If you’re wondering why the risk-asset rally feels inexorable on most days — why the default setting for equities seems to be “higher” and spreads “tighter” — one popular strategist has a theory. An all-encompassing, holistic hypothesis.
Everyone’s familiar with a few key puzzle pieces. And also with how they fit together.
You didn’t need a cork board, red string and a basement bunker to make the connection between Janet Yellen’s bond-bullish QRA in early November and the Fed’s concurrent about-face (relative to the September FOMC communications and dot plot). Yellen (a Democrat) and Powell (a Republican) were engaged in a bipartisan effort to cap the rise in long-end US Treasury yields and engineer a turnaround for risk assets.
It worked. And in spectacular fashion. (Note: The chart below cuts off in mid-February, when the rolling FCI window captures the December FOMC meeting.)
Whether you believe that effort was designed to bolster the incumbent president’s flagging approval ratings in the lead up to an election year is a separate matter, but I’d gently note that we should be careful not to conflate an aversion to chaos with personal animus towards America’s last president. Put differently, there are behavioral thresholds beyond which the old adage about everyone deserving a second chance ceases to apply. In the minds of some (not everyone, but some), 45 crossed at least one such threshold and maybe several of them.
Whatever the case — and panning out a bit — you could argue that the early November Yellen-Powell tag team effort (which continued with Chris Waller later that month and crescendoed with the December FOMC meeting) was a microcosm of a larger dynamic wherein Fed and Treasury see an opportunity to facilitate what could be viewed as a political imperative in the post-pandemic socioeconomic reality defined as it is (and will continue to be) by increasing demands on fiscal policy. They also see a mechanism for implementation.
In a Tuesday note, Nomura’s Charlie McElligott tied all of this together. Risk-asset buoyancy is, of course, in part a function of rate-cut expectations and a Goldilocks macro narrative. But, he said, “there is another more secular component to the highly speculative market regime shift.”
The Fed pivot, he went on, comes amid “a more permanent and aggressive usage of fiscal deficits and stimulative policies in the post-COVID world from governments and politicians, especially in the US where ironically, both Biden and Trump run on the same ‘economic populism’ platforms” characterized by “onshoring, protectionism, tariffs, subsidies, infrastructure-building and tax cuts / credits with major stimulative implications for growth, inflation and market- and policy- volatility.”
The natural trade would be short duration (i.e., bearish bonds), but Charlie noted that Yellen’s effectively moved the goalposts by shifting issuance to Bills, thereby capping the term premium, or at least removing a key bearish long-end catalyst. Never-ending money market fund inflows ($190 billion YTD and $6.1 trillion in total AUM) suggest Bill supply will find ready buyers, but just in case, both Waller and Powell recently messaged some inclination (or willingness to consider) shortening Fed balance sheet WAM — i.e., favoring shorter maturities.
McElligott also highlighted recent commentary from former Fed trader Joseph Wang, who weighed in on the potential implications of an ISDA recommendation submitted to the Fed board, the FDIC and OCC. Here’s a short excerpt from Wang’s piece that captures the gist of it:
Tweaking regulations to encourage more bank involvement would be an easy private sector solution to financing the anticipated surge in Treasury issuance. While Fed purchases are the ultimate backstop to any market, a modest adjustment to Basel III leverage calculations would save them the trouble. Capitalizing on the deep unpopularity of proposed regulations, ISDA is recommending a permanent exemption of Treasurys from Basel III leverage calculations.
In case you’re not picking up on the message, Wang’s title said it all: “Manufacturing Demand.”
As Charlie put it, Wang offered “yet another potential solve” for one of the market’s more pressing questions: “Who’s going to buy the bonds?”
I assume most readers can see the bigger picture. If not, McElligott offered a seven-point summary:
So there you have it. Whether,
- The ‘fiscal dominance’ of perpetually large deficit spending and the impact on a run-hot economy, or
- Treasury’s ever-increasing role in monetary policy and market intervention, or
- both the Fed’s Powell and Waller now advocating for a balance-sheet ‘mix shift’ towards shorter maturities in order to absorb potentially ‘permanently higher’ Bill issuance going forward, which in the eyes of markets looks like
- a future-state of backdoor debt monetization, and now,
- an SLR regulatory change which could allow banks [to act] as a ‘limitless’ purchaser of Treasurys to then
- provide a private sector solution to finance the surge of Treasury issuance, which in turn acts as
- a de facto ‘permanent indirect QE program’
Coming full circle, McElligott put it as a question: “Is it any wonder that assets are trading like they’re short?”
What happens if Trump is re elected?
My guess is chaos that no one expects because he is in no way predictable. He’s just eaten an entire political party.
burp
Dramatically increased import tariffs and “mass” deportations would suggest that the inflation rate will reverse back into a higher trajectory, no?
I think increased inflation is a foregone conclusion. Something rarely discussed is that the FED is partly focused on managing policy in a way that increases GDP the full employment part of their mandate. Put another way, they endeavor to keep the party going as log as possible while raising rates. Your observations about tariffs and deportations it seems these helps the fed along by helping stoke the fire along with fiscal stimulus.
Fiscal stimulus has been primarily encouraged by IRA act. Though military obsolescence caused by drone wars in Ukraine is having an outside effect. I saw a chart where currently we are seeing $11 billion a month in new factory investment. Since these investments tend to produce results for decades after initial investments we are likely to see economic fires burning well past our lifetime. Hence the idea of higher for longer is being further baked in every year we enjoy a surge of factory investment.
I’m confused how higher inflation leading to higher interest rates stimulates capex. Via “import substitution?”
Nor can I see how reducing the labor force in the much larger service sector helps fuel economic demand. Perhaps for more automation at the drive-through window but how do you replace bussers and hotel maids/cleaners? How much can construction be automated and how long would that take?? The writing has long been on the wall in agriculture, but so far robotic crop picking technology has proven to be disappointing.
We’re not a factory-driven economy anymore.
See fourth paragraph under the Voila chart. Each administration and their leaders have demonstrated an affinity for MMT, varieties of protectionism, and a willingness to spend to solve what they perceive as problems. Their actions suggest they don’t perceive the deficit as a problem, and as H notes w/ help from Wang paper, “manufacturing demand” helps completes the spend and fund circle.
These sort of Fed-Treasury machinations and the both sides from the middle trading ops they foster (sell vol, trend momo, ETFs, etc.) combine to create the energy leading to the “elevator down” effect (see H’s many related articles). Timing unknown.
I’m not sure what else anyone would want from our authorities? A return to the 19th century?
We have a Fed (Central bank) and a federal government (centralized government with a fair amount of state capacity). It’d be dumb as rocks if they didn’t intervene to manage the business cycle to the best of their abilities and coordinate in doing so.
The real problem the USA faces in that respect is not unique but it’s pretty acute – it’s taxing the rich/raising taxes generally AND/OR delivering greater goods and services to the tax paying middle class.
To simplify a bit – if you’re a continental European middle earner, you may be paying a bit more in taxes than an American of similar income. But you get a heck of a lot more public goods and services in return. This goes a long way to make taxes palatable or at least tolerable.
In the US, if you’re middle class, you pay taxes, you pay all kinds of weird fees (for rubbish collection or, for example, for the simplest of banking functions etc) and you get very little in terms of public goods. It’s no wonder the middle class tends to side with the rich against tax hikes.
I don’t know how to break the cycle and Democrat politicians don’t seem to either – hence the (over?)use of deficits.
NB: I am well aware that Europeans use deficits too and are actually in a worse shape than the US when it comes to debt to GDP. But at least it’s not for a lack of taxation. In our case, it’s a lack of economic growth in the face of worsening demographic constraints.
A de facto permanent indirect QE program in what is effectively becoming an indirect YCC regime, even more so if the ISDA proposition to exempt Treasuries from Basel III gets traction. To be honest I’m surprised something similar has not been implemented yet, higher risk assets is a logical conclusion in this environment until some external factor disrupts the gathering momentum.
As a young man, before I would read a magazine I would remove the free standing insrts and tear out the attached ones. Now, I make a list of acronyms and define them. A person who can explain a subject in plain English without acronyms, insider signalling and weird words that most people don’t understand is a relief. That’s why we have all these overconfident explainers on the internet. Before I would put something forth at work, I found it helpful to explain it to one of my children. If they coudn’t understand it, I went back to the drawing board. As to Mr. McElligott, let’s remember he was trained at O’Connor. Not perfect but pretty darned good….