Submitted by Rob Parenteau, CFA, and sole proprietor of MacroStrategy Edge and editor of The Richebacher Letter. He also serves as a research assistant to the Levy Institute of Economics.
A combination of falling asset prices and falling nominal incomes against the back drop of high private debt loads tends to pose a serious challenge to the ability of market economies to self adjust. In response to a financial crisis, the private sector tries to net save and favors liquid assets in the face of large losses of wealth and income uncertainty. Unless some other sector is willing to net deficit spend, nominal incomes will fall, reducing the ability of the private sector to service existing debt commitments. Spending will drop even as final product prices drop, profits will dry up, and delinquencies and defaults will spread.
In addition, unless some other sector is willing to accumulate risky assets or increase the stock of money, asset prices will fall, reducing collateral values and net worth. Bankruptcy and attempts to deleverage, with all their ensuing contagion effects, will spread. Along the way, as markets adjust along these paths, history suggests that societies can experience substantial dislocations. Hy Minsky traced out many of these dynamics decades ago based in part on the contributions of J.M. Keynes and Irving Fisher, but his work was mainly ignored or forgotten by professional investors and mainstream economists favoring the self-equilibrating properties of markets.
The response to recent dislocations in many countries has been to a) increase fiscal deficit spending to both meet the surge in desired private net saving and reduce solvency uncertainty for key financial institutions, while b) reducing policy rates to near zero and expanding central bank balance sheets through purchases of privately held assets (quantitative easing). Market self-adjustment mechanisms that can otherwise lead to market self-destruction are thereby believed to have been short circuited. A “corridor of stability” is being re-established as the guard rails of fiscal and monetary policy have been buttressed.
This time around, however, it may be more complicated than that. Two questions arise with regard to the policy fix underway: who is going to accumulate the issuance of government debt associated with large (and possibly prolonged) fiscal deficit spending, and are there inconsistencies introduced by pursuing a large quantitative easing approach at the same time?
The nub of the policy challenge is as follows. Central banks have dropped policy rates to zero and they have begun purchasing government debt, MBS, and even corporate debt while expanding their balance sheets. Their aim is clear: reduce the cost of private borrowing, and raise the price of less liquid assets by lowering the return on the most liquid assets, thereby forcing many investors to reach for yield in riskier asset classes. Raising prices of risky assets in this indirect fashion reduces insolvency fears, reverses wealth losses and hence adverse wealth effects on spending, and sends favorable financial signals to producers – all of which are expected to contribute to reversing downward economic momentum.
Zero (or near zero) policy rates plus outright purchases have drawn government bond yields down to historically low levels. Low yields on bonds introduce a high risk of capital loss to investors if yields return to historical norms (for bond geeks, think McCauley duration), and if investors cannot be sure they will hold the bond to maturity. The private sector will wish to raise their holdings in government bonds only if they perceive risk adjusted returns elsewhere are less attractive – yet this is antithetical to the very purpose of quantitative easing, which is to break the high liquidity preference of private investors by “trashing cash” and lowering the yield on default free government bonds.
If government yields back up – either because private sector portfolio preferences are taking their cue from QE and shifting toward riskier assets or because fiscal stimulus is helping economic activity which has the same effect – then mortgage rates are likely to back up as well, confounding any stabilization in housing sales.
Alternatively, if central banks step in to buy Treasuries and thereby contain the back up in Treasury yields, more professional investors are likely to conclude “monetization” is underway and they will try to increase their exposure to inflation hedges. The net result would be a likely rise in the relative prices of energy, precious and industrial metals, “commodity” currencies, and ag products and ag land – all of which, as inputs to final products, would tend to represent an adverse supply shock to the economy. In addition, raising the price of essentials like food and energy is more likely to crowd out consumer spending in discretionary items. Neither of these supply and demand effects are particularly supportive of an economic recovery.
The expectations management effort, this time around, looks somewhat challenging. We previously took the stance that central banks can peg government bond yields at a level of their choosing, much as they did during WWII. We now think the policy path that involves QE and rising fiscal deficits may prove more problematic given likely shifts in private portfolio preferences. Put simply, central banks may have created something of a “liquidity trap” by pulling government bond yields below historical norms with near ZIRP (zero interest rate policy) moves. In addition, to the extent QE operations are successful in encouraging private investors to migrate toward riskier assets, government bond yields are likely to rise if that asset class is to compete with expected returns on other assets.
This obviously endangers any incipient housing recovery, and we are hard pressed to imagine much of an economic recovery will transpire if home prices are still falling. Commercial banks could step into the breach with their $1tr in reserves, but they probably will need more clarity on future loan losses before they try to ride the yield curve like they did in 1991-3 in order to rebuild net interest income and capital. Alternatively, if central banks end up being the main bidders of government bonds as a last resort, this is liable to send private investors in search of even more inflation hedges. The subsequent relative price increases for industrial metals, energy, food, etc. could equally inhibit economic recovery by increasing costs of production and draining discretionary household income.
Many professional investors have concluded the policy response to date has once again reset the game. Bank stocks have doubled since their lows, and US equity indexes are up 30-40% since early March. A rise in interest rates and commodity prices is certainly typical of economic recoveries, but this has not been a typical recession. The housing market damage is unprecedented; so too is the dramatic shift of households to a higher saving rate and a net reduction of household debt. The fact is that housing and consumer durable spending historically have tended to lead the US economy out of recession. The higher mortgage rates and higher gas prices resulting from investor reactions to the policy push may get in the way. They are salt in existing wounds. Perhaps the fiscal thrust is so large this time around that a recovery can be led by different sectors like infrastructure and technology and a Japanese style stagnation can be sidestepped. On the above analysis, however, the way forward may be a bit trickier than many investors now expect.