On the Fed’s playing chicken with the bond vigilantes

Yesterday the US Federal Reserve Open Market Committee released a policy statement that it has decided to stay the course on accommodative monetary policy through zero rates and quantitative easing. It provided absolutely nothing in terms of hints regarding future tightening despite a massive upgrade in economic forecasts for 2021.

Although there were some minor movements in FOMC members dots on the dot plot, showing rate rises in 2022 and 2023, I would characterize the statement as the Fed’s playing chicken with the bond vigilantes. And as I awoke this morning, 10-year yields across the developed economies were markedly higher, some 7.5 basis points in Germany, 5.4 in Australia and 10.1 in the US. Unless the Fed changes tack, this is setting us up for some market breakage at some point in the future.

My thinking on monetary sovereignty

Let me first explain how I am thinking about the tete-a-tete between markets and the Fed before I get into the nuances. And we can start with a 2011 post I wrote called “Bond vigilantes and the currency relief valve“.

In that post, I write that the “consolidated government’s balance sheet consists of IOU liabilities that it can manufacture in infinite quantities.” And by that I mean that a government and its monetary agent, the central bank, have unlimited resources to defend a rate regime. In today’s world where currencies float freely and government liabilities are only backed by the full faith of the government and its ability to tax, all government debt  in major currencies is effectively government (and central bank) IOUs. That means that, in extremis, governments can either simply manufacture more IOUS to replace existing IOUs or instruct its central bank to do so.

We see this clearly during the pandemic where governments have spent far in excess of their tax receipts with nearly no worry about solvency or the impact of deficits on future solvency. In fact, interest rates globally have plummeted as the deficit spending has increased, showing us that deficits do not dictate where interest rates go, central banks do.

But, it’s not that simple or monetarily sovereign governments would simply create IOUs at will all the time. To maintain faith in their fiat currencies, a whole litany of mechanisms have been created to prevent governments from manufacturing IOUs at will in the ordinary course of business. In the European Union, there is even a rule that the central bank cannot work hand in glove with member state governments in ‘financing’ their deficit to give the appearance of independence to the central bank. However, with the pandemic’s arrival, we see this independence is mostly fictional. In times of economic stress, the central bank and governments work hand in hand.

Bond vigilantism

This is where so-called bond vigilantes come into play. They aren’t in control of rates. And so, the role of bond vigilantes is not to push the central bank around like a broken rag doll. The role of bond vigilantes is to test the resolve of the government and the central bank in defending its monetary stance.

For example, the Fed told us yesterday that it expects the U.S. economy to grow 6.5% in 2021, the best performance in several decades and one of the biggest annual growth numbers since GDP record-keeping began. A lot of market participants believe that this level of growth is incompatible with a zero interest rate policy and an open-ended quantitative easing policy simply because the inflationary pressures in the economy will be great enough to force the Fed to backtrack on its pledge to remain accommodative.

So they are testing the Fed. They are, in essence, front-running future Fed tightening, betting that the Fed is either wrong about what their future policy will be or telling the markets something that simply isn’t true. That’s all fine and good. This is how markets work. Different people have different macro views. And they can express them as they see fit. Ultimately time will tell who is right.

But, let’s be clear; a committed central bank will always win the game of chicken. If they want to hold firm, they can do so. Rates will adjust to the new reality over time and the currency will be the only release valve. What the bond vigilantes are really doing then is testing the central banks’ resolve.

And I believe the Fed has enough resolve to see this through until we see financial conditions tightening via a slowing or halt in credit market access or a large fall -say 20-30% – in asset prices. Until we get either of these, the Fed will stand pat. That’s my view right now. Other central banks have less resolve – certainly the Reserve Bank of Australia and the European Central Bank. But I believe that the Bank of England is in a similar mode to the Fed.

Forward-Looking View

So what does that mean for the economy and markets? First, let’s remember that while asset prices are supposed to reflect events in the real economy over the long term, stocks are not the economy. The momentum in the real economy and in asset prices can diverge for numerous reasons from overall animal spirits to inflation expectations to market structure problems and so on. So, when we think about the Fed, asset prices and the economy, in some ways, it’s irrelevant what happens in the market.

Economies can survive a stock market crash, as Martin Wolf put it in the Financial Times recently. The 1987 Market Crash is a perfect example. There was a lot of angst out there about another Great Depression when the market crashed in 1987. I remember. But central banks worked to ensure we didn’t have a liquidity crisis that turned into a solvency crisis and a Great Depression. Their efforts were so successful that the market eventually recovered and the economy continued to hum without a hiccup all the way through the end of the decade..

In today’s version of events, let’s remember that, if the reason a market crashes is because so-called bond vigilantes are playing chicken with the Fed, pushing interest rates higher and causing equities to sell off, that’s because they expect economic growth. And economic growth is a good thing. Higher nominal GDP growth expectations pushing forward market expectations of Fed tightening and pushing up interest rates are expectations for a robust economy, not a poor one.

The problem occurs only if those expectations are so unmoored that it tightens financial conditions in a way that impacts the real economy, reducing liquidity, diminishing investment, and throwing people out of work. We’re not there yet. But we could get there if this rise in interest rates goes on long enough. In fact, my expectation is for the Fed to do absolutely nothing until it becomes afraid of just this outcome. Only then will it act. And by that time, I think there will be serious damage to asset prices.

So, the forward-looking view here is one in which the Goldilocks scenario is one where rates rise due to positive global GDP growth expectations but not so much that it derails the market or the real economy. And if the march higher in rates derails the advance in asset prices, it doesn’t necessarily have to derail the economy. In fact, it may be a good thing as valuations are universally stretched and signs of mania are all around us.

From a markets perspective, I think large cap tech stocks underperform while this plays out. Bank stocks outperform as long as the problems in commercial real estate remain contained. The cheapest hedge in this environment is for a crash down in yields because that’s opposite of where the momentum is now. And that’s the outcome which is most pernicious because it would be due to a crashing of economic growth expectations.