The Big Conversation
Episode 66: Is the fed too dovish?
This week we look at the potential repercussions from the Fed’s dovish turn at the March FOMC. Inflation is one of the primary concerns of the market at this moment, but will an aggressively loose stance again divert capital from more productive means? Distortions of capital have led to price distortions in the market. In this week’s Chatter we talk to Refinitiv economist Oliver Dancel-Fiszer about the impact that the Fed’s dovish turn could have on yields, inflation, and growth.
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[00:00:00] At the March FOMC, Jay Powell, the Chairman of the US Federal Reserve, gave the clearest sign yet that they were willing to let things run hot by holding down interest rates until the economy has fully recovered. The intention was to keep a green light for the risk-on environment that they've nurtured since the lows that were hit in March 2020. But does maintaining loose monetary policy mean a one-way ticket for risk assets? As U.S. yields push to a new recovery high, it increases the concerns for stocks as those yields edged closer and closer to the top of the long term trend channel. The last two visits in 2007 and 2018 coincided with a peak in equities. The growth differential between the US and the rest of the world also continues to widen out with the spread between the U.S. and German yields at its widest level in over a year, making the US an increasingly attractive destination for capital that could put a bid under the US dollar.
[00:00:57] Emerging market currencies have been under pressure in recent weeks, and although the reversal in Turkey's assets this week are largely self-inflicted, after Erdogan fired the head of the country's central bank, the magnitude of some of the moves reflects a dollar that is no longer on the back foot against many countries. Is the Fed's dovishness therefore friend or foe? That's today's Big Conversation. Fed officials sharply upgraded their forecast, predicting that the US will grow by six point five percent this year, compared with four point two percent at their December meeting. The upbeat projections from last week's FOMC fall in the wake of the one point nine trillion fiscal stimulus package and the country's swift vaccination rollout. But despite this optimism, the US central bank still signaled a desire to keep interest rates close to zero until at least 2024. Whether other funding markets will be as obliging is less clear. The December 23 euro dollar contract for interbank funding has already diverged from U.S. government yields and looks like it's about to break again in favour of higher funding rates, even as the US two year yield bubble's about in a tight range near historical lows. Can the Fed's monetary largesse keep the rate vigilantes at bay? The Fed's actions are on top of the massive fiscal stimulus package that was just passed by Congress. Powell wants to see the unemployment rate drop to three point five percent and inflation averaging two percent or so. He would tolerate significant spikes in inflation because he believes that they would be transitory. But will the market be as forgiving? The implication of Powell's view was that the US economy was going to have a sugar rush from the fiscal stimulus and the pent up demand of consumers' one point five trillion of additional cash savings that's ready to be unleashed on the travel and leisure sectors once the pandemic restrictions are relaxed. But as every parent knows, too much sugar leads to a rush of energy, which is then followed by the comedown and lethargy. The Fed is worried that the US economy will slip back into the low growth trajectory that existed before the pandemic slump and are therefore willing to keep a sugar rush going. US equities have embraced the dovishness, though we have noted the rotation from growth to value, that has caused some pain behind the headlines. But skepticism remains. The U.S. economy has achieved a three point five percent unemployment rate and two percent inflation only twice since the 1960s. Inflation expectations have risen above two point six percent, though the move has been greater in the belly of the curve. The difference in the 20 year expectations, minus five year expectations has never been wider in favor of the five year. So far, this rise in inflation expectations has kept a lid on real yields - that's the difference between actual yields minus inflation expectations - and the Fed may be willing to let inflation run hot if we can stop real yields from rising too quickly. Powell could not have been more direct in the FOMC meeting press conference, the Federal Reserve will not be contemplating a retreat from its ultra dovish stance any time soon, perhaps influenced by the comparatively muted consumer confidence numbers in the US, which remain in recessionary territory despite consolidating.
[00:04:09] Now, the inflationist view that the US economy may overheat has also been gathering a head of steam. Larry Summers fears that the fiscal and monetary stimulus will lead to excess demand and so drive up prices across the board, eventually forcing the Fed to raise interest rates far sooner than currently predicted by their own dot plots. Summers argued that the economy would bounce back once the pandemic was over, just like seaside towns go to sleep in winter and then wake up when the tourist season starts. He thinks that the US economy will revive of its own accord and fiscal stimulus is unnecessary. But the experience of the last year has been much longer and more damaging than a simple winter break. At the other end of the argument, Treasury Secretary and Fed Chairman Janet Yellen reckons there is no danger of overheating or rising inflation because there is plenty of slack in the economy. The number of jobs that have gone missing during the pandemic is huge. And recouping these losses won't be a quick fix because the 'hysteresis' effect on the economy from the pandemic slump. Many workers have been forced to leave the workforce for good over the last year, and many small and medium businesses will never return. The long depression has seen a steady reduction in estimates of U.S. productive capacity. So which of these camps is going to be right? Some of the business indicators of inflation have rocketed. The Philadelphia Fed's business survey Prices Paid Index surged to a 41 year high, while the New York Fed's Manufacturing Index of Prices Paid and received jumped to the highs since 2011. But both these reflect the input prices, which are affected by bottlenecks in the supply chain, rather than a pick-up in consumer demand. Those household savings have not yet started to be spent. Central banks have therefore justified their exceptionally loose policy measures as necessary because consumer inflation, as opposed to producer inflation, has persistently undershot inflation targets remaining below three percent over the last two decades, even as equities have soared. Now the CPI calculation itself is fraught with inconsistencies and accusations of manipulation. But there's also a question as to whether the lower policy rates have actually been successful in stimulating economic demand, particularly when used repeatedly over time. Recovery from the Great Financial Crisis in 2008 has been the slowest in the postwar period, despite or perhaps because of these extraordinary monetary measures. Consumption may also suffer because low rates of return forced people to save more to meet retirement goals and mispricing capital by subduing interest rates also leads to a misallocation of capital which can itself lead to investment losses compounding that low growth. There's also reason to believe that the effectiveness of monetary stimulus diminishes with extended use. Lower rates induce people to borrow and spend today, and that's what they would have otherwise spent tomorrow. Ratios of debt to GDP had already risen by over 50 percentage points prior to the pandemic. And yet this consumption, that was brought forward still generated very little organic inflation. If that spending has been used for unproductive purposes, then that buildup of debt becomes a burden that slows future spending, creating a negative feedback loop. Now, first, these can be offset by yet more aggressive easing but as the headwinds grow, monetary policy eventually ceases to work at all. If sustained for a long period the undesirable side effects accumulate - higher debt levels, increase systemic risk. Institutions and pension funds see their expected returns squeezed, forcing them to reach for yield to compensate and opening themselves to unanticipated risks. Now that activity is being exacerbated by the threat of yield curve control, which caps yields, as we've already seen in places like Australia. In the non-financial part of the economy, capital investment might also fail to respond to the ultra-low rates now on offer. Present consumption may benefit from the build up in savings last year, but future consumption could be held back by the headwinds of corporate debt that discourages new employment. And despite these low-interest rates, there has been a deterioration in underlying credit conditions both in the housing market and the auto market. Furthermore, company pension schemes with defined benefits are hurt by low rates, which can weaken future cash flow and investment whilst encouraging corporate concentration via M&A. Whilst low rates may benefit the very short term outlook, they distort long term growth decisions and investment, encouraging corporate management to borrow in order to finance share buybacks instead of investing in productive capabilities that benefit the long term economy. Higher asset prices only benefit a small section of society who have a lower propensity to consume everyday goods, whilst the longer run interests of corporations are not well-served if the stock of productive capital doesn't expand. Some of the bottlenecks experienced during the pandemic were due to the lack of existing capacity as much as they were due to the impact of the pandemic itself. So central banks have therefore created a safety net that encourages a conservative outlook and a reallocation of capital away from long-term growth and towards the short-term rewards of a higher stock price. Unusually easy monetary conditions over long periods therefore threaten the effective functioning of financial markets. In recent years, we've seen recurrent flash crashes such as the Euro versus the Swiss Franc in 2015, after pressures built up resulting from the persistently low eurozone rates. Even the rapid decline in the S&P 500 that ended almost exactly a year ago was fueled by funds that have been structured around a 'lower for longer' mentality, as well as shadow banks who had levered up on cheap funding.
[00:09:47] Easy monetary conditions and low underlying volatility therefore encourages a build-up of concentrated risk. These price increases can initially mask the undesired consequences of easy monetary conditions, but when fundamentals reassert themselves, pockets of intense volatility can follow. Central banks have been caught up in a debt trap. Tightening policy could trigger the very crisis the initial easing was designed to avoid. Conversely, failing to tighten invites other unintended consequences, such as rampant inflation. Central banks believe that they could control it when they see it, but when they see it, it may already be too late. The Fed may therefore have embarked on a dangerous journey when it committed to an extended period of low-interest rate policy. Now there's a hope that they can combine their monetary policy with fiscal policy in order to fix the last decade of subpar growth. But so far, the evidence from the street is that consumers will do the same with their fiscal checks that the financial system did with monetary stimulus and throw it all the equity roulette wheel rather than convert that cash into genuine consumption and economic growth.
[00:10:53] So how should we expect markets to react to the Fed's dovish stance? I spoke with the Refinitiv Economist Oliver Dancel-Fiszer, about how to view risk assets in a loose monetary and fiscal regime. The Fed is applying an aggressively stance to its monetary policy, and that's got implications for inflation, economic growth and yields.
[00:11:17] Personally, I reckon that inflation will be a lot higher than the two percent target that the Fed have. My guess is potentially even four even five percent over the next 12 to 18 months. And why should it not be? I mean, you've got a lot of forecasters forecasting economic growth to seven percent over the same time period, you've got a rebound in commodity prices, you've got a vaccination program doing really well. You know, on top of all of that, you've got the stimulus program, which is putting lots of money into people's pockets as we speak. So I wouldn't really be surprised if four to five percent is actually even a conservative estimate is that guess. That said, you know, I think the amount of cash that people are sitting on and whether they actually spend it will depend largely on whether or not they think it's income or whether or not they believe it's wealth. But I think in a way, it's probably not such a bad thing that the Fed are allowing the economy to run hot. We know that the Fed are concerned about the massive level of jobs lost over the pandemic. So in a way, they're kind of right to let know, to try and pull back a lot of those jobs. Unfortunately, what that means for bonds is while inflation expectations will probably have to rise, and that unfortunately, will have to feed into higher bond yields. And I don't really think that's a bad thing because historically, 10 year treasuries have been really, really low. So over the short term, you might get a bit of fluctuations in the market, over the longer term, I don't really see there being a massive issue in what the Fed are doing.
[00:12:44] In a world in which the Fed lets the economy run hot, we may need to reevaluate what we consider to be risky assets.
[00:12:51] I guess at the start of the pandemic twelve months ago, cryptocurrency, the size of the market in terms of market cap, i'm talking about Bitcoin and alt coins, the entire market was sitting at one hundred and fifty billion. Fast forward 12 months later, it's now one point eight trillion. And what is that? That's a twelve hundred percent increase over that same time period. So if you bought cryptocurrency, you know, the riskiest asset of them all, you will have done really, really well. So I guess turning to now, you know, equities, I guess if you look to look at the benchmark, the S&P, even a 70 percent increase over that same time period, you would have done really well. And why is that? Because S&P probably had one of its best years in history, likely, and a lot more than what you would get for, say, cash and bonds. I think that really hammers home the point about risk assets. I would probably say that you might want to flip it on its head. You know, cash and bonds are potentially right now the risk asset. Lots of people think 'cash is trash' and that's not you know, it's not an overstatement because you can't have an economy where you're effectively debasing printing money, you know, all the time, so your money is losing purchasing power day by day, week by week, month by month, so on and so forth. And same with bonds. I mean, will the two percent, 10 Year Treasury really cut it for you? I'm not really sure a lot of people and what investors want to be holding the bag off the 10 year given there's a massive opportunity cost of holding bonds and what you could do with that. Crypto and I guess equities very much demonstrates why that is.
[00:14:28] The pandemic has also seen a new generation of market participants embrace new styles of investing that can often seem alien to traditional investors.
[00:14:37] So I think going into the pandemic, most people would agree there was a general trend towards passive investing, both young and old. If you look at the rise of BlackRock, you got Vanguard, all of those ETFs. People didn't really have too much time on their hands and of course that was the trend. But because of the pandemic, people had a lot more time on their hands and I really wouldn't be surprised if actually the pendulum had now swung completely back the other way towards active investing. That's only been exacerbated by things like zero commission, easy entry, relatively low risk trading apps like Robin Hood, free trades here in the U.K. all of which means that, you know, investors, young and old, would be wanting to do their own research and really take a stab at active investing. That said, I would probably say that younger people are more likely to want to invest based on recommendations on social media. But to be honest, Roger, the one thing I'm really interested in are the sudden emergence of all of these alternative asset classes. In the last 12 months, for example, you've had a massive explosion of things like decentralized finance non-fungible tokens, we've seen recently in the news where an artist sold a non-fungible token for sixty nine million. And that's really, really great. I think that's really interesting. I think that really bodes well for potentially a whole host and different way of investing styles for generations to come for both young and old. And I think the pandemic has only really exacerbated that. Pandora's box in a way has really lifted the lid off all of this.
[00:16:07] All of this, in many ways, this trend has parallels with the dot com era, where several investments lost money as the equity market unwound. There are signs, however, that current trends may be sustainable.
[00:16:18] You know, if you were to compare the entire crypto market to, say, gold, you know, the crypto market is still only just under two trillion. Gold is 10 trillion, equities globally are 90 trillion, global real estate is 300 trillion, and then god knows what options and derivatives are, probably close to a quadrillion. So I'd probably say there's still quite a lot more room for those classes to end up growing. I think the general narrative is, you know, if you're looking for a safe haven asset then Bitcoin is probably only going to go up because, you know, you can't really tamper with it in the same way as governments can just print money and debase their economy. So I don't really believe it's just transient in that respect, I think it's very much here to stay. I think if you're an investor, if you can withstand short-term volatility and come in there with really strong hands, then generally speaking, over the long term, you'll always do very well.
[00:17:15] The combination of the pandemic with the fiscal and monetary policy response has upended many traditional notions of investment. So these trends will fall away as they do in any cycle. However, the participation of a new wave of investors who are willing to embrace new technologies and new products is set to become a permanent feature of the investment landscape.
[00:17:37] And a permanent feature of The Big Conversation is that the podcast is now available to download on Spotify, Apple, Acast and Stitcher.