ZIRP and QE have deflected the threat of debt deflation. But at what risk...?
IN OUR YOUNGER DAYS, when we used to rock climb, this was known as the crux – a move or series of moves that were particularly dicey and could leave you dangling from the end of rope 20-30 feet lower in a dazed state if you failed to finesse them, writes Rob Parenteau of the Richebächer Letter.
As we have documented in recent weeks, the list of US macro series showing stable nominal levels over the past 3-4 months continues to increase. These include retail sales, new orders for durable goods, and imports of materials and finished goods.
But that is not what usually happens in a debt-deflation dynamic, which cumulatively builds on itself.
Our read always has been that the wave of debt-deflation dynamics building last year would provoke a massive policy response. While home price deflation is still ripping, and headline consumer price indexes are showing mild deflation, it appears the debt-deflation risk is being contained by extreme fiscal and monetary measures.
Stability is better than free fall, but it is not the same as expansion, and we believe equity investors have shoved valuations high enough over the past three months that they now require signs of economic growth – not just stability – to carry equity indexes higher. We think the odds of them getting that could improve after we get past the auto production and dealer downshift later in the summer, but the rise in Treasury yields is becoming alarming.
While there were no failed auctions this week, longer-dated Treasury bond yields continue to back up not just on supply issues, but also as private portfolio preferences have moved toward riskier assets and, in some cases, into inflation hedges on the bet the Fed will be forced to monetize the growing fiscal deficit.
Our view has been unless the commercial banks start putting some of their $1 trillion in cash holdings into Treasuries (thereby picking up net interest income to rebuild profitability and balance sheets), the Fed will be forced into taking steps that imply a ceiling in Treasury yields is in place. The only other way out we can see is if the US macro news flow relapses and private portfolio preferences shift back to less risky assets, which puts equity indexes at risk of a sell-off.
So from a strategic point of view, we believe equity investors want and need to see stronger economic and earnings results to drive indexes higher, while bond investors need just the opposite to calm Treasury yields down. In addition, through near-zero interest rate policy (ZIRP) and quantitative easing (QE) approaches, the Fed has been trying to push private investors into riskier asset classes while the Treasury's debt issuance calendar implies they need private investors to prefer owning Treasury bonds, which are generally not the asset of choice in an economic recovery scenario.
In other words, we have contradictory crosscurrents here. If the Fed doesn't intervene to slow or halt the Treasury yield backup, there is a chance the stabilization in unit home sales will wither away. If the Fed does step up QE operations to halt the Treasury yield rise, professional investors taking the "green toilet paper" view will continue to sell dollars and buy commodities. Down the line that implies higher energy prices for consumers and higher input prices for manufacturers, neither of which we would consider growth supportive developments.
Our concern is the green toilet paper contingent has the Fed in a corner for the moment with a trade that initially could look self-fulfilling, along the lines of the infamous Soros 1992 trade against the British pound and the Bank of England. At the moment, we honestly cannot see an easy resolution unless some Goldilocks growth path (not too hot, not too cold) develops, but we would we need to monitor this one very closely.
To wit, we can envision the following scenario feeding on itself. Because you cannot have:
- A central bank pursuing near ZIRP and QE, which, after all, are designed to trash cash and force private investors out the risk spectrum into equities, corporate bonds, mortgage bonds, lower rated debt, etc;
- And also have the Treasury issuing loads of public debt at the same time from a massive fiscal ease designed to reaccelerate the economy without expecting Treasury yields to increase.
Not unless the central bank and commercial banks are willing to soak up Treasury issuance with money creation, or unless the Treasury can get away with "underfunding" – that is, direct monetization of the deficit.
There is a policy incompatibility problem, in other words, or at least really incoherent expectations management. And that puts the Fed on the spot.
Do they choose to cap Treasury yields by explicitly stepping up QE operations and buying more Treasury bonds in the open market (or possibly more mortgage-backed securities, to thereby decouple mortgage rates from rising Treasury yields)...? Or do they just let Treasuries find their own equilibrium, accepting the risk the economy may relapse again as 10-year US Treasury yields sail through 4%...?
Let's say Helicopter Ben Bernanke decides he does not want to take the tail risk of setting off the next Great Depression. He doesn't want to go there because he has already exhausted his bag of unconventional monetary policy tricks and he knows he will have to come up with even crazier policy moves, like buying equities outright or making direct loans to companies, if he faces a relapse in economic activity. That means if he flinches, some investors will take that as a sign to increase their short dollar/long commodity trades...
- which feeds inflation fears...
- encouraging more investors to sell existing Treasury holdings to the Fed...
- which creates more "monetization" of public debt...
- and more short dollar/long commodity trades...
- eventually begetting more intervention by foreign central banks trying to defend the Dollar and thereby prevent their own currencies from kiting higher by creating their own money to buy dollars...
- which transmits inflation fears out of the United States into a wider range of countries...
- creating a fantastic, self-fulfilling feedback loop.
Stepping back, one could see this as a doomsday machine for fiat currencies...Shades of Soros 1992, when he took on the Bank of England and broke the Pound, except this one is larger scale, with much more at stake.
We intentionally avoid sensationalizing our analysis – the world is a wild enough place without all the hype. But we feel it important to flag this one for you, because we can see how this dynamic could feed on itself...and we know professional investors have been trained over the serial asset bubble years to flock toward such trades...and we can see how policymakers may be checkmated by professional investors.