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Thursday 28 March 2024

Summary: Terrible as it’s been for humankind, the pandemic has given scientists a unique period in history in which to examine orthodox theories, and create new ones.

For economists, this has been a year observing how most workers were, at the least, forced to change how they interact with the workplace – for many millions more it’s meant furlough or unemployment.  The pandemic also closed supply chains, but never resulted in significant food shortages. It did, however, show the value of self-sufficiency with vaccine production. And perhaps most significantly the pandemic showed the power of the state at a time of international calamity – government spending has filled the gaps that Covid made in the economy, albeit at immense fiscal cost. So economists now have more evidence to show what works, and what doesn’t, when an economy unexpectedly closes down. 

In his book “Economics in One Virus”, Ryan Bourne looks at some of the economic questions that Covid threw at us, and analyses society’s responses. Ryan works at the Cato Institute in Washington DC – this think-tank is libertarian in its outlook, and his conclusions lean towards the idea that the private sector will usually allocate resources in the best possible way, and that government intervention is much less effective. Personally I’d say that it’s precisely at times like this that big government gets to prove its value, but there are good arguments that the free market showed it worth here – you could point to the UK supermarket chains as a good example. Despite a couple of days of empty shelves following March 2020’s panic buying, their contingency planning worked pretty flawlessly, without government intervention.  It’s hard to imagine what the UK would look like without the significant state support that those out of work received over the last year though. 

You can see my interview with Ryan here:

Here’s an update of my favourite long term measure of bond market valuations.  I’ve been updating this chart on the blog over the years, and if you’d bought and sold US Treasury bonds when they diverged significantly from the range implied by the Fed’s long term rate expectations, you would have done OK.

So what does my favourite chart show?  I’ve shown the 10 year US Treasury bond yield, 10 years forward.  This is derived mathematically from the US Treasury yield curve, and is the implied 10 year yield starting in ten years’ time: 2030.  The beauty of using a forward rate is that it does away with shorter term noise; when we look at the period from 2030 to 2040, hopefully we don’t need to be talking about the strength or otherwise of the global Covid recovery, or about Trump and Biden political risk.  It’s a measure based on long term expectations of rates based on inflation trends, potential growth, central bank mandate commitments, globalisation, government borrowing and demographics.  At the moment, the 10y10y forward rate in the US is 2.09%, compared with the 10 year bond yield of 0.92% today.  Remember that this is a nominal rate and that broadly inflation targets around developed economies are 2%.  Effectively this means that the bond market is expecting real (inflation adjusted) yields in 2030 to be near zero. 

The other part of the chart is the median level of the Federal Reserve’s “dots”, and the range of the highest and lowest expectations of FOMC members.  Each quarter, the FOMC releases the “Dot Plot”, formally called its “Policy Path Chart”.  Each of the 16 FOMC members estimates where the Fed’s short term interest rate will be at the end of the next three years, and over the long term.  It’s that long term rate that I’m interested in, as it looks through the noise and short term economic uncertainties.  Last night, following the FOMC meeting, the Fed left its dot plot unchanged.  Rates for 2021 are expected to be left at 0% to 0.25%.  This is despite the market consensus that 2021 US GDP will come in at an above-trend 3.8%, and despite a rise in inflation expectations—but remember that the Fed adopted Average Inflation Targeting during 2020, which allows it to let inflation move above its old 2% target if it’s been below 2% historically.  The long term dot median was also unchanged at 2.5%, consistent with a real yield of something like +0.5%.  The long term real rate of interest is also known as R* (“R-star”).  The New York Fed publishes an estimate of R* based on the Laubach-Williams Model.  Its inputs are GDP, inflation and the Fed Funds rate.  At the start of the year, R* was estimated at over 1% on this model; it’s now below 0.5% post-Covid, consistent with a median long term “dot” of 2.5%.  You can see the model’s output here: https://www.newyorkfed.org/research/policy/rstar

The dislocation between trend growth and R* is dramatic.  Ageing bond managers like me used to look at models that said, based on the Efficient Markets Hypothesis, that nominal bond yields should be roughly the same as nominal GDP growth.  There shouldn’t, ex ante, be a different expected return in investing $100 in a US Treasury Bond than there should in putting $100 into the US economy (caveats around volatility excepted).  Trading bonds on that model would have led you to miss 20 years of bond market rallies…

Anyway, here’s the chart.

From March onwards, the 10y10y forward US Treasury yield collapsed below even the most pessimistic FOMC member’s long term dot.  Was it really likely that Covid would still be depressing interest rates between 2030 and 2040?  Possible but unlikely.  Selling bonds from March onwards looked attractive, and 10 year yields have nearly doubled since then from 0.5% to 0.92%.  Now though, we are back within the Fed’s range of outcomes.  It’s still at the lower end of range, and arguably bonds remain expensive.  The market’s forecast for the 10 year bond yield at the end of next year is 1.3% and for 2022 it’s 1.5%, with a roughly parallel shift higher at longer maturities.  Remember that bond markets have forecast higher bond yields every year for decades now, and have been wrong almost every time.  I can buy the idea that US Treasury bond yields go higher from here, but the high water mark for them might end up being much lower than bond bears are predicting.  You need to have some very good reasons to explain why a 40 year bull market in Treasuries is going to enter into sharp reverse.

Happy Christmas and a Happy New Year.

In this 15-minute interview I ask M&G’s Greg Smith, an emerging market debt strategist with a speciality in Africa and formerly a World Bank economist in Zambia, how the continent is coping with the Covid-19 pandemic.  We also discuss how worried we should be about the negative headlines coming out of the region over Zambia’s recent default on its international bonds.  Is this the start of a wider trend in African defaults?   And how is Chinese state power manifesting itself in lending and recoveries in the region?

We didn’t get the chance to discuss it in the video, but afterwards Greg talked of his sadness that Ethiopia is once again at war.  A year ago Ethiopia’s Prime Minister won the Nobel Peace Prize for ending Ethiopia’s war with Eritrea.  Today the region of Tigray appears to be the centre of some significant military activity, and there are fears for the 500,000 citizens in its capital.

We also discussed the sad fact that Africa usually appears in the news only when bad things happen – debt default, famine or unrest.  In the video, Greg points out that emerging market defaults have been lower in Africa than elsewhere to date, and that actually Africa’s Covid experience has in many ways been less severe than that of many other regions – probably because of the much lower average age of populations.

The first half of this year saw one of the fastest and most aggressive market corrections in history, as Covid-19 spread around the globe.  Just as unprecedented was the speed and extent of the subsequent recovery, thanks above all to governments and central banks having sent in the cavalry to boost liquidity and plug the consumer confidence gap.  Combining fiscal and monetary stimulus, the global policy response is estimated to be $14 trillion and counting.  With all this in mind, what’s next for global markets as we enter the second half of 2020 and beyond?

The 2020 Taper Tantrum

The second half will be all about the new Taper Tantrum.  The first one was about the Fed’s balance sheet unwind, leading to a surge in Treasury yields as the central bank announced the tapering of its quantitative easing (QE) programme in 2013.  This one will be about the end of furlough schemes in developed markets.

Countries are opening up again in order to limit economic damage, especially in the northern hemisphere where governments are keen to support growth through holiday spending.  In the absence of a vaccine, this means that an acceleration of Covid-19 cases is almost inevitable, even with measures such as local lockdowns.  However, death rates will be lower than they were in the “first wave” for a number of reasons: we now have better treatments (e.g. steroids cut death rates in intensive care units), we have learned lessons on shielding the most vulnerable, and very sadly, many of most vulnerable may have died already in the first wave.  Most developed economies should return to some form of normality.

However, despite the recent rebound in employment (look at the US jobs numbers last week), unemployment is still exceptionally high.  US unemployment is up 12 million from February, while in the UK we have over 9 million people out of work—more than a quarter of the UK workforce.  So far, the economic damage done to individuals has been cushioned to a large extent by furlough schemes, in which the government pays a large percentage of salaries for staff whom would otherwise have been laid off.  As a result, with little to spend money on during lockdown, many people have been able to save or reduce debts.

In the US, thanks to the CARES Act, the largest economic stimulus package in US history, we have a situation in which some workers have actually been better off being out of work than they were in their previous jobs.  With direct payments to Americans and loans to business, the $2 trillion Bill amounts to 10% of US GDP, and is much larger than the $0.8 trillion Recovery Act of 2009.  Adding together compensation of employees plus government unemployment benefits, we have the strange situation in which people in the US are receiving more income on average now than they were before Covid-19.

This is a rather odd recession: they don’t normally send personal incomes soaring.

The danger is in the taper

But what will happen when this stimulus begins to wind down?  Government debt levels have exploded since March as tax receipts collapsed and unemployment costs rocketed.  Deficits have moved well above 10% for most developed market economies, while debt-to-GDP ratios have generally moved to, or above, 100%.  While there’s a lot of debate about whether this matters (see Stephanie Kelton’s recent book, The Deficit Myth, which suggests that we can print money to get ourselves out of the problem; or Eric Lonergan (of M&G) and Mark Blyth’s Angrynomics, which says that having negative sovereign interest rates makes this a time to invest in infrastructure), most governments want to start to taper assistance to the economy later this year.  In the UK, this means that government furlough payments will be reduced in August and October, putting some of the wage burden back onto employers.

What happens then?  In anticipation of furloughs ending, UK retailers in particular have already announced mass redundancies.  How many of the world’s furloughed workers don’t realise that they are actually unemployed?  For this reason, plus the continued impact of Covid-19 on global travel and trade along with social distancing nervousness (however reduced from its peak), talk of a V-shaped recovery seems difficult to square with the environment we now face, despite low rates and some continued fiscal stimulus.

Lessons from history

It is likely that there will still be more fiscal stimulus and debt levels will continue to rise from here.  How will we deal with them?  The usual three options are: grow, inflate or default.  The answer is basically the same sort of policies that allowed the UK to deleverage from 250% debt-to-GDP after the second world war.  These included forms of financial repression like forcing high bank ownership of government bonds.  In the US, it involved pinning bond yields to low levels – like we have seen in Japan since 2016, and in Australia in March this year. Such yield curve control (YCC) is already under active debate within the Fed (YCC is different from QE in that it targets a bond price or yield, rather than simply being a purchase of a set volume of bonds).  Might we also see negative interest rates from the BoE and Fed?  On a further slowdown it is likely.

We should also consider central bank independence.  Former Bank of England Deputy Governor Paul Tucker has warned that, as the Bank is now buying basically the same value of gilts as is being issued by HM Treasury (as well as offering the government a Ways and Means overdraft for lost tax revenue), it is at risk of being seen as the financing arm of the UK authorities.

The return of inflation?

Does this make inflation more likely?  The jury is out, and this largely depends on who wins the battle between labour and capital in the recovery.  Labour has lost out for decades now.  Will Covid-19 change that?  The data so far are not promising: the latest research from the US Brooking Institute think tank says that it is the bottom 20% of wage earners that have suffered the highest unemployment rates, so hopes that we would emerge from the crisis wanting to reward low-paid key workers (nurses, delivery drivers, supermarket staff) might be dashed.  There’s still a chance of some supply side inflation, thanks to food going unpicked and disrupted logistics.  Shopping basket inflation did rise in March, as shops ended promotions and limited product ranges (and this inflation was inflicted disproportionately on lower income households as a result of how lockdowns have pushed them to buy more food while not spending as much on other, less inflationary items and activities).  But demand-driven inflation seems very unlikely overall.

Received wisdom is that QE = inflation.  Is this true?  The money supply expansion is huge – but so is the collapse of the velocity of money (i.e. the speed at which it circulates in the economy).  Some argue that the most powerful effect of QE is that on a currency: as money is printed, the currency depreciates and inflation is generated through higher imported goods prices.  But what if everyone is doing QE?  What if everyone is trying to get their currency down?  It has no impact.  Famous bear Albert Edwards goes further, to say that YCC will be even less inflationary, since countries like Japan have been able to keep yields low without even having to buy many bonds – the signalling effect is so powerful that there’s not even a monetary expansion.

Positioning for the new taper tantrum

Credit

We’ve come a long way since the lows of March, which offered some great opportunities to be overcompensated for default risk as a credit investor.  Corporate bonds, which at their lows were pricing in IG and HY default rates of 25% and 54% (23 March 2020) respectively, are now closer to fair value (pricing in 12% and 35% at 7 July 2020).  Undoubtedly this has been driven mainly by central bank buying, particularly in high yield where we have seen and can expect to see more defaults.

Despite considerable volumes of issuance, high yield spreads have come a long way.  The main reason is not fundamental but rather the action of the Fed, which has for the first time been buying high yield ETFs and high yield bonds which were downgraded after 22nd March.  It’s hard to get excited about credit valuations at these levels.  There is still some value in investment grade: these companies are the big employers, so it is politically easy (and arguably a decent policy tool) to support them.

The Fed’s support also begs the question, is it right that these companies survive?  We have lost the creative power of destruction, where the old makes way for the new.  Is capital really being allocated correctly and efficiently?  We have seen how growth and productivity stagnates under these conditions in Asia at the end of the last century.

Developed markets

Despite the huge fiscal stimulus we have seen, it is difficult to be too bearish on government bonds now given the yield controlled world we live in.  And bonds like bad news: while they are clearly very expensive, they do offer potential upside in the event that negative sentiment returns to markets in the second half.  With inflation unlikely to rise significantly in the short term, I don’t mind owning duration.

In Europe, the planned recovery fund and continued Pandemic Emergency Purchase Programme (PEPP) have been supportive.  Just as important as the planned spend itself is the sentiment of burden-sharing, when it comes to helping contain EU break-up risk.  Despite some resistance to the stimulus plans from the more frugal Euro nations, Italian BTPs and other peripheral bonds have strongly outperformed core government bonds since the announcement.  I’m not convinced we’ll see much more outperformance from BTPs since their aggressive rally.  Flows are slowing as spreads are compressing, so demand is likely to shift to other high yielding sovereigns in the region that have been less aggressively bought so far by the ECB and investors.  For this reason I like bonds like 10 year Netherlands.

Emerging markets

One area in which I do see value is emerging market (EM) debt.  Firstly, it offers higher real yields than developed market bonds.  Also, EM currencies have lagged the recovery, meaning that some local currency bonds do offer attractive value (you can buy more per dollar).  Emerging markets clearly face challenges due to Covid-19, particularly as a result of headwinds to global trade, but greater EM central bank intervention than we have seen before is helping and there are regional pockets of relative value.  For example, I would expect Asia to outperform other EM regions, since high real rates make currencies here broadly attractive to investors.  Additionally, many of these economies are net exporters and so this should also improve current account balances.

Currencies

We should see some mean reversion in valuations that moved aggressively in the first half.  While EM local currencies looked fundamentally cheap across the board in the first half, going forward I expect to see some more moves based on fundamentals.  I therefore anticipate rotating out of some of those currencies that have rallied aggressively (for example the Indonesian rupiah) to those where fiscal and central bank positions are strong, but valuations still look attractive (for example the Russian ruble).  I would also favour higher-beta currencies (for example those that are heavily commodity-driven, or with a reliance on external rather than domestic demand) to capture any second half mean reversion.  Likewise I am following central bank moves closely: currencies in those countries where central banks have been relatively conservative in expanding their balance sheets (e.g. the New Zealand dollar over the Australian dollar) are where I want to be (though in rates I would favour issuers where central banks are providing strong support).

Unlike many EM local currencies, the dollar looks quite expensive on a fundamental basis.  Despite this, I do own some dollar exposure, as it does its job in a risk off environment.  On balance though, I prefer the Japanese yen for the better diversification and risk off hedge it offers.  With the ECB having removed a lot of downside risk in the region through their aggressive buying programme, I also like holding the Euro.  It has become a very cyclical asset (rallying as sentiment improves, the opposite to the way the dollar is behaving), so I hold it against the safe haven currency of the region, the Swiss Franc.

Short term action, long term impact

The focus of financial markets moves quickly.  We saw over the first half of 2020 just how quickly.  After the deep and rapid panic-driven sell off as Covid-19 spread around the globe, the extent to which asset prices have recovered reveals markets’ new focus: the unprecedented magnitude of fiscal and monetary stimulus.  With millions of jobs lost in a few months, there is no doubt to my mind that it is this stimulus which is now driving markets: they are being driven by technical factors, not fundamentals.  I think the focus may change just as rapidly in the second half, and it will be to the other side of the coin: what will markets make of the inevitable end of the monetary and fiscal bridge?

Governments and central banks have, on the surface, succeeded in containing much of the financial fallout of the lockdown-driven fall in demand.  The danger now is in the taper.  In this light, it seems difficult to support the idea of a V-shaped recovery.  And the short term response of governments and central banks brings up longer term questions.  How will we get out of all this debt?  Grow?  It seems implausible that trend growth will be higher in the aftermath of this crisis than before.  Inflate?  Central banks haven’t been able to achieve their inflation targets even in the good times, so what chance do they have of inflating away the debt now?  Default?  There’s no need to default if you can print your own currency – but we might see some debt jubilees (cancellation of student loans for example), wealth taxes and confiscations, and even the cancellation of government bonds held by the central banks as part of QE.  And what happens if the market stops believing that central banks are independent?  Could that finally be the catalyst for inflation expectations to return to developed markets and, after decades of losing, will labour win over the power of capital this time round?  The actions of a few months bring up these questions and more.  We may have to wait for some years to learn the answers.

This new book by Eric (an M&G multi-asset fund manager) and Mark (an economics professor at Brown University in the US) is getting a lot of attention at the moment: Martin Wolf put it on his list of “must read” books for FT readers over the summer, and the book’s ideas are very much answering the big questions of today.  Why are we all so angry?  Where did these culture wars come from?  Why have populist governments replaced the stable, sensible technocrats that we thought were a permanent feature a few short years ago?

By the magic of Zoom (not just for quizzes) I was able to speak to both Eric and Mark about the book.  Here’s what they had to say about both the types of anger that have driven the crazy political world that we now live in, and their suggested solutions to the causes of that anger (clue: negative interest real rates are pretty useful here…).

 

Last week I interviewed Philip Coggan, the Economist journalist who writes the Bartleby column. His new book, “More: The 10,000 Year Rise of the World Economy” is out now, and it’s essential reading for anyone at all interested in the development of the global economy from the caveman through to the tech giants of today. One review of the book I read suggested it was a 21st century update to Adam Smith’s “The Wealth of Nations”, and defence of the liberal, open economies that we’ve come to expect today. At its heart is the idea that human connectiveness is the key to prosperity and invention – this of course raises questions about the recent rise of populism, trade protectionism, and the impact of Coronavirus, all of which might put what we’ve taken for granted at risk. The book is a great read, packed with stories and astonishing facts – for example, did you know that “knocker-uppers” (the people who would walk the streets to wake workers up to go to their jobs in the early morning) were still operating in London’s East End into the 1970s? Please take a look at the video below for the interview. You can also find our whole series of interviews with economist authors on our Bond Vigilantes YouTube channel.

And if you’d like to win a copy of Philip’s book, answer this question: What prop did Philip bring with him for our filming? Enter HERE. T&C HERE. Closing date for entries is 5pm UK time on Friday 27th of March.

[This competition has ended]

 

Let me start with two predictions. Firstly that the title “2020 Vision” will be irresistible to all year-ahead outlooks, no matter what publication or industry you work in. This is why I trademarked the idea many months ago, and now expect to retire on the proceeds of all the copyright breaches. My second prediction is that in my industry, bond fortune telling, virtually all of those 2020 outlook pieces will declare that it will be the year that the “bond bubble” bursts. Maybe they’ll be right this year, after a 30-year streak of “sell bonds” predictions. But their track record doesn’t suggest they have an edge in the bubble popping business.

If you do believe that 2020 is the year for bond bears finally to triumph, I think you have to believe that a lot of very long term, established trends are about to come to an end simultaneously. These trends are the Secular Seven. If you think that their powers are at an end, or significantly diminished, then you should join the January anti-bond mob with their pitchforks and flaming torches. Otherwise you’ll probably want to wait to see a conclusive break in the 30-year downtrend in bond yields and inflation before saying goodbye to fixed income.

The Secular Seven

1 – Demographics. OK Boomers. The post-World War 2 baby boom impact on the economics of the developed economies can’t be overstated. In the 1970s and onwards as the Boomers left education and came to dominate the workforce, the labour scarcity that had been a feature of the western economies for a couple of decades started to come to an end. Trade Unions lost their membership and their power, and wage inflation dropped. Economies became more productive, and wealthier. With largely young and healthy populations, pressures on the welfare state (for example pension burdens, and care and healthcare costs for the elderly) were relatively subdued. As the demographic basketball (the Boomers) passed through the snake and reached peak earnings, their desire to save and invest those savings also hit new highs. Demand for income and safe assets grew dramatically – driving bond yields down.

2 – Technology’s impact on inflation. Why can’t we generate consumer or producer price inflation in developed economies despite zero or negative interest rates, “money printing” and periods of growth and low unemployment in the past decade which historically might have generated CPI of at least twice the current common inflation targets of 2%? The dramatic deflation in consumer goods is one answer, and a good part of that has been driven by the collapse in the price of technology. The 1996 Motorola StarTAC mobile phone cost $1000 then; a similar level phone today is about $200. 1996 was probably also the year I stopped hiring a TV (paying monthly) from Radio Rentals and bought one, as they’d become affordable. And it’s not just the cost of the hardware: I used to spend at least £50 a month on music on compact discs (and cassettes before that, which I note are now fashionable with youngsters). Now I pay £12.99 a month for all the music in the world on Spotify. Think also of all the free stuff that the internet provides, from maps to encyclopaedias and news, and perhaps the impact of low inflation is actually understated. The transparency of the internet also allows me to find the cheapest thing in the world whenever I buy something. Awful news for high street retailers, but the deliverer of a huge consumer surplus and disinflation. Finally, we haven’t even discussed the Rise of the Robots yet: what if AI and robotics are finally deployed in the workforce on a massive scale? What does that do to wages? To employment and disposable income? It certainly sounds like a further technological leg down in price inflation is possible.

3 – Independent Central Banks. When Paul Volker was appointed Chair of the US Federal Reserve Bank in 1979, inflation in the States was 11.3%, peaking in March 1980 at 14.3%. US Treasury Bonds were thought to be almost uninvestable as yields were eroded by the rise in the cost of living. Volker set the Fed Funds rate above the rate of inflation – at the time a radical idea. Inflation fell steadily through his tenure, and an “inflation fighting central bank” culture was established. This led to explicit inflation targeting around the world, from New Zealand through to Gordon Brown making the Bank of England independent, and on to an ECB which was so wedded to this inflation-fighting mandate that its President, Trichet, hiked rates twice in the midst of the Global Financial Crisis on the grounds that oil prices had risen year on year and had taken eurozone CPI above 2%. Central bankers have certainly taken a lot of the credit for the bond friendly environment we’ve been in for the past couple of decades, but it’s clear that this separation of their powers from elected politicians coincided with some arguably more powerful trends.

4 – Capitalism. As labour has become less powerful since the entry of the Boomers into the economy, capital gained the upper hand and has taken the bigger share of profits and growth in developed economies for years now. Governments have deregulated financial markets and labour markets (with some notable exceptions like the introduction of the Minimum Wage in the UK), and the emergence of the new tech giants (the FAANGs) has led to both increased competition in some areas (Amazon has delivered massive consumer surplus in its race to acquire market dominance) and monopoly creation in others (Google is a verb as well as an online advertising giant). Capitalism has thus kept wage growth low, and encouraged the growth of a tenuous gig economy landscape. Whilst there are examples of monopolies developing, as the land-grab continues, prices have stayed low. Take a look at some of the bloggers in the US who write about existing on free trial subscriptions (everything from mattresses to groceries) and half price food delivery offers as companies try to buy some market share. I’ve got a 50% off Uber Eats trial in my inbox right now. Burger or pizza?

5 – Globalisation. China joining the World Trade Organisation in 2001 didn’t start the process of globalisation, but it did signal that everything had changed, especially for manufacturing companies. The supply chain became a global one, and goods prices collapsed as we all imported cheap stuff made by people earning fractions of western wages. The liberalisation of trade barriers and tariffs, together with advances in the logistics and cost of containerisation and shipping, meant that manufacturing jobs went east and cheap goods flowed west.

6 – The Austerity Meme. I’ve been fascinated by the Reinhart & Rogoff “This Time is Different” book ever since it came out. Flawed in some of its initial calculations, its narrative of higher government borrowing leading to economic disaster nevertheless set the scene for a decade of austerity in many of the economies hit hardest by the Global Financial Crisis. Now the relationship between government borrowing, bond issuance and bond yields is surprisingly weak: you’d think that as governments issued more bonds, prices would fall. This turns out not be true historically, as times when governments borrow more have usually been those times when growth and inflation are weak. Nevertheless, the UK for example has seen relatively low bond issuance since the GFC as the result of the longest period of austerity recorded. Germany is running a budget surplus, despite stagnant eurozone growth. It’s therefore possible that this period of relatively low bond issuance at a time of weak growth has delivered lower bond yields than we’d have normally had.

7 – QE. We’ve had 3 rounds of Quantitative Easing from the Fed since the GFC. The Bank of England has also bought both gilts and corporate bonds. The Bank of Japan and the ECB have also massively expanded their balance sheets in bond purchase programmes. And the ECB has just announced endless QE in Mario Draghi’s parting policy announcement. Does QE reduce bond yields? Yes. A study of all the academic papers on the impact of QE around the world showed that on average the three rounds of US QE reduced US Treasury Bond yields by about 70 bps, 20 bps, and 10 bps respectively. Whilst inflation remains below target in most of the developed economies, it’s unlikely that we see any unwinding of the bonds held on central banks balance sheets – in fact some of us think that these bonds will never be set back into the wild, and will mature in the dark of those central bank vaults.

So are any of the Secular Seven under threat?

Yes. Many of them look to be less powerful than they were at their peak, although it’s possible that we’ve only so far seen the first stages of technology’s impact on wages and inflation: companies are sitting on cash piles that will be invested in productive technology at the first sign that their flesh and blood robots are achieving higher wages. An example of this in action was the introduction of self-service ordering systems in fast food restaurants after minimum wage increases for workers in those US businesses.

Demographic trends remain in place, although the never ending increases in life expectancy that we’d come to expect have stalled in some demographics, thanks to obesity related illnesses and opioid addiction. There are also some stark differences across the developed world, with birth rates in the US much higher than in parts of Europe, implying higher potential growth rates in America in the future. Japan shows us that even when labour force growth peaks and declines (Japan is a decade ahead of the west demographically), this isn’t enough on its own to combat entrenched deflationary forces.

Have we had enough of independent central banks? Donald Trump certainly has if you read his tweets over the past year. Fed Chair Jay Powell has come under immense pressure to cut rates towards zero again, and if Trump is re-elected in 2020 you have to imagine that Powell is replaced by someone more willing to turbo charge the US economy. In the UK, Mark Carney remains as the Bank of England Governor for the time being, but you could imagine some post-election outcomes that deliver some partisan choices as his replacement. Incidentally, the Bank of England just announced it is changing the title of its Inflation Report. It will now be the Monetary Policy Report which, if Sod’s Law has its way, will mark the return of rampant price rises. Central banks took the credit for the collapse in inflation over the past thirty years – and as I’ve discussed they were just one smallish part of that story – so they shouldn’t be surprised to take the blame now that inflation is too low for comfort, and this will undoubtedly threaten their mandates.

Whether capitalism’s dominance of the economic system continues to the same extent rather depends on a couple of rather important election results. On the electoral front, whilst neither candidate is a bookmaker’s favourite to take office, both Jeremy Corbyn in the UK and Elizabeth Warren in the US have a chance of power, and both have radical agendas which would likely involve higher rates of corporation tax, wealth taxes, financial transaction taxes and higher government spending. Monopolies in the tech space could be broken up, and financial regulation could tighten once more. Nationalisation of some industries couldn’t be ruled out. After a period of right wing populism in the UK (Brexit) and US (MAGA), the pendulum might swing the other way, and the left could take its revenge. Coupled with existing protectionism movements in the US (the trade war with China could be cooling, but has already damaged the global economy) and new European trade barriers post-Brexit, the left’s anti-globalisation philosophy (on the grounds that it produces a race to the bottom in workers’ rights) could exacerbate the stalling on global trade flows.

We go into 2020 then with some of the tailwinds for falling bond yields having been diminished, and one in particular – that of the austerity meme – likely to have turned into a headwind, with some potentially large increases in government borrowing in prospect. Also importantly, our starting valuations for “risk free” assets are unattractive, with most developed market government bonds having negative real yields. I don’t believe that a negative real yield is in itself an aberration, and we should come to regard the elevated real yields of the 1980s as the exception rather than the rule (you could get RPI plus 4% when you invested in index-linked gilts for a time), but clearly government bonds are expensive historically.

All of this means that I too will end 2019 with an underweight view on government bonds, expecting yields to move higher next year. But on any significant move up in bond yields, I’d want to buy back my gilts, bunds, Treasuries and JGBs, as many of the Secular Seven trends remain powerful, and there are clearly significant economic and social fragilities in the global system that could trigger further central bank policy moves – both traditional (rate cuts) and extraordinary (rate cuts below zero, more QE) – and a new flight to quality. We ain’t out of the shadow of the GFC just yet, and with more debt in the global system than there was in 2007, rising bond yields themselves could trigger the next big downturn.

Finally, remember that the global government bond market sets the “risk free” rate which is the major input in the valuation of all asset prices – from corporate bonds, to equity, to property. So if you are expecting a bond blood bath, the impact on other asset classes could be even more severe…

No doubt the main thing that Mario Draghi will be remembered for is his famous “whatever it takes”. He told financial markets that the Eurozone was not about to collapse and made it clear that the ECB would save the banks and peripheral sovereign nations of Europe.

More interestingly, however, is to think about how Draghi found himself in the position to be able to QE and to undertake other exceptional monetary policy actions in the face of quite severe opposition, especially from countries like Germany.

When we look at the Eurozone crisis we must remember that by then the euro currency itself was just over 10 years old. The first two ECB presidents, Wim Duisenberg and Jean-Claude Trichet, with their Northern European mindsets, had established the Eurozone currency area’s credibility. In the case of Trichet, this inflation hawkishness had led to the ECB making the biggest policy mistake of its young history, in hiking rates in the midst of the Global Financial Crisis.

So when Draghi, with his Southern European mindset took over, the eurozone was already established as a credible currency area. And more importantly, it had already experienced hawkish policy errors. If the eurozone crisis had happened shortly after 1999, I expect that the currency block would have disintegrated. So Trichet’s failures allowed Draghi to experiment. And in the absence of fiscal policy coordination, and with markets punishing profligate borrowers, it was entirely left to monetary policy to do the economic heavy lifting.

So the ECB and Draghi did save the eurozone, but at what cost? Well, we now have too many “zombie” banks and companies in Europe, used to cheap money, and this will depress future growth. And we also know that QE has diminishing returns as central banks do more of it, so the incoming Christine Lagarde will find that more bond buying will have less bang for the buck.

But history will be kind to Mario Draghi – in a world where politicians refused to save the eurozone through fiscal redistribution, he did “whatever it took”. It wasn’t perfect, but it was the best we had.

Economists usually think of “bubbles” as being negative for economies and societies. Think of the US housing bubble and its role in the 2008 Global Financial Crisis as a great example. Defining a bubble is tricky, and often its causes are difficult to explain even with the benefit of hindsight. In their paper “Bubbles in Society – the Example of the Apollo Program” Gisler & Sornette say that during bubbles “people take inordinate risks that would not otherwise be justified by standard cost-benefit and portfolio analysis (and they are) characterised by collective over-enthusiasm as well as unreasonable investments and efforts”.

Making a case for bubbles, they declare them to be a “necessary evil to foster our collective attitude towards risk and break the stalemate of society resulting from its tendency towards stronger risk avoidance. An absence of bubble psychology would lead to stagnation”. They call this the “pro-bubble” hypothesis and suggest five examples of pro-bubbles: the 1840s British railway boom; the Human Genome project; the internet boom of the late 1990s; animal cloning (Dolly the sheep) and finally, the US Apollo programme.

As we reach the 50th anniversary of the first moon landing by Apollo 11, it’s interesting to look back to the 1960s and the period following John F Kennedy’s 1961 speech, which challenged the US to “land a man on the moon and return him safely to the earth” by the end of the decade. This endeavour is important for the technological advances it brought about. In 1965, Gordon Moore postulated his eponymous theory that the number of transistors in an integrated circuit doubles every two years. It was the need for this lightweight computing power onboard the Apollo spacecraft that helped kickstart and sustain the development of Silicon Valley, but also led to the development of the device you are reading this blog on. Interestingly, it also caused a change in emphasis on monetary and fiscal policy. During the 1960s, fiscal policy was used as an accelerant on a “normal” peacetime economy on a sustained basis, which saw the normalisation of budget deficits. The Fed also moved away from preventing financial imbalances towards an inflation fighting role – one which it failed to fulfil. As with echoes of Trump’s pressure on Powell today, it was persuaded (including by physical force) to let the US economy run hot.

The US started the 1960s in recession, with GDP falling by 1.6% between April 1960 and February 1961 and unemployment hitting 7.1% later that year. President Kennedy had been elected on a programme of higher spending and tax cuts, and of coping with a “New Frontier” – a catch-all which included the space and military race with the Soviet Union, and domestic issues around racial and economic inequality. Congress passed legislation for spending on public works, farm assistance, food stamps, minimum wages and hospital construction. There were also permanent tax cuts for individuals and businesses. And to fund the goal to put a man on the moon, NASA’s budget rose from less than 0.25% of the total federal budget in 1960, to around 4.5% by the end of the decade. The moon landings cost $25 billion, more than $150 billion in today’s money. They also resulted in NASA and its contractors employing over 400,000 people. There was unease about the extent of government spending on these projects (and Kennedy himself had grave doubts about the value of the moon-shot just two months before he died) but after JFK’s assassination the new President Lyndon Johnson (LBJ), with a backdrop of overwhelming public grief, declared that the project would continue, and that the launch centre would be named after Kennedy. On top of government spending, the private sector also loosened its purse-strings (thanks in part to spill-over effects from the space and other programmes, but also due to the corporate tax cuts), with capital spending doubling over the course of the 1960s.

With the fiscal levers all set to “go”, the economy recovered quickly. Real GDP rose to 6.1% year on year in 1962, and peaked at 6.6% in 1966. Inflation was initially well-behaved, averaging around 1.5% between 1960 to 1964, but in the second half of the decade it began to accelerate, averaging around 4% per year. So did the Fed take away the punchbowl? No.

Going back a decade, in 1951 the Treasury-Fed Accord ended a period of conflict between the Truman White House and the Fed, resulting from Truman’s insistence that the Federal Reserve supported government bond prices to finance the Korean War, despite rising inflation (10%+ in 1951). The Accord separated the responsibility for debt issuance from the monetary policy function to “minimise monetarisation of the public debt”. From then on it was “bills only” for the Fed, rather than it manipulating longer dated bond prices. The Fed’s independence and its role in “leaning against the wind” led to it hiking in the late 1950s as inflation rose to 3%, triggering the recession that Kennedy inherited.

The new administration was hostile to this inflation-fighting Federal Reserve so Operation Twist was introduced to once again reduce longer term US Treasury yields – it also boosted shorter bond yields to reduce capital flight as the administration feared a gold crisis. With price pressures emerging as fiscal stimulus took effect and invigorated the economy, LBJ and Congress believed that any move by the Fed to tighten monetary policy by hiking rates would be going against the democratic will of the people. Both Kennedy and Johnson also appointed Keynesian Governors to the Fed’s FOMC, making it more difficult for Fed President William McChesney Martin to hike. The pressure was even more intense that this implies – in 1964 President Johnson invited Martin to his Texas ranch and “physically shoved him around his living room, yelling in his face, “Boys are dying in Vietnam, and Bill Martin doesn’t care”” (from The Man Who Knew. The Life and Times of Alan Greenspan by Sebastian Mallaby). The parallels with the Trump administration’s pressure on Fed President Jay Powell do not go unnoticed.

The Fed did hike rates, but not until 1966 when inflation had already accelerated. Anticipating fiscal consolidation (that never really arrived) it wasn’t until 1969 Martin realised that restrictive monetary policy was required. It was too little too late, and the inflation genie was out of the bottle. Martin’s term ended in 1970 (in his view, in failure) and US inflation averaged around 6% for the next few years, accelerating into the mid-teens by 1975. US Treasury bond yields rose alongside inflation, hitting 8% at 10 years by the end of the 1960s.

So the arguments that the space programme was a “pro-bubble” aren’t entirely clear cut. There were consequences from running the US economy too hot for a decade, and the 1970s became known for high inflation, recessions, western manufacturing decline and high unemployment. The 1960s normalised budget deficits; under Kennedy and Johnson the deficit was around 1% of GDP (but as growth was so strong the post-World War 2 debt to GDP ratio fell dramatically over the decade, from around 55% to below 40%). Under Nixon it was -1.6%, and Ford -3.5%. By the time Reagan decided to repeat the Kennedy/LBJ economic stimulus policies the deficit was at 4.3%. But the goal to land a man on the moon certainly did have significant technological benefits for humankind, and likely accelerated that progress by decades. It also showed what is possible when humans set out to solve a problem by throwing money and resource at it – something that can give us a glimmer of hope when it comes to thinking about the problems of today, like the current climate emergency.

A decade on from the Global Financial Crisis after multiple rounds of QE across the developed economies, we are stuck with mediocre growth rates, the anticipation of renewed policy easing and the prospect of yet more bond buying from the ECB.

Yet much of the academic research into the impact of QE suggests there are diminishing returns from successive bouts of bond purchasing. It also seems likely that by boosting all asset prices in distorting the value of the risk free asset (gilts, treasuries, bunds etc) the unintended consequences – like a rise in inequality – might be doing more harm than good.

In this short video I interview the famous financial author, Frances Copolla, about her new book – ‘The Case for People’s Quantitative Easing’ – the cover of which shows a helicopter dropping bank notes on the town below. That should give you a clue as to some of her suggested alternative ways to stimulate economic activity! Whether policy makers are willing to go that far is debatable, but policies like student debt relief, or money printing to fund a Green New Deal could certainly find real world support.

 

We are also running a competition to win a copy of Frances’s book. To win a copy, answer this question: how much QE has the Bank of England done in the U.K.?

[This competition has ended]

Author: Jim Leaviss

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