Late last month, in a lengthy piece, I asked if printing press-financed stimulus could break the back of the four-decade bond bull.
It was a fairly in-depth discussion, as far as ad hoc market musings go, but the overarching point was to ponder what the future might hold for long-end yields in the event the political tide continues to turn in favor of MMT-esque policy partnerships, whereby monetary policy coordinates directly with fiscal policy in order to, for example, ensure full employment and fund expensive progressive agenda items.
You’re encouraged to note that this kind of policy prescription isn’t the sole purview of progressives. When Donald Trump explicitly calls for negative rates and QE at a time when he’s borrowing to fund tax cuts, that too is a policy partnership, only in the service of supply-side stimulus. Some have gone so far as to suggest that Trump is (unwittingly, of course) the first MMT president.
In that linked piece I cited MMT patron saint Stephanie Kelton, and also Harley Bassman (if you’re not familiar, Bassman literally created the MOVE – more here). Last year, Bassman wrote the following of MMT:
I do not believe that MMT is viable over the long-term; although as stated prior, it is unlikely my personal horizon will overlap its eventual denouement.
Kelton herself appreciated the humor.
Many thanks for including me. I got a kick out of the long-run quote.
— Stephanie Kelton (@StephanieKelton) December 29, 2019
Well, in his latest commentary, Bassman delivers a fresh critique that looks at each successive round of QE and also at MMT.
The full commentary is much longer, but the bits which are most pertinent to the above discussion and most readily accessible to a wider audience are reprinted below with permission.
“I believe that demographics and politics will pull the curtain back on the Wizards of Western Central Banks to reveal their folly”, Bassman wrote, in the message accompanying his latest commentary. He continued:
This will not occur soon, rather over the later half of this decade. Of course, the problem is that markets may well anticipate prior.
Fortunately, as fire insurance is cheap when its raining, so too are certain long-dated risk management tools.
I will caveat that although I am certain of the denouement, it is possible its date is vastly longer than my career; thus, similar to other insurance products, I will not mind if this too expires worthless.
Read on, for more.
Via Harley Bassman
The full quotation is: “Pigs can fly if shot out of a large enough cannon, but they eventually return to Earth as bacon.”
Thus, I will summarize my thoughts on Quantitative Easing (QE2 to QE~), and the inventible engagement of Modern Monetary Theory (MMT): Yikes !!
QE1 was a legitimate and necessary policy. For better or worse we live in a financially based economy where leverage (borrowing) is at its core. As such, when the monetary plumbing became clogged, the financial Plumber in Chief (the Federal Reserve ~ FED) had to plunge the system.
Subsequently, the FED and the Federal Government should have followed its 1989 playbook from the Savings and Loan financial crisis. Irreconcilably bad institutions should have been closed, and the senior villains should have been prosecuted. Even if convictions could not be assured, public trials should have occurred as both good policy and politics. Monetary settlements from highly compensated CEOs only evidenced that they could game the system twice.
Recall that Al Capone was ultimately convicted for tax evasion, not bootlegging, bribery and murder. So too do Wall Street managers fear the SEC’s catch-all crime of “failure to supervise”. This statute is so broad that a first-year legal associate could convict a ham sandwich; and you wonder why our politics have become so acrimonious ?
But enough bloviating, let’s return to the matter at hand. I will stipulate that a fiat currency cannot be created at a faster rate than the growth of the economy without inflation. Over 5000 years of collective civilization, we have no record of the Sovereign printing the coin of the realm at such a pace without the currency becoming devalued. If such were the case, surely there would be legends of how poverty was eliminated with the wave of the hand.
It has been my stated opinion that the US Treasury ten-year rate will not exceed 3.50% until at least 2023. It is here that the –baltic line– Labor Force Growth Rate rises significantly and should begin to pull up the –carnelian line– of interest rates.
While this is not news to frequent readers, what should be highlighted is that the year 2020 marks the mid-point of when the Baby Boomers reach the age of 65. As such, the speed of their exit from the work force diminishes relative to the increase of Millennials finally leaving Mom’s basement to find a job.
The point here is that this baked-in-the-cake demographic inflection point is no longer in the distant future, but rather within the reasonable investment horizon.
And indeed, one should be quite fearful of owning financial assets come the day interest rates rise above ~4.00%; but don’t fret yet, there is time to prepare.
Since the start of the Great Financial Crisis (GFC), stocks and bonds have moved in opposite directions; when stocks trade down, bond prices rise (to a lower interest rate), effectively offering hedge value for a diversified portfolio.
The –buttercup line– correlation has been a boon for quantitative investment managers, especially those who employ leverage via a ‘risk parity’ strategy. Here, one might use $100 of capital to buy $130 of bonds and $70 of stocks. Such a portfolio has delivered superior returns with a lower volatility; truly an Investment Nirvana.
Significant research has been done to isolate the key drivers of this correlation, and they mostly identify interest rates as the independent variable, with an inflection point between a UST ten-year of 3.50% and 4.50%. [Note: the level of inflation is also important.] In support of this notion, notice the Q-4 2018 Equity market pullback kicked off when the T10yr kissed 3.25%.
It is my opinion this correlation will reverse as the ten-year rate nears 4.00%, which includes a 2.50% level of inflation.
To be clear, I am not saying there will be a financial Chernobyl at this rate, but rather that the leverage in the asset markets will slowly start to unwind, and both stocks and bonds will deflate in unison.
I still believe demographics will cap rates at 3.50% rate until at least 2023; but the likelihood of an expansive fiscal policy could challenge that level soon after.
The –gobelin area– highlights another consequence of our aging demographic.
While there has been some growth in -Defense-, -Interest-, and -Discretionary spending, it is the -Mandatory- spending (driven by the aging Baby Boomers) that accounts for most of the budgetary expansion.
A worrisome accelerant is that both political parties seem supportive of some form of Modern Monetary Theory (MMT), over and above projected baseline spending. The Republicans will clothe it as Infrastructure spending, while the Democrats will not mince words when they roll out Universal Basic Income (UBI).
Finally, let’s remember that the entire Baby Boom generation (1946 to 1964) will be over the age of 65 by 2029.
So, while I cannot pinpoint when the final denouement will occur such that long-term interest rates rise above 3.50%, we can likely bracket the date to be somewhere between 2023 and 2029.