Goodbye Goldilocks

The prospect of Republicans holding the Senate and proceeding to block Democratic spending proposals was one “panic catalyst” that prompted a multi-session unwind of reflation trades, Nomura’s Charlie McElligott said Thursday.

The stalled bear steepener is one good example of markets having become suddenly more dubious on the chances of a pro-cyclical, post-election reality. Clearly, new lockdowns in Europe’s largest economies and plunging crude prices don’t help.

Wednesday was a bit messy, with bonds failing miserably to hedge equity weakness, but the overarching point is that both betting odds and markets now reflect the reality that even if you’re reasonably sure Joe Biden will win The White House, the Senate is a coin toss.

A Republican Senate is a problem. You can call that a partisan assessment if you like, but don’t call it an anti-Trump statement. Because it’s not.

Donald Trump wants more stimulus. No, his ideas aren’t the kind of “pure” demand-side measures that would lead to the best outcomes for everyday people, but he surely wants to send out more checks with his signature on them. And my guess is he wouldn’t mind spending a trillion or so on infrastructure in a hypothetical second term either.

The cold, hard reality is that a Republican-controlled Senate will likely balk at any package with a price tag in excess of $1 trillion. They will surely push back on a $2 trillion bill, no matter who supports it and no matter what’s in it. That’s why a GOP-controlled Senate is a problem.

On Thursday, McElligott described the market’s begrudging, half-hearted embrace of a blue sweep as follows:

There was a clear macro “risk sentiment” element to this drawdown–that being election risk with regards to the market not loving a Biden win (punitive tax hikes and re-regulation of industry), but marginally at peace with it under the rationalization that an outright “Blue Sweep” would at least clear a path for a much-needed and massive COVID stimulus program release, as well as set [the] table for a multi-trillion dollar infrastructure plan moving ahead, openness towards persistent fiscal via UBI, all under a future-state paradigm shift in Federal government deficit spending.

Why is that bullish? Well, I’ll explain, for the umpteenth time.

We’ve been mired in a “slow-flation” world for more than a decade, and longer than that depending on how you want to conceptualize things. “Slow-flation” used to be synonymous with “Goldilocks,” as it gave central banks plausible deniability vis-à-vis persisting in accommodation despite reasonably sound growth outcomes.

Stubbornly low inflation and subdued (but not “bad”) growth was “just right” from the perspective of markets — it kept the benefactors with the printing presses in the game and out of the tightening business, while avoiding the kinds of overtly bad macro outcomes that would mandate de-risking no matter how committed central banks are.

Now, with the pandemic, things have changed. The world is trying to claw its way out of a depression — with a “d.” It’s a lowercase “d” in that the recovery was swift, but it’s a “d” nevertheless. And while you might be able to rate-cut and asset-purchase your way out of a recession (with an “r”) you need a strong, committed fiscal impulse to get you out of a depression, with a “d” (lowercase or otherwise).

The kind of policy conjuncture on offer under a blue sweep is increasingly seen as the only plausible way back from the pandemic — the only economic solution that realistically has a chance of fully resurrecting economies and dodging a fate spent mired in moribund outcomes for what might as well be eternity.

To be clear, McElligott doesn’t himself advocate for such a policy turn. Rather, the point in featuring the excerpt above is to explain why traders and investors are, as he puts it, “marginally at peace” with what, in the past, might have been considered an unequivocally “bad” electoral outcome for markets.

Of course, the amusing thing about all of this is that if one looks at the history of market performance under Democratic and Republican administrations, it’s hardly clear that the latter is preferable.

Pesky facts. Always getting in the way.


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7 thoughts on “Goodbye Goldilocks

  1. It blows my mind that the public seems to think that Republicans are stronger on the economy and defense than Democrats as a general rule. If you look at history since the turn of the 20th century it is completely the opposite.

  2. It seems obvious to me what Dems are for and Pubs are against. McConnell’s Senate is against any stimulative spending and for tax cuts that leave most American’s out. Biden/Harris want to spend trillions to stimulate our economy, create jobs, and improve our infrastructure…..promising not to raise taxes on anyone making under $400,000. Pubs want to see fewer people with health insurance and Dems want
    everyone to have access to health care. Pubs want a good education to be available to people who can afford it……Dems want a good education available to whoever wants it. Pubs are perfectly happy seeing people with full time jobs living in poverty…….Dems think anyone who works full time should make a living wage. Pubs are willing to run trillions in deficits to support tax cuts…….but are unwilling to run deficits for anything else……..Dems think tax cuts and spending should help people who actually need help. Etc.

  3. Risk is elevated, the critical events coming up are binary, and there is some “unknowable” risk related to contested election etc.

    The probability of approved vaccines in the next couple months is fairly high (60-70%), the probablity of a Biden victory is reasonably high (75%-ish, based on poll-based and betting-based forecasts) and the probability of the GOP losing the Senate is better than even (60%-ish, based on poll-based and betting-based forecasts). The last two are not independent events from each other; the probability of the full Blue Wave (Biden + Dem Senate) is I’d guess around 65%? The first event is independent of the last two.

    0.65 x 0.65 = 43% probability of the bullish outcome (vaccine soon – Blue Wave). Max bullish for short term stock market reaction (not considering ideology or long term here).

    0.35 x 0.65 = 23% probability of a middle outcome (no vaccine soon, Blue Wave). No vaccine help near term, but trillions in fiscal stimulus.

    Same 23% probability of a middle outcome (vaccine soon, no Blue Wave). Vaccine help, but no big fiscal stimulus (Biden wins) or modest fiscal stimulus (Trump wins).

    12% probability of a max bearish outcome (no vaccine soon, no Blue Wave).

    What do you think the market has baked in at today’s level? That’s my dilemma.

  4. We should keep in mind that it may take some time to determine who will control the Senate. As in the Presidential race, vote counting may be slow this year. Even after we know who will be President, there may be Senate races that are close or contested for some time. Then, we have the special case of Georgia. State law requires a runoff on January 5 if no candidate gets 50% of the vote. Georgia has 2 Senate races. Both are close, and one or both may result in a runoff. So even with a clear Biden victory, we may have no idea how big a stimulus package could get by the Senate until some time in January.

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