Poking the Bear

Dating back more than a century, the colorful idiom came into prominence during the Cold War as a warning to avoid angering the nuclear-armed Soviet Union. “Poking the bear” refers to an act of deliberately antagonizing someone or something to provoke a reaction, an apropos expression that can be easily applied to several prominent issues today. The parallel for today is that long dormant inflation may be awakening from its lengthy hibernation as fiscal and monetary authorities seem intent upon poking this great grizzly.

With the introduction of a $2.3 trillion infrastructure plan, on the heels of the $1.9 trillion coronavirus relief bill, the Biden administration is accelerating an already aggressive fiscal policy stance. While higher corporate taxes have been proposed to pay for the “American Jobs Plan,” its focus will be on roads, bridges, broadband, and research and development, and it is only part one of an enormous investment plan. Part two of Biden’s ambitious plan will release additional details in the weeks ahead and will likely cost another $1 trillion and $2 trillion. As the economy has already entered a healthy recovery phase, these massive stimulus programs threaten to bolster growth too much, potentially prompting overheating and forcing a premature policy response.

Aggressive policy making is nothing new to the Federal Reserve and its global central bank brethren. Since the Great Financial Crisis in 2008, the Fed has married its zero-interest rate policy, or ZIRP, with a plethora of additional programs as it attempts to attain its dual mandate of full employment and stable prices. Maintaining orderly financial markets has been seen as a prerequisite to its efforts and has led to an unprecedented expansion of the Fed’s balance sheet. While mainly concentrating on purchases of U.S. Treasuries and mortgage-backed securities (Quantitative Easing), the Fed boldly expanded into other parts of the market in March 2020. To ensure that credit markets remain available to corporate borrowers, the Fed developed programs which included purchases of investment grade and high yield bonds and ETFs. Though only a relatively modest amount of corporate bonds was purchased, the mere announcement of Fed support quickly remedied much of the liquidity issues and market valuations swiftly rebounded. Now, a year later, with markets functioning quite smoothly, the Fed has maintained a very sizeable $120 billion per month of QE and has kept the Fed Funds rate at zero. Fed Chair Powell has been quite clear that the Fed does not intend to hike short-term rates until at least the end of 2023, so easy monetary policy is expected to remain for the foreseeable future. Some strategists have argued that QE will be tapered in the second half of 2022, though the Fed has remained noncommittal. Any continued increase in longer term bond yields may, in fact, push the Fed to increase, rather than decrease, the purchases of longer maturity Treasuries to keep a lid on rates and limit any damage to the economic recovery.

The backdrop of extremely aggressive fiscal and monetary policies would likely be enough on its own to improve GDP growth and increase broad price measures. Following a year of the global pandemic, with varying degrees of economic closures, the rollout of vaccines and re-opening of most facets of the economy are certain to unveil a significant amount of pent-up demand. Areas that were hit hardest, such as restaurants and travel, will experience meaningful bounce backs.

Prior to the pandemic, the nationalist movement was already well in swing, causing global supply chains to become stressed as countries focused on moving production back home. As Covid spread across the globe, supply chains suffered further damage as shortages from toilet paper, beef, and technology products became evident. Highlighting the fragility of supply chains, the six-day Suez Canal blockage caused by the grounding of the enormous Ever Given container ship will further pressure prices for numerous goods. Coupled with rising commodity prices, heightened input costs should translate into higher goods prices in the months ahead.

After stumbling out of the gate, U.S. vaccination progress has been gaining momentum, recently administering a record 4 million shots in one day. With more than 70% of adults over 65 years old having received at least one shot, and more than 40% being fully vaccinated, the U.S. is well on its way to herd immunity. Though it remains difficult to obtain a vaccination appointment in many states, supplies are ramping up and most states are accepting appointments for all age groups within the next few weeks. The expectation that a majority of the population will be fully vaccinated within several weeks may hasten the recovery and push growth expectations higher. To date, analysts have been consistently increasing GDP estimates as numerous signs add to the optimism for a full reopening in the months ahead. With many anticipating a healthy 5% rate of growth, several firms have lifted expectations in recent weeks. In March, the Fed elevated its 2021 GDP forecast from 4.2% to 6.5%, while Goldman Sachs and Morgan Stanley noted the more aggressive fiscal policy responses as central to their improved estimates to 8% and 8.1%, respectively.

Robust growth will help to repair the employment sector, which suffered dramatically during the second quarter of 2020. Having reached nearly 15%, the unemployment rate has steadily dropped to 6.0% in its most recent release. Despite adding 916,000 new jobs in March, nearly ten million U.S. workers remain unemployed, and the rate of those underemployed, as measured by the U-6, remains stubbornly high at 10.9%. Thus, while slack in the jobs market may limit immediate wage pressures, average hourly wages have risen by 4.2% over the past year and government transfer payments will add considerably to disposable incomes. The combination of pent-up demand and a high propensity to spend will result in much of this income disbursed on goods and services and enable companies to pass along higher prices.

For many years, there have been economists and market strategists arguing that inflation is poised to rise. Following the Great Financial Crisis and the extremely accommodative monetary policies by global central banks, the predictions for inflation grew louder during the eventual recovery. Years later, following the absence of price pressures, most market participants have abandoned the old-school Phillips Curve framework as they no longer believe there is necessarily a trade-off between employment and inflation. More recently, other historically important concerns have dissipated as Modern Monetary Theory, or MMT, has shifted from a fringe theory to a more mainstream philosophy. MMT proposes that a government that controls its own currency can spend freely, rather than be constrained by tax receipts or budget deficits. Government spending can grow to help the economy reach its full capacity without worrying about deficits since money can always and easily be created to pay off indebtedness. Though many traditional economists take great umbrage with MMT and its proponents, various legislators and policymakers appear to have embraced its tenets, which is only likely to gain more followers and further open the floodgates for additional government spending.

The growing list of evidence supporting strong growth and higher inflation is mounting. Extreme fiscal and monetary efforts, coupled with the economic reopening, pent-up demand, robust growth expectations, and a de-globalization movement are primary reasons that commodity prices have soared, the yield curve has steepened, and market-implied inflation rates have elevated. With all these forces working toward higher price levels, it certainly begs the question as to the rationale for introducing policies that may increase the risk of overheating the economy or incite too lofty an increase in inflation. Said another way, with so much improvement visible in the U.S. and abroad, why poke the bear and risk angering it?

Should the great bear awaken, the Fed may be found guilty of prodding it too much. One possible stick to the hibernating bear is the Fed’s change in its inflation targeting. In the aftermath of the pandemic-induced economic shutdown, most of the Fed’s immediate responses were both necessary and helpful. However, the more recent altering of its inflation target is more worrisome. For years, the central bank has employed a 2% inflation target, with an understanding that it served as a ceiling. Breaches above this threshold would be dealt with promptly to ensure a stable price environment. However, the Fed’s adoption of a symmetrical target of 2%, with extended shortfalls being offset with sustained overshoots, strikes many as dangerous. Having registered average price gains, as measured by the Fed’s preferred core PCE price index, of approximately 1.5% for the past decade, this newly adopted framework suggests that the Fed should now attempt to have inflation run hot at 2.5% over the next several years.

The Fed, in its ever-growing dovish ways, will label the upcoming increase in price levels as transitory, one of its favorite and most reliable excuses for inactivity. Due to the economic shutdown and falling prices that occurred from March 2020 through May 2020, highlighted by a -0.7% CPI reading in April 2020, the base level comparisons for the year-over-year inflation measures are certain to appear considerably above recent figures. Thus, in this instance, the appearance of surging prices may not provide an accurate depiction of ongoing price changes, but it is unlikely to return to the more subdued 1-2% range any time soon. Money supply has grown at an impressive clip, with M1 and M2 measures surging 21% and 18%, respectively, over the past year. Though this expansion of money supply has not yet proven inflationary, much of that is due to a depressed velocity of money. Stay-at-home measures, business shutdowns, and heavy job losses contributed meaningfully to a reduction in the rate at which money changes hands, but this should begin to change with the vaccine rollout and business reopenings, as well as the sizeable job gains and government transfer payments to households. Other inflation signals support the case for higher price levels. Commodity prices, including precious metals, have gained considerably over the past year, with the CRB index up more than 10% year-to-date and greater than 51% over the past year. The steepening of the yield curve is also indicative of stronger growth and inflation. Having been as flat as 11 basis points in Feb 2020, the yield differential between the 10-year US Treasury note and 2-year US Treasury has widened to 158 basis points at the end of March 2021. Market-implied inflation, as measured by the difference between the same 10-year US Treasury note and the 10-year TIPS, has also confirmed investors’ changing opinion of upcoming inflation. From its recent March 2020 nadir of 55 basis points, the market is now expecting the inflation rate over the next decade to average 2.37%, the highest level since 2014.

The Fed’s determination to maintain its zero-interest rate policy and refrain from tapering QE for the foreseeable future, as well as the substantial fiscal largesse, threatens to not only awake the sleeping bear from its slumber, but also may resurrect the long-absent “bond vigilantes.” Coined by Wall Street economist Ed Yardeni back in the 1980s, this group of bond market investors first came into prominence in the 1980s with their retaliation against the undisciplined actions from fiscal and monetary policy makers. Whether reckless spending or inflationary monetary actions, the bond vigilantes would aggressively sell bonds and push yields higher, thus punishing past deeds and warning authorities that the market will not accept policies that reignite inflation.

While few market participants seem overly concerned by the unprecedented monetary and fiscal activities, with market manipulation and supportive actions becoming both commonplace and eagerly accepted, there may still be a small contingent of bond market investors that believes unfettered money printing and spending could become problematic. As such, the first quarter finally experienced a noteworthy increase in benchmark yields, with the ten-year Treasury increasing from 0.92% at year end to 1.74% at the quarter’s close. Though credit spreads remained well behaved, price declines were felt across intermediate and longer-dated bonds.

Although the nascent return of bond vigilantes may not be enough to pressure policy makers to moderate their vast spending and excessive monetary accommodation, it may have served as an early warning shot to certain investors and could curb dangerous behavior. Following the crazed trading in meme stocks, epitomized by the frenzy with GameStop shares, and the blowup of highly levered Archegos Capital Management, the shift higher in rates might reduce some of the most egregious speculation. And should the move up in rates become more pronounced, risk assets will certainly face increased pressure. However, a significant deterioration in financial markets would be met with either monetary action, namely yield curve control, or additional fiscal stimulus. The Fed is quite aware of the damage that higher rates can cause, especially as households, businesses, and governments have become accustomed and reliant upon inexpensive financing. In addition, as low risk assets become more attractive, some investors will no longer need to stretch for yield in higher-risk securities, thus posing a further threat of market danger. For these reasons, if rates move too high, likely 2.50% on the ten-year, the Fed will embark on yield curve control to establish a ceiling on rates or even to push them back to a more comfortable level for the markets.

Following such expansive efforts, the Fed should be determining appropriate exit points in which it could wean investors off their dependence. Based upon recent comments by the Fed, generosity knows no bounds. In addition to its desire to allow inflation to run above 2%, the Fed seems to have also adjusted the target for the second part of its dual mandate, full employment. Rather than focusing on headline unemployment figures, the Fed will place increased weight on sub-indices. Unemployment for minorities, wage growth for the bottom quartile, and labor force participation for those without college degrees comprise important statistics that the Fed will more closely monitor. The central bank intends to delay monetary tightening until this new definition of full employment is reached, pushing back the field goal posts and making the challenge considerably more difficult.

It appears that the rules of the game are changing, with the definitions for the Fed’s dual mandate becoming more loosely interpreted. At the same time, fiscal stimulus is ramping up to untested heights. Since the markets have grown more dependent upon government aid, tapering either type of stimulus will likely be pushed well into the future. But with equities near all-time highs and the economy projected to produce robust growth, additional monetary and fiscal support should be used judiciously as excessive stimulus can create considerable risks. This may no longer be a simple stick, but rather a red-hot poker that could awaken a very angry bear.

This article was originally published as part of Lido Consulting’s Spring 2021 newsletter.