Authored by Michael Every via Rabobank,
The markets sent a clear message yesterday: they don’t buy all the inflation story. How else does one interpret US-year Treasury yields reversing Wednesday’s 10bp jump to fall below 1.50% again, and 30-year yields plunging 17bp intra-day, closing down 12bp? Or the broad DXY dollar index jumping for a second day? Or commodities continuing to tumble, with US corn futures down nearly 7%, soybeans -6.7%, and wheat -3.4%?
The mere threat of acting on rates to a minimal degree two and a half years from now --and an unexpected rise in US initial claims-- prompted the bond market to recall that beneath our Covid- and supply-chain distortions still lies the New Normal. That’s a backdrop which as recently as 2019 had everyone worrying about secular stagnation; and it suggests Fed rate hikes into an economy which even their own economic projections show can run ultra-low unemployment rates AND low GDP growth AND low inflation would be a policy error, just like the last US tightening cycles where the yield curve flattened towards inversion.
As importantly, the Fed won’t sell all the inflation story. Massive QE is staying in place given that despite long-term dot-plottery we are still “substantially” short of clarity on when any tapering will happen. This is not the sign of a central bank that believes that absent asset-price inflation there is much of an economic game in town.
Yet one can also see the Fed does not like one form of asset price inflation at all: in commodities. Can you imagine for a solitary moment how the Fed would react if S&P futures were down 7% on the day in response to their perceived hawkishness, rather than corn? Or if house prices were suddenly 44% off a ridiculous peak, rather than just lumber prices? In this, the Fed and the PBOC are of one mind: let’s keep commodity prices stable at a “reasonable” level. The alternative is a far-too evident, pocket-book-walloping inflation for consumers and businesses. Central banks clearly want house prices going up - but not lumber, iron ore, steel, copper, concrete, glass, or plastic; nor the wheat, butter, meat, and vegetables that go into the BLT a builder might have in their lunch-box.
Here we come to a quandary touched on before, and related to the New Normal, QE, and Build Back Better: how to get capital to flow where governments and central banks want it to, creating only ‘healthy’ inflation.
It’s easy to throw trillions into the financial system via QE – but it does not flow into productive investment and then to wages. It is now clear even to those who never read Kalecki arguing the same thing a century ago, that without *structural reforms* you just get asset-price inflation. Yet central banks want to hypothecate which kinds of assets get inflated: equities – yes; housing – yes; rude-named cryptocurrencies – no; commodities – no. That is despite the fact that commodities are key inputs into one of the assets on the ‘allowed’ list. Obviously, this can’t work for long, meaning commodities won’t stay down if real demand stays up.
On which note, the current Congressional dynamic and US stock-market addiction means it would arguably take a major correction in asset prices (and I do not mean corn or wheat) to get enough votes for such stimulus to pass. As the old joke about an would-be insurance scam has the prospective policy-holder asking: “So how do you start a flood?”
Meanwhile, let’s presume there isn’t one. What next, to get liquidity where needed? How about extending the current ECB and PBOC schemes to incentivise banks to lend where desired. Well, imagine a bank is incentivised to lend $500m to a firm because what it does is seen as important to the state; but the firm’s CEO realises there are higher profit margins elsewhere and lends that money on, or buys or makes a different product, or speculates on land via the back-door. All of which happens all the time in one economy I could mention.
Could we not leap to decentralised finance, where blockchain tech allows central banks to lend directly to firms? This could make loans to each firm not fully fungible: here is $500m for firm X to buy inputs Y and Z in order to make product A at price B. Mission accomplished! Except this is how Soviet planned economies worked! Funds were made available from the central bank to firms only as part of state five-year plans, with specified details of how the *non-fungible* currency had to be spent. And the result was economic ruin and empty shelves due to repressed inflation – because what does a central bank know about how to manage every firm in every sector in the entire economy?
In short, the Fed might think it is sitting pretty right now, but attempts to both inflate and not inflate asset prices are doomed to failure however one looks at it – and this will be made much clearer if we see a major US fiscal stimulus. Indeed, the whip-saw market action we have seen in the last two trading sessions is just a warm-up for what comes next. (And that is before we look at issues like US equity options expiry today.)
Meanwhile, I have not even mentioned the mess at troubled Chinese giant Huarong, which is selling off assets and has been dropped from the MSCI EM equity index; but I will note that the same MSCI who happily introduced Western investors to the delights of this Huarong volatility yesterday flagged that they are now considering the launch of a new cryptocurrency index.
And geopolitics is making that same point as above on a different front. The US Commerce Secretary has stated there are discussions with allies about adopting a standardized approach to mitigation measures against the use of apps originating from “foreign adversaries”, forcing them to keep all user data in the West, or perhaps not collecting it at all – which sounds like more of the rhetoric we heard at the G7 and NATO and the EU-US summit. Tick, tock, tick, tock TikTok (and others)?