While all eyes over the last week were fixed on the putsch in Washington and COVID everywhere else, the Fed stunned investors with a policy pirouette. The Dallas, Atlanta, Chicago and Richmond Fed chiefs suggested in unison that the institution might start to wind down QE as soon as this year, with rate rises to follow quickly.
They sniff inflation. The M2 money supply – the country’s money supply including cash, checking account deposits, and easily convertible near money – has risen 24 per cent over the last year. Nobody knows how long this will remain inert or how suddenly it will ignite as society opens up. They want to pre-empt fiscal dominance before this is put to the test, and they want to escape the clammy embrace of the US Treasury.
The catalyst for this hawkish shift was the Democrat victory in the Georgia Senate elections, opening the way to high-octane Keynesian fiscal reflation. Richard Clarida, doyen of Fed policy, has since tried to calm the waters, insisting that the next taper is “well down the road”. But the cat is out of the bag. Fiscal loosening will be met by monetary tightening sooner than markets had supposed. It is a major policy shock.
Nor will the Fed intervene quickly to cap surging bond yields. Yields on 10-year treasuries – still the global benchmark price of money – have doubled to 1.18 per cent since early October.
It is a meaningful move in a world where debt ratios have surged to a record 365 per cent of global GDP (IIF data) – up from 320 per cent in mid-2019 – rendering the system hyper-sensitive to any changes in borrowing costs. Stretched equity values are a function of ultra-low bond yields. So how far can treasury yields rise before they set off a stock market crash and the whole process short-circuits?
Bond bull Albert Edwards from Societe Generale says we are there already, arguing that leveraged tech stocks require a sub-1 per cent world to keep defying gravity.
Most of the big banks have pencilled in 1.5 per cent and think this is manageable so long as it is the result of economic growth and not the result of supply constraints and incipient Seventies inflation. Bank of America’s Bruno Braizinha thinks 10-year treasuries could reach 2 per cent this year. That would be a minor earthquake.
‘Fully fledged epic bubble’
Few dispute that Wall Street is overvalued. The Buffett index – the ratio of stock market wealth to GDP – has reached 153 per cent, past the peak of the dotcom bubble in 2000, and probably 1929 as well.
Value investor Jeremy Grantham from GMO says this expansion has “finally matured into a fully fledged epic bubble” with the usual tell-tale signs of idiocy and parabolic acceleration. It is an odd bubble. Other such episodes at least happened during an economic boom and had a believable narrative.
It was Irving Fisher’s “permanently high plateau” in 1929 after the advent of assembly line manufacturing; or Alan Greenspan’s hopes in the late Nineties for a step-change in the economic speed limit, led by information technology – akin to the leap forward with the steam engine.
This time there is… what exactly? Trade is contracting. Globalisation is in retreat. The US economy has been ravaged by COVID and there will be plenty of scarring. Yet the S&P 500 is 10 per cent higher than before the crisis hit.
Some say the pandemic has brought forward the Schumpeterian switch from dead wood – retail shopping, inner city property – to more efficient use of IT and remote working. This smells like ex post facto rationalisation. A cynic would say the narrative this time is belief in the Fed “put” and QE forever. Take that away, and there is nothing to justify nosebleed price-to-earnings ratios.
The debate over Fed tapering may soon be eclipsed by the next twist of the pandemic. Today’s epidemiology has echoes of early 2020 when the markets remained serene weeks after Wuhan had turned into Korea, and then into Iran, and then into Lombardy, and that this was clearly going to be our global future.
Changing the equation
Once again, investors seem deaf to warnings from virologists that Europe and America will be forced by variant strains into a second Great Lockdown. Goldman Sachs has just pulled forward its $US65 call for Brent crude, but is it looking closely at the eruption of cases in China, or Japan’s state of emergency?
Global fund managers may have called the all-clear a quarter too soon. I fear one more unpleasant surprise before it is over. But let us assume for the sake of argument that the world economy is already out of the woods. Markets still have to navigate the implications for inflation and Fed policy.
Much depends on the shape of Joe Biden’s New Deal. The early signs are that he will not push for a hard-Left spending spree along the lines of the party’s wish-list manifesto. He will seek to work across the aisle with Republican leader Mitch McConnell in the Senate.
Pandemic top-up stimulus will probably be $US500 billion to $US600 billion. Krishna Guha from Evercore said the total package will be roughly $US2 trillion once infrastructure and the green deal are included.
This is big enough to change the equation for the Fed. It has less need to keep bailing out investors – in the hope of economic trickle-down to the descamisados, the ‘shirtless’ poor – if the Biden Treasury has taken over the job and is doing the heavy lifting. The Fed will therefore tolerate bigger Wall Street corrections.
Put crudely, the Biden era mix of “loose fiscal-tight money” is good for workers, less good for capitalists.
If 2020 was the year when the poor were hammered while the rich made out like bandits, 2021 will see the tables turned. We may see a thriving economy even as Wall Street languishes.
It is the revenge of the bottom half. About time too.
The Daily Telegraph, London