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Good morning. Yesterday was opposite day in the US stock market. Things that have generally worked in the past year or so didn’t work (technology, financials) and the things that have lagged lately did well (energy, staples, real estate). There have been a couple of these inversions of the normal order lately. Is regime change coming? Send us your thoughts: unhedged@ft.com.

Causal and existential questions about fiscal dominance

After the Trump administration opened a criminal investigation into the Federal Reserve, I wondered why the markets didn’t seem to care about the threat to the central bank’s independence. One of the popular answers was that Fed independence is an academic abstraction, or possibly a pious fantasy, at a time when the US deficits are so wide and its debts so large that some form of central bank monetisation of the debt is inevitable. Why should markets care about something that, in effect, does not exist?

This back-and-forth prompted some mail from clever readers. One regular correspondent, a somewhat hot-tempered fixed-income manager, objected to the idea that the government’s fiscal incontinence was responsible for the subordination of the Fed and other central banks. In his view, the central banks did it to themselves (and to us): 

We got here because of [central banks’] extreme and experimental actions to try and move the inflation needle from ~1.7 per cent to 2 per cent [after the great financial crisis], with less than dubious theoretical and empirical justification . . . because of their inability to accept any drawdown in equities or the economy (Schumpeter be damned), because of their hearty embrace of this “excess/ample reserves” system with all its levered consequences . . . and because of their utter disregard for moral hazard (Bagehot is rolling in his grave), free market pricing, price discovery, and the unintended consequences of their persistent naive interventions. Governments today have no discipline because central banks of yesterday allowed them to learn terrible and damaging lessons. Now we are all trapped.

In other words: because central banks protected markets from the consequences of reckless government spending and correspondingly high leverage in the financial system, government spending and financial leverage have increased further. The system is now so precarious, and the consequences of a collapse so great, that the Fed has no choice but to intervene whenever the markets start to twitch. The moral hazard only gets worse; that’s the trap.

This view is most relevant in the context of overnight borrowing markets (as Unhedged discussed here and here). The “ample reserves” regime referred to above is the amount of financial system liquidity that allows the Fed to control overnight rates despite the upward pressure on those rates from the massive amount of leverage in the system. But it is sometimes hard to distinguish controlling short-term interest rates, which is monetary policy, from suppressing volatility by cramming cash into the system because otherwise the whole overleveraged monstrosity might explode, which is just an attempt to clean up your own mess. The perverted aspect of all this, my correspondent argues, is that the target of monetary policy was meant to be the real economy. Now the target is and has to be the financial system.

All this liquidity pumping will cause inflation, my correspondent says. Why doesn’t the bond market register this fact? Because it won’t be consumer price inflation. It will be financial asset inflation. The money central banks force into the financial system doesn’t leak out. This may not sound too bad; better asset price inflation than inflation in the cost of living. But the distributional consequences are nasty. Consider what has happened to consumer prices, house prices, stocks and wages since quantitative easing began in late 2008:

Wage earners (pink line) have got richer relative to the prices of most goods and services (dark blue line). But they’ve got poorer relative to house prices (light blue line) — houses are of course financial assets now. Meanwhile, shareholders (green line), as direct participants in the financial system, have quintupled their money and are wondering what everyone else is complaining about.

I’d be curious to hear what readers think about this rather bleak picture. But to give some sense of the range of opinion on these matters, another reader of Unhedged, Matt Klein of The Overshoot, wrote to argue that the reason that the bond market is not responding to a threat of debasement or “fiscal dominance” is that there is no threat to respond to. The synchronous rise in long sovereign bond yields in recent years isn’t about the approaching debt monetisation or a debt unsustainability crisis. It’s about somewhat faster real growth and higher inflation: 

I really don’t find the “fiscal dominance” argument convincing. The most obvious explanation for the rise in yields since 2020 is that yields were weirdly low and have since normalised as the economy improved. The 2010s were understood at the time to have been a period of abnormally slow nominal GDP growth and correspondingly low yields on fixed income, which nobody at the time liked. If we have exited that world it makes sense that yields would be higher. It is a story about inflation and growth expectations rather than deficits and debt dynamics.

Klein also pointed out to me that the idea that debt is becoming unsustainable is harder to maintain when you look at the wider context. What has happened is less a massive accumulation of debt than a transfer of debt from households to the government. Below is a chart of federal and household debt and the two combined, all expressed as a percentage of GDP. Note that the total debt burden (the light blue line) has been quite steady for 15 years:

What are my own views? What caused fiscal dominance? Does it even exist? I’m no longer sure. My head is spinning from thinking about it too much in the past few days.

One good read

On le Carré’s best novel.

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