Thoughts through the cycle: W3 January ’21

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2021, and the Fed is starting to feel the Bern.

  • For most of 2020, the various regional heads of the US Federal Reserve have spoken in public with a degree of coordination and harmony that would earn them pride of place in a Chinese Olympic opening ceremony. 2021 has started a bit differently, with dissolute talk in some quarters of the tapering of quantitative easing (QE) and rate hikes making the Fed look more like So Solid Crew, the fractious, hydra-headed UK garage and hip-hop collective from the early 2000s. Something is clearly going on.
  • Part of the skittishness probably comes from the fiscal and monetary largesse of 2020. The US primary deficit was 15.8% at the end of 2020. As of the end of Q3 2020 (the last official figure), US debt to GDP had risen to 127%. The Fed balance sheet rose to $7.3tn in 2020, and QE is still running at a rate of $120bn per month. The dollar has weakened as a result, with the DXY dollar index finishing the year at 89.93 (vs 96.38 at the end of 2019).
  • With a Covid-19 vaccine being distributed in the US, the end to lockdowns is in sight. Such a return to normality may lead to a consumption surge during H2 2020. Housing costs and with them building materials are already bubbly, so the added impetus of a post-lockdown splurge could push up inflation substantially. The graph below shows the huge spike in the US savings rate during 2020 which one would expect at least to partially normalise with a return to normality.

Source: Bloomberg. 15th January 2021.

  • Headline inflation is set to start spiking in the next few months from base effects. Inflation is a year-on-year measure so the collapse in inflation due to the lockdown in March and April 2020 will effectively make the figures for March and April 2021 look considerably higher (anyone remember oil at minus $38 per barrel?). The question is whether this sharp, expected increase in inflation will mark a more permanent shift in inflation expectations.

 

  • The Fed’s dual mandate requires it to target both price stability and full employment. With respect to the latter, January 2021 Bureau of Labor data shows initial jobless claims at 800k and continuing claims at a huge 5.27m, while the overall labour participation rate had dropped from 63.4% to 61.5% (this number reflects the horrific tally of those who have dropped out of the labour market altogether following business closures due to the pandemic and lockdown). These are the sad statistics that enumerate the nature of 2020’s K-shaped recovery. With stock markets booming and inflation expectations picking up at the same time as the job market remaining in a severely distressed state, it is hardly surprising that the Fed is showing some vacillation about what to do next.
  • …And then there’s politics. Wall Street has a magnificent way of spinning politics to be dovish whatever the outcome. The current spin is that the blue wave is just blue enough to allow for stimulus (market positive) but not blue enough to mean tax hikes (market negative). If growth with low inflation is the macro version of goldilocks, then what has happened in US politics since November the 5th (invasion of the Capitol by the mountain men and militia-types notwithstanding) appears to be the political version of it, at least so far as markets are concerned. What remains to be seen is whether Goldilocks finds daddy bear’s porridge a bit too hot, if daddy turns out to be Bernie Sanders.
  • If you were looking to put together a full house of spendy, devil-may-care interventionists who could corner markets to do good (or at least try to), then ten would be control of the Senate, jack would be a Democrat in the White House, queen would be a former head of the Fed (Yellen) at the Treasury, the king would be arch-socialist bogeyman Bernie Sanders as chairman of the Senate Budget Committee. The ace? That would be a Fed willing to finance it. This is what makes Chairman Jay Powell’s Princeton speech on the 14th January so important.
  • When the Democrats took both Georgia senate seats, the bond market started to react to the expectation of more fiscal stimulus, so real rates and nominal rates rose, with the yield curve steepening. The graph below shows the long-term ratio of 2yr to 10yr US treasury yields. Year-to-date in 2021, the 2s-10s curve is 15bps steeper at 96bps. It is worth noting that previous periods of steepening in the graph actually show recessions – usually what happens is the Fed cuts rates at the start of the recession and the curve steepens. But we’re not in recession and the curve is steepening. Strange days indeed.

Source: Bloomberg. 15th January 2021.

  • What are the Democrats going to do? So far, Biden has committed to a $1.9tn relief bill including $1,400 stimulus checks (this is in addition to the $0.9tn stimulus package in December which, amidst the pork, included $600 checks). This is just the relief bill announced on the 14th President-elect Biden is promising an additional $2tn recovery bill, the details of which will be announced next month. The Congressional Budget Office (CBO) has predicted at 2021 deficit of $2.1tn. Add in December’s $0.9tn, January’s 1.9tn and (say) another $2tn for February. In aggregate, the US primary deficit for 2021 will therefore be $6.9tn. 2021 GDP is estimated to be around $23tn, so the deficit as a percentage of GDP should be around 30%. This is a big number. The question is who is going to fund it.
  • Enter Jay Powell and his button-down collar and cashmere jumper combo for an informal Zoom update on Fed policy for Princeton University. The Bloomberg headlines[1] below give the thrust of his argument:

*POWELL: HIGH PUBLIC DEBT DOES NOT AFFECT MONETARY POLICY

*POWELL: NOW IS NOT THE TIME TO BE TALKING ABOUT FED EXIT

*POWELL: WE’LL LET THE WORLD KNOW WELL IN ADVANCE ON TAPERING

*POWELL: TIME TO RAISE INTEREST RATES IS `NO TIME SOON’

*POWELL: ONE-TIME RISE IN PRICES WON’T MEAN PERSISTENT INFLATION

*POWELL: WE’RE A LONG WAY FROM MAXIMUM EMPLOYMENT

  • Despite the other regional Fed chairs’ recent mouthing off, one ought to focus primarily on what Powell said. He has been the focus of press and Congressional questioning on how 2020 saw the rich get richer while the poor got poorer, and despite the criticism of the Fed for doing QE and forcing asset prices higher, he somehow continues to claim that he is a friend of the working man and that Fed policy does not cause inequality. Given the changing political environment in the US, Powell was particularly vocal about how full employment was the key Fed pre-Covid achievement with respect to ensuring a better lot for the less well off.
  • Into 2021, the dollar has been rising with treasury yields, suggesting that it is US savers and foreign investors who are going to have to buy all these extra treasuries. This risks a repeat of the sharp risk-off events witnessed in Q4 2018 (Fed over-tightening) of Q1 2020 (forced deleveraging of liquid USD assets). What Powell is saying though seems to be a bit different this time.
  • The Fed has already committed to an average inflation policy – this means a willingness to run inflation ‘hot’ if it has previously undershot the 2% target. The quotations above show Powell reiterating that. He went on to say that the Fed fully expects inflation to overshoot in the summer due to base effects, but this is all part of the averaging process, so this is not an indicator that the Fed will taper QE or hike rates.
  • In addition, and consequent to this inflation element of the dual mandate, he emphasised that full employment was the key target and this was where the economy was still struggling. Alone, this would seem like nothing more than the usual platitudes. But when taken with his former colleague Yellen as Secretary of State for the Treasury, one has to assume a closer-than-usual Fed-Treasury relationship. This follows a year when monetary policy increasingly fused with fiscal policy due to the pandemic. We are not quite at the singularity moment yet though – that would involve a revision of the 1913 Federal Reserve Act to allow the Fed to buy treasuries in the primary market. But we are close. Factor in Bernie on the budget committee and Biden’s commitment to build back better (and greener), then the scene is set for a spend-a-thon funded by the Fed which may at some point necessitate yield curve control or at the very least more QE. Watching bond yields and dollar-strength is a key factor here.
  • This may be more than the market expects, and more than it wants. Not only has the market become used to Trump’s fireside tweets about the Dow, but the last 40 years of disinflation and financialisation have changed investment habits and expectations. Companies’ share of income has grown at the expense of labour’s, resulting over the decades in the 1% vs 99% problem. We may be at a moment when this starts to reverse, and the market will likely take fright in various ways if it does.
  • In addition, Biden has hinted at tax rises. While announcing $1.9tn of stimulus on the 14th December, he also added, “where we are making permanent investments, as I said on the campaign, we will pay for them by making sure that everyone pays their fair share in taxes”. The stock market sold off a bit. Policy options include rolling back elements of the 2017 Tax Cuts and Jobs Act which reduced the tax burden for corporations and high net-worth individuals. Details have yet to be announced.
  • If the Fed has to step up, then one should assume yields get ‘capped’ and real rates fall. The graph below shows 10yr real rates already at -1%. Yield curve control would likely see them fall further. Inflation would rise to fill the gap between real rates and nominals. The dollar would likely weaken. Equities could rally in nominal terms but with around 85% of S&P 500 assets currently intangible, they may lag in real terms due to inflation. Time for the 1% to feel the Bern as well?

Source: Bloomberg. 15th January 2021.

[1] Source: Bloomberg, 14th January 2021

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