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.”)


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5 thoughts on “Zeus’s Catch-22 (Forget The Bonds. Take The Cannoli)

  1. Another alternative the Federal government should consider is to swap a high portion (say 2/3) of the Fed’s holdings in UST bonds for a special 100 year floating rate bond the Fed would hold. The Fed still would have a balance sheet they could conduct policy with. The bond would be callable at anytime and the rate would float annually based on the average cost of all UST debt oustanding each year. That would free up a lot of space over the next 30 years for the UST to issue regular UST bonds since the bonds that they swapped for could be retired and would not have to be rolled over and refinanced. If UST so chose they could call any of the bonds the Fed held at par.

  2. My goal is to never have to trade and to rarely have to readjust my portfolio. I just want to keep enough of an understanding about what is going on, mostly at a macro level, to remain confident about staying long, setting it and forgetting it.
    The most important issue that you have covered (over the yrs) related to my goal- and about which I have completely changed my thinking over time- is the issue that you covered in this post. Up until recently, I rarely saw much else written about this topic (except here) and to be honest, I have mostly stopped looking.
    I remain primarily interested in understanding the status of the US within the world ( GDP, political, and as a world leader on the environment), money printing (around the world) and what it is used for (short or long term benefit to USA and the world), recirculating money within the USA via taxes and the USD as the world’s reserve currency, etc.
    I remain interested in learning about other topics- but they are mostly relevant to “traders”- a group I hope I am not “forced” to join.

  3. Great article. Very interesting take on the inequality catch-22. I think Yellen and the Biden administration are keen on taking on inequality and have very little to zero concern about some of the high flyers coming back to reality.

    That isn’t to say there won’t be enormous pushback from the chattering class via their employers.

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