Brrrrr goes the money-printing machine
As the Federal Reserve takes hold of the economy by its strings, the financial crisis playbook has fast become the de facto economic manual. This marionette performance is one that we’ve all seen before, but this time the Fed has a dancing partner — the U.S. government. The Fed’s money-printing scheme alone isn’t sufficient to engineer a bailout galore. This type of lockstep monetary and fiscal relief can only mean one thing: the financial markets are being nationalised.
The high price tag for these fiscal measures means a more massive U.S. budget deficit. After all, the record-setting economic relief bill is not being “paid for” in the traditional sense (e.g. fiscal spending not being offset by simultaneous tax increase).
According to the Wall Street Journal:
The U.S. government’s budget deficit rose 92% in May from a year earlier as revenues plummeted and spending surged on efforts to stem the new coronavirus pandemic and the fallout from lockdowns. Since March, Congress has authorized more than $3.3 billion of aid for the economy in the form of higher spending and lower or delayed taxes [1].
Earlier in March, Forbes reported that the policies proposed/enacted under the Trump administration would add up to a $4–5 trillion budget deficit by the end of 2020. This deficit increase would roughly equal 20% of the 2020 U.S. GDP, increasing the U.S. budget deficit from 79% of GDP today to ~100% by the end of 2020.
The Committee for a Responsible Federal Budget (CRFB) projects that U.S public debt will exceed the size of the economy by the end of the 2020 Fiscal Year and surpass the prior record set after WWII by 2023 [2].
2020 is turning out to be a global health war, and wartime measures do not call for concerns about fiscal austerity. Instead, the key is survival.
“In a war, you worry about winning the war, and then you worry about paying for it” — Carmen Reinhart, Chief Economist at the World Bank
Where do people stand on the U.S.’s piling debt crisis? Some view this as a transitory concern, while others believe that debt will end up on central bank balance sheets for a very long time [3]. The aggressive monetary policy measures from the Fed have inflated its balance sheet by two-thirds since the end of 2019 from $4.2 trillion to over $7 trillion(roughly 37% of GDP and growing). Fed Chairman Jerome Powell argues, however, that we should not be concerned about the ballooning balance sheet as eventually, “the assets that we have on our balance sheet from this era will come to maturity.” He emphasises that it’s important to view the size of the balance sheet relative to the size of the economy. For context, the Fed’s holdings from the end of 2014 until 2017 came down “just by holding the balance sheet constant,” from 25% of GDP to 17% [4]. Surprisingly, the Fed’s balance sheet shrank for the first time since February 2020, indicating that the global financial markets are no longer experiencing a significant liquidity crunch. (More on that in a future post. Read here for an excellent in-depth explanation.)
It’s hard to imagine a world without the U.S. dollar.
Uncle Sam can’t run out of dollars. The U.S. government is the issuer of our currency — the U.S. dollar — which means that, unlike Greece, it can never find itself in a situation in which it has bills coming due that it can’t afford to pay [5].
In an economy reeling from a possible second wave of COVID-19, we see continued quantitative easing and a stronger Dollar. The question is: who wins and who suffers from a stronger Dollar?
Winner: The country that claims the Dollar as its local currency — the U.S.
Loser: Foreign countries that hold an imbalanced amount of dollar-denominated debt (relative to dollar reserves). A stronger Dollar means bad news for holders of U.S. denominated debt as debt repayment becomes more expensive.
Sometimes we forget that much of the world we live in today — from commodities to debt — is priced in dollars. Indeed, the Almighty Dollar has proven time and time again that it is a challenging opponent to dethrone.
Dollar history
The Bretton Woods Conference gave birth to a managed exchange rate system, which lasted for 12 years before a robust five-year Dollar rally during the Reagan era forced a change to the system. Ultimately, the G5 (U.S, Britain, France, West Germany, and Japan) ended the strong Dollar rally through consensus-based intervention. This coordinated effort saw these countries selling Dollars on foreign exchange markets, forcibly devaluing the Dollar.
The following excerpt is from a 1985 New York Times article Reagan’s Turnabout on the Dollar:
The Government has finally shed its faith that market forces alone would reduce the value of the swollen dollar sufficiently to rekindle American exports.
The choice is no longer between government intervention and the market. Since Reagan, central bank intervention has been the primary driver of dollar valuation. First, a bit of history.
Fiscal and Monetary Policy Matrix
Let’s look at a brief history of strong Dollar rallies:
Reagan dollar rally: Loose fiscal policy; tight monetary policy
- The Reagan era: large budget deficit, transition from free-market ideology to protectionism
- Volker’s punk monetarism (tight monetary policy) led to dollar overvaluation during the first half of the 1980s
- The Plaza Accord (1985) saw concerted intervention from the then G5 to drive down the Dollar.
- The Louvre Accord (1987) was another attempt at central bank intervention to help stabilise the USD exchange rate. The agreement only lasted eight months, however, until the stock market crash of October 1987.
- Between the years 1985–87, the value of the Dollar fell by 40%.
Clinton dollar rally: Tight fiscal policy, loose monetary policy
- The Clinton era: committed to federal deficit reduction mainly through raising taxes and cutting spending. Over his two terms, he created a $63 billion budget surplus.
- During Clinton’s first term, Greenspan began to increase interest rates to account for early signs of economic growth. Post the 2000 dot-com market burst, Greenspan started to lower interest rates in 2001, bringing the rates down to 1% by 2004.
- Clinton’s legacy was a strong Dollar, which rallied +25% during his presidency.
Obama/Trump dollar rally: Loose fiscal policy, loose monetary policy
This time around is different in scale.
The following excerpt is from a 2012 (yes, 2012) Economist article, The Nationalisation of Markets:
Each step taken by the authorities over the past five years has been designed to prop up the economy and save the financial system. But the cumulative effect has been the creeping nationalisation of markets. Central banks are the biggest players in many rich-world government-bond markets. Equity markets seem to perk up only when central banks are expanding the money supply. And banking systems are incredibly reliant on implicit or explicit government support.
Eight years later, this reality remains unchanged. The hands of the federal government and central bank are becoming more intertwined in determining the fate of the financial markets. The markets are being nationalised through expansionary fiscal AND monetary policy.
#whateverittakes
“We’re not thinking about raising rates. We’re not even thinking about thinking about raising rates” — Fed Chairman Jerome Powell.
Just as the Byrde family in Ozark lives a warped semblance of a ‘normal life,’ so too it seems we are experiencing a distorted sense of normalcy.
We are living in a period best characterised by a fragile sense of calm:
“This apparently relaxed attitude to huge deficits is down to the fact that investors think the Fed and other central banks are moving towards so-called yield curve control,” according to Jim Bianco of Bianco Research. This is a technique pioneered by the Bank of Japan, intended to keep yields at a predetermined level using open-ended asset purchases.
Yield curve control is a form of interest rate capping. According to the Brookings Institute, the Fed would target some longer-term rate and pledge to buy enough long-term bonds to keep the rate from rising above its target [6]. Unlike quantitative easing, which requires large-scale monthly bond purchases, under yield curve control, the Fed would announce a target rate for long-term bonds and buy the necessary amount to enforce the rate cap. For now, it’s TBD as to what would warrant the Fed’s implementation of this policy. Count nothing out just yet — anything is possible.
Running on empty #Hertz fuel
Earlier this month, the Fed announced that it would be adding to its arsenal of ETF purchases, extending its credit facility program to individual corporate bonds. It’s fair to say that even though the markets have responded reasonably well to these announcements, the Fed’s “visible hand” in the economy is deepening the economy’s addiction to debt.
“What it does primarily is continues to push fixed income lower and tighter and helps prop up the stock market, which is the real issue here.”[6] — Patrick Leary, Chief Market Strategist at Incapital
The resurgence of COVID-19 in the States has the markets reeling once again. Yet in the grand scheme of things, the markets have held up quite well, with stocks recovering around 90% of their losses, companies raising capital in the bond market at a record pace, and risk premiums embedded in corporate bonds yields going back to where they were in early March [8]; however, the piling of undesirable debt should be a cause for concern. Research firm Oxford Economics reports that the number of companies with an interest coverage ratio below 1 (aka companies that are not able to meet current interest payment obligations) has doubled to 32% during the crisis.
The Fed’s new credit facility addendum is supposedly another step toward stabilising the bond markets. But the program does not limit the Fed to purchasing investment-grade corporate bonds. A portion of their investments is actually in non-investment grade or “junk” bonds. During his recent testimony before the U.S Senate, Jerome Powell reasoned:
So the only so high yield bonds that we can buy are those of companies that were investment grade on March 22, but that have been downgraded, so called fallen angels. These are some, in many cases, very large us companies with many, many thousands of employees. And we made them eligible for the investment grade for the primary market corporate credit facility. And we don’t want to have a cliff there to where the investment grade markets are working well, but the leverage markets or non-investment grade markets are not.
Let’s just say Senator Van Hollen was not satisfied.
The Fed is signalling false assurances by sending a lifeline to these “fallen angels”, some whose poor performance preceded the health pandemic. One such example is Hertz, who filed for bankruptcy with $20bn in the hole. Through its $1.8bn ETF shopping spree, the Fed now owns defaulted Hertz bonds through two high-yield ETFs and is effectively a stakeholder in the company’s bankruptcy process. What’s more interesting — this “fallen angel” is now making a relatively strong comeback in the stock market, but we all know that a company’s stock price is not indicative of the actual health of the business. Price and value are not the same.
Artificial pain relievers are always temporary. Let’s see what move the Fed makes next. I’m sure the government is watching.
Sources:
[2] http://www.crfb.org/blogs/budget-projections-debt-will-exceed-size-economy-year
[3] https://www.ft.com/content/0f289d20-6e97-11ea-89df-41bea055720b
[4] https://www.marketnews.com/content/mni-policy-fed-balance-sheet-703t-37-gdp
[5] https://theintercept.com/2020/03/27/coronavirus-stimulus-package-spending/
