It felt too good to be true and maybe it was. The Panglossian optimism that prevailed in the markets over the summer has faded thanks to perceptions of a weaker growth momentum in the global economy and, more especially, in those twin engines of global growth, the United States and China.
Business and consumer confidence has waned, job growth has been disappointing, energy prices have skyrocketed, and supply bottlenecks are everywhere. That, in turn, has led to growing concern about inflationary pressures.
Central bankers who previously insisted that rising inflation was purely temporary are now reconsidering it, raising the possibility that they may soon reduce the support they have been offering to a recovery that now appears to be waning. In a delicately revisionist phrase, Andrew Bailey, Governor of the Bank of England, has speak of possible circumstances in which “the transience would be longer.”
Since September, the result has been falling stock prices and rising bond yields. This has created problems for conventional portfolios that comprise 60 percent stocks and 40 percent bonds. The change in the correlation between the two asset classes means that there is no longer a rise in bond prices or a drop in yields to offset the pain if stock prices fall.
That is what happened in the great stagflation of the 1970s, which was also marked by rising energy prices. Drastic increases in interest rates were required to curb rising inflation expectations. Under Paul Volcker, the US Federal Reserve raised official interest rates to about 20 percent in 1981. In an effort to re-anchor expectations, the Federal Reserve kept rates above inflation into the new millennium. .
In the early 1980s, the economies of the developed world were much better equipped to handle steep increases in interest rates than they are today. Debt levels were low, whereas now, due to the pandemic, world debt in 2020 jump by 14 percent to a record $ 226 trillion, having seen a large increase earlier after the financial crisis of 2007-09. That reflected the ultra-flexible monetary policy of central banks that encouraged borrowing and a bond market bubble.
Another consequence of the Fed’s suppression of Treasury yields through its asset purchase program, highlighted by TS Lombard’s Seven Blitz, is that stocks have become a massive percentage of net worth. of households in the US and therefore have a huge impact on consumer discretionary spending. He believes the implication is that an overvalued equity market has become a vigilante governing the Fed’s actions.
This seems counterintuitive. Bond market watchers in the 1970s imposed fiscal discipline by refusing to buy excessive issues of government debt on the primary market. An equity watchdog today would be selling shares on the secondary market to pressure central banks into monetary indiscipline.
However, Blitz is on to something. There is no doubt that if the monetary authorities normalize policy, the resulting tightening of financial conditions could harm the recovery.
In his last Global financial stability report, the IMF says there is significant uncertainty about the effect of the normalization on asset prices given the larger role central banks play in sovereign bond markets, the anticipated increase in the supply of government notes and the cycles of divergent monetary policy between countries.
If anything, that understates things due to the extraordinary extent to which central banks have nationalized global equity markets. The IMF’s own figures show that the monetary authorities have increased the assets held on their balance sheets to about 60 percent of gross domestic product, almost double the level that prevailed before the pandemic.
Any reduction or reversal of the support that central banks now offer to the global economy and markets could have a devastating impact. Central bankers know this, and they also know that if their response to rising inflation precipitates market collapse and a recession, it could cost them their independence.
It follows that there could be a behavioral bias towards caution and delay in adjustment. However, the lessons from monetary policy in the 1970s and 1980s were that while the rise in unemployment resulting from early tightening could easily be addressed through a policy change, the delay would cause inflationary expectations to undock. Much tougher policy and a more severe recession were required to control inflation.
In fact, the delay was the Fed’s response under Arthur Burns, who insisted that the rise in food and oil prices was not a monetary phenomenon and therefore should be ignored. This is how the United States hit a benchmark political interest rate of about 20 percent and a horrendous recession in the early 1980s. Few now doubt that central banks will shortly cut their asset purchase programs.
However, investors’ deep conviction that monetary authorities will always come to the rescue if stagnant markets suggest that weak bond and equity prices will not turn into defeat just yet. That said, we are in an unstable equilibrium. In due time, something has to give.