like the early approach to climate change, the global climate system is dynamic. We put all of this faith in the models; one has an outside chance of being right or wrong here that could be catastrophic either way. And so proceed with caution as a result of that.

It leaves us with a little time to preview the SARB MPC meeting next week, on Wednesday, not Thursday because of the public holiday. We’ve seen inflation expectations improving, but with oil back above $100 a barrel, and all that ‘under-recovery’ in diesel in particular, Warwick, it really does worry me. And now with the Fed also hiking, which way do you see the MPC going next week?

Warwick Lucas

Well, certainly, our next mooted fuel price hike, which would come at the month end, I would be expecting now 250 cents for both petrol and for diesel, which is obviously a little bit of glum news. But yes, that’s where the price inputs are pointing right now. It makes it harder and harder for the MPC to stand pat.

They may take a ‘look-through’ approach. After all, the economy does not look like it’s about to run away from itself. Or they might say, well, stagflation problem anyway. You still got to hike. So that’s the dilemma. Is the economy weak enough to pass it over? Or do you want to snuff out ‘stagfkatiomary’ pass-through anyway, basically?

How they’ll go, I don’t know. But ‘credibility retention’ does matter to the SARB. They tend to err on the side of caution. So it looks like a hike is closer. If not this one, then the next MPC meeting.

Michael Avery

Raymond, which way do you see it going?

Raymond Parsons

Clearly, there is an awkward dilemma, with room for legitimate difference of opinion. I see that Nedbank today also emphasized it’s going to be a ‘close call’ for the MPC. I agree. The MPC needs to weigh the upside risks on the inflationary front against the downside risks on the growth front in present circumstances.

That’s the dilemma, given our domestic economic circumstances and what we’re also seeing globally. Of course, with the MPC you can ‘pause’ in rates, but still couple it with a strong ‘hawkish’ message about what might happen next time. Because there might be whirlpools on both sides, not on one only,

This what a wise central banker once said a few years ago – it was the late Alan Greenspan who said, “I always ask myself the question, what are the costs to the economy if I am wrong? If there is no downside risk, you can try any policy you like’. It seems to me that, if there is a real cost to the downside, you therefore must weigh your options very carefully and give yourself room to manoeuvre in future.

That’s the message I would tend to convey to our MPC, as next week they weigh up a close call on what is the right thing to do in present difficult economic circumstances.

Michael Avery

Yes. You’ve just got to have a look at the transmission mechanism for SA’s consumer confidence because we’ve seen there’s a striking ‘disconnect’ . Our sovereign risk has improved, bond yields have improved and our fiscal credibility has improved.

Borrowing costs have improved. We’re showing structural reforms – but consumer confidence remains deeply negative across every single income group. Bear that in mind, when you want to slap another quarter percentage point on the South African consumer and the impact that that could have on the economy.

Raymond Parsons, thank you very much. Warwick Lucas as well. As always, great insights.