I am sceptical of the long-term durability of this cycle. But, we have to remember that we had a record-long economic cycle after the Great Financial Crisis. And now, policymakers are not willing to accept impotence, either on the monetary or fiscal side. So, in many ways, we are in a new policy paradigm.
In the last cycle, it was just the monetary side that was all in. We saw the Fed move to zero rates and start quantitative easing. And we saw the ECB go negative, start QE and do “whatever it takes” to defend euro area sovereign debt. But, if you look at fiscal policy, it was not super accommodative. The US, the UK and the EU governments all tightened fiscal policy as soon as they could, perhaps even causing secular stagnation.
Now, during this pandemic, we are seeing record deficit spending to go along with loose monetary policy. But the question is how long policymakers are willing to keep this up.
The bond vigilante paradigm
That’s a particularly apt question on the monetary policy side given the widespread belief that inflation is coming. So, I want to outline briefly how to think about this, because there are a lot of misconceptions about the power of markets to dictate outcomes in this fiat currency era.
Back in the 1990s, US Presdential advisor James Carville memorably quipped that he wanted to be reincarnated as the bond market, because “you can intimidate everybody”. The thinking back then was that you needed to keep deficit spending in check because, if you didn’t, the bond vigilantes would be onto you and send your interest rates to the moon, forcing you into fiscal rectitude.
This is pure tosh, of course. The right way to think of bond vigilantes is not as a force of intimidation but a market in speculative prediction. Here’s how I put it in March:
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.
The Fed’s resolve
So, how’s the Fed doing so far? Pretty well I think. The 10-year US Treasury bond is currently yielding 1.587% and the US Dollar Index is down to 91.115. What those two levels are telling you is the bond vigilantes have temporarily ceded the first round to the Fed. They’ve said that after testing the Fed all the way to the 1.77% to see if they could force capitulation, the Fed hasn’t given up on monetary accommodation.
Here’s the Fed’s newest governor toeing the party line just last week:
“I do buy into the idea that this is going to be temporary,” Mr. Waller said on CNBC, during his first television interview since President Donald J. Trump nominated him to the role and the Senate confirmed him. “Whatever temporary surge in inflation we see right now is not going to last.”
[…]
“We know the stimulus is going to have some impact, but once the stimulus checks are spent, they’re gone,” Mr. Waller said. “We also know that the bottlenecks that are currently there are going to go away.”
What Christopher Waller is saying is that the Fed is going to ride out this increase in inflation. They are not going to be intimidated by rising long-term interest rates into changing forward guidance on policy rates. In effect, “the bond vigilantes can’t push us around”.
That’s what I expected the Fed to do. That doesn’t mean that the bond vigilantes won’t have another go at the Fed though. I think that, after the current (long overdue) market consolidation, long-term bond yields risk rising again if economic data continue to outperform. It’s not because of inflation, which is arguably temporary, as the Fed says it is. It is because of financial conditions.
For example, Dogecoin, a cryptocurrency, conceived as a joke, is going parabolic. That tells you the psychology in this market is very speculative. It’s saying that financial conditions are so accommodative that liquidity is seeping into every nook and cranny of financial markets, creating a mania. And manias end badly. The Fed doesn’t want to get blamed for that.
So, when we think about the Fed’s resolve, we should be looking more at Dogecoin and the crypto bubble and less at inflation.
My View
I think the Fed gets a free pass, perhaps until the summer because of the distortions around inflation from the year ago period due to the lockdowns. But once the summer is over, if inflation prints continue to be high and speculative action in financial market continues to be rampant, the Fed can use inflation as a pretext to tighten monetary conditions.
They will say it’s because the US has gotten over the hump in the pandemic with vaccination and that they have accomplished their mission in restoring the economy to health in that timeframe. But, it will be the speculative nature of markets that will bring urgency to the Fed’s removal of accommodation.
There’s a mania, a bubble, happening right now in financial markets with crypto. Coinbase, the newly public crypto exchange, has a market capitalization of $67 billion. That’s about the same as Intercontinental Exchange, which owns the New York Stock Exchange, among other things. This is absurd. It’s emblematic of the mania surrounding us, because valuations are more and more representative of what the market will bear, what the greater fool will pay for a financial asset, and less of the underlying value of that asset.
People are saying, “we’re in a new era” because the policy paradigm has shifted so dramatically. They think that, when bad things happen, policymakers will have their back. And so, it’s fine that fundamentals don’t matter.
But this is a phase. And this phase will end. And it will end with a pop, not a fizzle.