This article is an on-site version of our Unhedged newsletter. Sign in here to have the newsletter sent straight to your inbox every weekday
Unhedged has nothing to say about Jay Powell’s reappointment as chairman of the Federal Reserve that has not been said already. It was a good idea and good politics, because continuity was needed and a new Fed chief was not a hill on which President Joe Biden had to die. If you think there is more to say than that, email it to us at firstname.lastname@example.org or email@example.com
Growth inflation, real rates and debt traps
Well, will you look at this:
According to the Atlanta Fed’s pure data-driven real-time forecast, economic growth in the fourth quarter follows an annual rate of 8 percent. This is a big acceleration from the 2 percent for the third quarter, and before high inflation. Headline to Chris Verrone of Strategas, who pointed this out in a recent note, on the grounds that no one paid attention – which was true, at least from Unhedged, which was fully in charge of this development.
The Atlanta lecture is also not uncommon. Verrone points out that, for example, Citi’s economic surprise index, which has been declining for a long time since mid-2020, has risen since September and is now far in positive territory, which means that the majority of reports are now falling ahead of expectations.
Jim Reid of Deutsche Bank called this environment “growth flational” yesterday, and I like the term, as a contrast to stagflation. But the signs of rising growth inflation make the refusal of real interest rates to rise all the more mysterious. Here is the standard power of attorney for real rates, the return on 10-year inflation-indexed treasury bonds, or tips:
This chart makes me ashamed to be an American. I mean, real rates of minus 1 percent, to a kazillion dollar’s stimulus, and in spite of consumers and companies flushing and spending for free? Come on, people.
It also makes me as an analyst ashamed, because I have always thought that increases in inflation, such as the one we have now, should cause real rates to rise. The argument for this idea is that because high inflation is always volatile, bond investors respond to high inflation by claiming compensation for the possibility that inflation will rise even higher, dragging up real rates (nominal rates minus inflation). This is not happening at all now.
A look at the long-term relationship between real rates and inflation just makes me feel a little better. Tips only exist for a few decades, so in this chart I used 10-year returns minus three-year rolling average core consumer price index inflation as a real rate setting. Here is the result, compared to the average core CPI inflation per se:
Interestingly, real rates hit or came close to zero when inflation peaked in 1970, ’74 and ’80. It took time for volatile inflation to drag real rates up to their early 80s peak, by which time inflation began its long-term decline. Perhaps we are now seeing a repeat of this pattern, and we can expect real rates to catch up. Decades of low and stable inflation have taken the inflation risk premium out of the bond market. It is not going to come back within a period of a few months. People may have to lose more money before the message gets through.
But there is another explanation why real rates remain on their backs: we are in a debt trap. The always-interesting Ruchir Sharma argued this rule in the FT yesterday. The idea is that debt has piled up so high that any increase in rates will make it terribly expensive to service, which will hurt the economy and cause rates to fall again:
“In previous austerity cycles, large central banks have usually increased rates by about 400 to 700 basis points.
“Now a much lighter sharpening can lead many countries into economic trouble. The number of countries in which total debt amounts to more than 300 percent of GDP has risen from half a dozen to two dozen over the past two decades, including the US. An aggressive rate hike could also deflate higher asset prices, which is usually also deflationary for the economy. ”
I’m not sure the debt trap hypothesis is correct, but it should not be rejected. Note that, as Sharma points out, it comes in two flavors. Following Robert Frost, we can call them fire and ice. In the fire scenario, higher rates cause an asset price crash that stuns the economy and ends inflation at once. In the ice scenario, rates cool high enough to end inflation economic growth over time. Like Frost, I’m in favor of fire: the last two cycles have ended in asset price crashes. Why should this time be different?
Correction of the Treasury market
The US Treasury Market almost broken in March 2020, which scared everyone to death. When things get tough, it’s important for people to be able to raise cash by selling treasures, because if they can not, almost everyone will fail at everything.
We recently spoke with Yesha Yadav, a law professor at Vanderbilt University who last year blueprint for the reform of the Treasury market. Yadav thinks that a few dozen primary traders – mostly large banks – support the liquidity of the treasury market. But they disappear when they are most needed. In last year’s crisis:
“We have seen price disruptions, liquidity has disappeared, bid-ask spreads have increased, treasury prices have not synchronized with the futures market. It was a catastrophe in terms of the reputation and credibility of the treasury market.
“[Primary dealers] has no restriction that binds them to liquidity supply in US treasury markets. What does it mean [rational] for them to do as they did in March 2020, in February 2021, in October 2021 – to simply leave the market. ”
The world’s most important market tends to fall apart when some firms decide that the risks of participation are too great. Something should be done about this, and suggestions differ.
Gary Gensler, chairman of the US Securities and Exchange Commission, wants a centralized Treasury clearing house, which eliminates the counterparty risks of bilateral clearing. JPMorgan believes that additional leverage ratio, which requires capital to be held against risk-free assets, should be excluded, as it discourages banks from holding treasury inventory. Yadav likes both ideas and also thinks regulators can get agreements from primary traders that they will trade “against the wind” during market turmoil. She writes:
“Such a commitment will not be open. But it can prevent a rapid deterioration of trading conditions during difficult conditions. This affirmative market creation was once common in the stock markets where, for example, New York Stock Exchange specialists provided this type of service. ”
Neither primary traders nor any other buyer will enter panic-stricken markets unless it is profitable for them to do so. A central clearing house, which terminates the SLR, and liquidity supply agreements will all increase risk-adjusted profits on the margin. But this may not be enough, given the size of leverage positions in the modern treasury market, and the huge mess they can create. Unhedged thinks that either the Fed will remain the buyer of last resort, as it was in 2020, or markets will have to learn to live without guaranteed treasury market liquidity (Ethan Wu).
A good read
Jonathan Chait think that Biden’s unpopularity does not come from Rooseveltian aspirations, but the stain from the hard left, “a privatized shadow party, funded by naive donors and staffed by ardent foot soldiers, carrying out an anti-political strategy”. A good version of an increasingly popular view.