Yesterday’s post dealt with how modern monetary theory might help your trading in the current environment. It focused on what I called the descriptive portion of MMT which explains how a modern fiat-based economy works. This next part will examine the implications for markets if the prescriptive part of MMT is adopted.
Before we go any further, I would like to highlight that even if you are a die-hard neo-classical or Austrian economics disciple who believes MMT to be nothing more than a rehashing of bad economic ideas from a few centuries ago (a claim that seems to fill my inbox whenever I write about MMT), ignoring MMT’s rising popularity would be about as smart (and effective) as a dog barking at waves in the ocean.
As traders/investors our job is not to decide the best way to organize society (we leave that to the much smarter politicians and economists), but to construct portfolios that will perform best under the existing circumstances. If you want to rail against MMT, then you are free to do. But I happen to believe you are missing a valuable tool for understanding how the economy and markets behave in the post gold-standard fiat-based world.
If in the coming years politicians adopt MMT policies, your outrage will do your portfolio little good. Therefore you might as well try as best you can to unemotionally analyze the implications of these potential policy implementations.
So without further ado, let’s try to determine how best to adapt to the MMT possibility.
Difficulty defining MMT
The first problem lies in the difficulty defining MMT. We know that at its heart, MMT centers around the idea that governments are not financially constrained by debt, rather they face a real resource limit (subject to certain conditions). It is easy to agree that MMT’ers believe there is more policy space for fiscal stimulus in almost all modern economies. For example, Donald Trump’s tax cut of late 2017 was entirely consistent with MMT policies. Even though a Keynesian would have argued that eight years into an economic cycle the government should attempt to balance the budget, MMT proponents would have counseled for more fiscal stimulus as inflation was running below target and there was still slack in the economy.
The problem arises in this next step. Given these beliefs about the way a modern fiat-based economy operates, MMT advocates recommend a variety of different policy options. Some want a universal job guarantee, others believe infrastructure spending should take priority, while many are pushing for a new green-deal that addresses climate change and finally there are those who believe significant cuts to payroll taxes are in order.
As MMT Professor Randall Wray stresses, “these are political choices with economic ramifications.”
There is no MMT recipe about how this fiscal stimulus should be structured. Yes, many MMT professors have argued for policies to address the underemployment problem and there are a variety of other programs popular in this crowd, but what holds them together is the belief that fiscal policy should play a much greater role in tuning the economy.
Full-MMT or the hybrid option?
We can agree that MMT supporters believe monetary policy should take a lessor role in macro policy, but to what extent? If I understand his position correctly, one of MMT’s founding fathers, Warren Mosler believes interest rates should be set to zero and all economic adjustments should be made through fiscal policy and tax adjustments. Now this is quite an extreme view. Does it make sense for us to determine portfolio implications for this outlier possibility? I don’t think so. Other MMT proponents have suggested that we should set interest rates to the target inflation rate so that hopefully, over time, the real rate is zero and there are no financial incentives to park money in riskless assets. Again, what are the chances that decades of a free market in bonds are abandoned in one fell swoop by the pinning of the whole curve to 2%? Not out of the realm of possibility, but probably too bold of an initial step.
Although these are interesting possibilities to debate, I view their adoption as extremely remote - as probable as Salma Hayek calling me up for coffee (see backstory here for a little of my thinking pre-MMT days and to learn about the freebie list).
So instead of wasting time figuring out what optimal portfolios should look like under a pure Mosler-MMT regime, I will focus on the most probable outcome which I believe to be a hybrid MMT world which combines elements of the current system with some of the new MMT thinking.
A brave new world
I have long chuckled at the idea that governments were powerless to create inflation. How many economies can you name that have collapsed due to deflation? I can’t name one. Yet the list is long and distinguished when it comes to those that have inflated it away.
But when you talk to bearish hedge fund managers, many will chastise you about the terrible problem of over-indebtedness and how it will end in a deflationary collapse. My favourite part? After warning about the problems of too much debt, they advocate buying the very asset they feel is the source of the problem!
Yeah, yeah - I know, in a deflationary panic, US government treasuries will outperform almost anything with a CUSIP.
But fundamental to their thesis is the belief that governments are powerless to create inflation.
That’s simply not the case under MMT. Although neo-classical economists are confused as to why the three rounds of US quantitative easing did not cause the massive inflation they warned about, MMT economists have no such bewilderment.
If they would have asked for the ‘tourist’s signature on that Open Letter to Ben Bernanke, I would have signed it. Back then, I too was worried about inflation. Yet I don’t see any MMT economists on that list.
No sense going through the theory behind it all, but MMT economists have consistently argued that the problem of too little inflation stems from the reliance on monetary policy and that the lack of inflation is entirely a self-imposed handcuff placed on the economy.
Handcuffs in the real world
Let’s revisit the Great Financial Crisis. The response from traditional economists was to inject increasingly large amounts of monetary stimulus into the dying patient. It would probably surprise the hard-money crew, but MMT proponents seem to agree with their Austrian brethren that this process was terribly handled.
During a lecture a couple of years ago, MMT Professor Randall Wray recalled how the American Central Bank did everything contrary to the Bagehot Dictum. In his famous book, Lombard Street, Bagehot argued that the Central Bank should lend freely, at a high rate of interest, and on good securities. Well, the Federal Reserve broke all three tenets. They did not lend freely but instead put quantitative limits on the amounts of loans. Instead of punishing the banks that needed to borrow, they subsidized them with discounted rates. Finally, the Fed took all their shitty credits. They did everything they could to help the financial economy while ignoring (or even worse, punishing) the real economy.
The reason I bring this up? MMT has a completely different solution than traditional economic theory.
MMT’ers don’t believe in force-feeding more monetary stimulus in the hope that somewhere it will ignite and cause an economic rebound. Although at the time I didn’t understand that my views were consistent with MMT, during the financial crisis I felt like the government’s response was ridiculous. The problem was a lack of demand, not “overly expensive” money. I argued that if the bond market was begging for an investable riskless asset, why doesn’t the government give it to them? At the time the 30-year US Treasury was ticking just above 2%. Instead of doing more QE, why didn’t the government float a gazillion of 50 or 100-year paper (back then I thought the government had to borrow first) and install internet-fiber to everyone’s home? Or fix all the bridges and airports. You know, something productive. I figured that even the government could invest the capital at a rate which would yield a return greater than the 3% interest rate I reckoned the bonds would trade at.
This won’t be a problem with MMT
I know it’s bat-shit-crazy, but the Federal Reserve is once again heading down this same road. They are currently setting the table for negative interest rates in the United States. Even though it’s clear that negative rates have been a disaster in Europe, during the last FOMC meeting the San Francisco Fed submitted research which argued that negative rates could have helped the previous recovery.
Make no mistake. Putting this sort of research into the record is the first step in the Federal Reserve adopting this policy.
It doesn’t mean they will, but this is the first step.
However, if MMT were adopted, it would mark the end of this fiscal-austerity-monetary-easing madness.
What portfolio changes should you make under MMT?
Enough messing around with what went wrong under the previous economic policy regime, let’s get to how it will be different under MMT.
I will assume it’s not pure MMT that gets embraced, but instead a hybrid implementation that relies less on monetary policy as a ballast against economic downturns, and rather uses the fiscal policy space to its fullest.
The political decisions regarding this fiscal policy will obviously affect specific industries. If AOC’s New-Green-Deal is adopted, then it’s clear that green technology stocks will soar. That kind of call is easy and not much value add.
I am more interested in the macro changes that will affect our portfolios for years and decades to come.
Which brings me to one of my main conclusions. Inflation, which had previously been a difficult target for the Central Banks to hit, will become more prevalent.
In fact, the MMT crowd will dislike me for this comment, but I suspect it will be a case of “be careful what you wish for, you might just get it.” And this not a criticism of MMT, but of politicians. Once politicians figure out they are not financially constrained, they will abuse the privilege.
Now please don’t send me comments about how this beats the status quo alternative. I agree. Yet that still doesn’t change the fact that as investors, the proper bet is to assume that the problem goes from lack of inflation to the opposite end of the spectrum - too much inflation. And no, I am not saying we will blast off in some hyper-inflationary spiral. I would argue it will be more like a secular shift upward in the rate. Whereas previously the 2% inflation target seemed to act like a ceiling, under MMT it will behave more like a floor. Not the end of the world, but a change that has serious repercussions for portfolios.
First trade - sell your bonds
If we get a sustained rise in inflation, it makes zero sense to own bonds. And no doubt in my mind, under MMT there will be more inflation. Full stop. That’s the whole goal. Use up the fiscal space until inflation becomes the real constraint.
I think it was Warren Mosler who called Treasury Bonds basic income for the rich. Well, that’s going to change under MMT.
No longer will financial assets be favoured over real productive assets. Therefore the risk reward for owning Treasuries becomes heavily skewed to the negative. Even if the MMT gurus manage to keep inflation at target, it will make US Treasuries at best a push in real return terms. And if inflation gets away from them on the upside, then bonds will get crushed.
Under MMT, treasuries will be a terrible trade.
Yet this will probably be a good thing. Bonds will be declining for the “right” reasons. They won’t be selling off due to credit concerns or lack of demand. They will decline in price because there will be more productive things to do with your capital.
It’s not like this trend wasn’t long in the tooth. We are now almost four decades into one of the greatest bull markets of all time, it was most likely a poor risk-reward even without MMT.
But let me be clear. The adoption of MMT will be the unequivocal end to the bond bull market and most likely the start of a rather large bear market.
Second trade - put on the steepner
Although with the adoption of MMT I am a huge bond bear, I don’t foresee the Federal Reserve cranking rates. In fact, I view the recent showdown between Trump and Powell as just a taste of what’s to come. I suspect that even though the Federal Reserve would like to offset any fiscal stimulus with higher rates, it will be extremely difficult for them to do so.
Therefore even if the economy and inflation picks up from the new policies, the Fed will find it difficult to raise rates and get ahead of the curve. Which is why I believe the trade for the next cycle will be the yield curve steepener. I believe that eventually we will hit record wides.
I suspect we will easily see 500 basis points in the 5-year versus 30-year Treasury yield spread. I know that seems preposterous, but don’t forget it wasn’t long ago that market participants thought negative rates were impossible.
Third trade - buy real assets
Ben Hunt, the author of the great letter Epsilon Theory is no fan of MMT. Although I don’t always agree with his views, I am open to the idea that I am wrong. Yet when I read Ben’s pieces I realize that he understands better than most that MMT is coming. Although he curmudgeonly complains about it, he is getting his portfolio ready. Ben believes there is a secular change occurring in inflation. Check. I agree. Ben’s next point? That financialization is coming to an end. Though I think he has a slightly different take on it than me, I will still steal parts of his narrative for this next trade.
Over the past few decades, Wall Street has increasingly been chosen over Main Street. Home owner gets in trouble? “Dumb” school teacher should know better than to buy two houses. Banks get in trouble speculating in mortgage securities? We need to bail out AIG/Citi/etc so the system doesn’t collapse!
The double standard has been disappointing to say the least.
Under MMT this will change. Productive assets will be worth more. Purely financial assets less.
Real estate will be bid. Goods with fixed assets will go up in value as inflation rises and the economy expands.
There will be a shift as the world will begin to resemble more the economy of old.
Fourth trade - value over growth
I have a theory that under MMT we will see a return of value stocks. Right now with so little real growth, investors are overpaying for the few growth stocks that somehow manage to defy the muted expansion. When you think about the fact that growth stocks are the longest duration of the equity styles (future earnings are pushed out the furthest and are therefore most sensitive to interest rates), rising rates will cause growth to underperform.
Now this is probably my trade with the least conviction. And there is a possibility that I am just talking my book - desperately trying to find a reason to justify my love affair of value over growth. Yet I firmly believe that with the introduction of MMT, equity markets will undergo a radical rotation. Investors have spent the past nine years since the Great Financial Crisis chasing the few remaining growth companies along with any stocks with a stable dividend. It’s been somewhat of a barbell. I am not sure how to articulate it, but I suspect with more MMT the middle will go bid and the ends will be sold.
Markets are always changing - don’t get stuck in the past
There was a time in the early 1980s when investors couldn’t imagine inflation ever slowing.
Seems funny now, but that was a real concern. I know many of you don’t like what MMT stands for. You believe it somehow changes the rules or that it will end badly. So be it. And who knows? Maybe you are right. But if MMT is coming regardless of your dislike, then why not prepare your portfolio as best you can?
Remember that markets are always changing. All I am confident about is that no one knows anything for sure (which reminds me of that joke about the trader who was never wrong. He thought he was wrong once, but he was mistaken.)