Zeus’s Catch-22 (Forget The Bonds. Take The Cannoli)

The Fed faces a “Catch-22,” BofA’s Michael Hartnett said, in the latest edition of the bank’s popular “Flow Show” series.

The current conjuncture of mass vaccination (synonymous with imminent reopening), heavy issuance and the prospect of “an inflationary boom,” as Hartnett put it, is conducive to higher yields. But, higher yields can mean tighter financial conditions. And tighter financial conductions can imperil the recovery.

So far, the Fed’s answer has been to suggest that the backup in rates simply reflects economic optimism. At the same time, officials (including and especially Jerome Powell) have emphasized that should financial conditions tighten or inflation overshoot materially, their “tools” are sufficient to address the problem.

That’s certainly true when it comes to the backup in long-end yields. As much as this irks some readers, bond yields in developed markets with sufficient monetary sovereignty are just policy variables. Clearly, there’s room for trading and for challenging the gods, so to speak. But the idea of “vigilantes” pushing bond yields sustainably higher than DM central banks want them to go is clearly nonsensical assuming central banks are inclined to toss lightning bolts. You can’t “outsell” a buyer with a printing press and a monopoly on the legal issuance of the currency in which the instrument in question is denominated. That’s a philosophical impossibility. The question is one of will, not one of means. That is: Are officials willing to smite heretics?

Traders like to talk around that reality. Usually, they point to innumerable instances where betting against central banks (in one way or another) ended up being a winning proposition. But that’s like pointing to Vietnam, Iraq and Afghanistan and claiming the US “lost” because asymmetric warfare and insurgency tactics proved highly effective against American troops. The US military didn’t “lose.” Rather, there was zero political will to go “all-in.” Asymmetric warfare doesn’t work well against nuclear bombs.

With apologies to any egos this might wound, nobody at the Fed (or the BoJ or the RBA or the ECB) cares if you put on a steepener and make some money or buy some TLT puts and luck upon a bear market in an ETF. In order for Zeus to start slinging lightning bolts, the steepener would need to get unruly or, in the same vein, yields would need to rise so fast (likely accompanied by dollar strength) that it tightened financial conditions dramatically via, for example, a sharp move lower in stocks that showed no signs of abatement and/or a quick widening of credit spreads.

For BofA’s Hartnett, the problem is that hurling lightning bolts to ensure adventurous vigilantes don’t short-circuit the recovery comes with risks of its own, some of which entail ironic outcomes.

For example, yield-curve control risks further inflating asset bubbles, which, he noted, “worsens inequality.” That would be the same inequality the Fed is trying to address by running the economy hot and tweaking the employment mandate to include a commitment to fostering inclusivity.

Seen in that light, the Fed’s “Catch-22 in ‘21” (as Hartnett quipped) is irony layered atop irony. Monetary policy operating without a sufficiently robust and durable fiscal impulse served to perpetuate inequality post-financial crisis. Now, having learned from that experience and shell-shocked by the pandemic, politicians are prepared to provide the fiscal impulse. But in doing so, they risk higher yields, the “fix” for which entails the Fed resorting to even more aggressive versions of the policies which widened the wealth gap in the first place.

In order to get a more equal society, we need more demand-side stimulus, and thanks to the pandemic, it needs to be unprecedented in size and scope. Orthodoxy (read: dogma) says that has to mean more borrowing or higher taxes. (Somebody’s gotta “pay for it.”) As faith in the recovery grows, yields rise, which in turn means borrowing becomes more expensive. At the same time, rising yields imperil the recovery via the financial conditions channel.

So, the Fed needs to be even more heavy-handed. The more heavy-handed they are, the more support for financial asset prices, and because the distribution of those assets is so hopelessly skewed towards the wealthy, the benefits of heavy-handed intervention to sustain the borrowing needed to build a fairer, more equitable society, end up making that same society less fair and more unequal still.

Of course, there is a way out of this absurd loop: Stop issuing the long bonds. If you insist that spending has to be “funded” (it doesn’t), then just fund at the short-end where the Fed’s control is uncontested. But really, considering how obviously ridiculous all of the above is, why not just end this charade altogether? Create the money but don’t issue any debt. (“Leave the gun – take the cannoli.”)