The writer is co-founder and chief investment strategist at Absolute Strategy Research
Regime changes are hard to spot — they only occur every 20 years or so and often slowly, rather than in a single moment. However, financial historians may look back to January 19, 2021 as a key date.
This was when Janet Yellen announced at her nomination hearing to be US Treasury secretary that it was time to “act big” on fiscal easing against a background of near zero interest rates.
Those two words, act big, may come to define the “Yellen moment”, when the economic policy and investment regimes of the past 20 years ended and a new one began — much as Paul Volcker’s 1979 declaration of his fight against inflation as US Federal Reserve chair defined the next two decades. A similar effect on markets was seen when European Central Bank president Mario Draghi declared in 2012 he would “do whatever it takes” to save the euro.
Why might the Yellen moment be a regime change? First, it may signal a return to the closer, pre-1997 relationship between the Fed and the Treasury than the style of greater central bank independence seen since.
Yellen, a former Fed chair, is an ultimate “insider” who understands monetary policy theory and practice and, also, how fiscal and monetary policy can be interlinked. This “spend-now-pay-later” narrative reflects a deep understanding of the way the Fed can fund additional spending.
Second, the act big narrative may signal a move away from an over-reliance on monetary policy (often hamstrung by fiscal rectitude) that led to a decade of muted recovery and undershot inflation targets. A world of loose monetary and fiscal policies may take its place. As the Treasury and the Fed work together to fight the pandemic, they may find this combination has powerful effects on the real economy and markets.
The 1950s may be an investor guide as to what the outcomes might be. After the second world war, the Fed engaged in financial repression, keeping rates low to help fund the national debt, while the Treasury engaged in greater fiscal activism. The result was dynamic economic growth, with nominal GDP growth peaking at eight to 10 per cent three times through the decade. Dynamic growth delivered dynamic markets, with equity returns beating bonds by over 50 per cent year-on-year at their peak in 1955 and over 40 per cent in 1958.
Another parallel may be the way Japan’s monetary-fiscal mix changed after the Plaza Accord of the mid-1980s. Policymakers used lower rates and fiscal expansion to limit the yen’s rise and boost domestic demand. However, it also resulted in debt-driven asset bubbles which saw real estate and equity prices more than double between 1985 and 1990 (with Japanese price-earnings multiples rising from 32 times in 1985 to peak above 70 times in 1987).
If the Treasury is keen to act big on fiscal policy, and the Fed to meet its maximum employment target, it is likely they will let the economy and markets run hot.
Even if the American Rescue Plan is $1tn, rather than $1.9tn, US nominal GDP growth could reach 7 per cent year-on-year by the fourth quarter of 2021, a growth rate seen only briefly since the 1980s. This move towards “escape velocity” could challenge bonds as the yield curve steepens and 10 year Treasury yields head toward 2 per cent from around 1.3 per cent now.
Strong economic and earnings growth, combined with low policy rates, also increases the risk that US equities could see the kind of debt-fuelled rally experienced in 1980s Japan. Despite already extreme US equity valuations, these expansive policies could see multiples beat previous peaks.
This may sound too good to be true for policymakers and investors. But be careful what you wish for. “Japanification” is now synonymous with the decades spent working off the debt built-up in the 1980s, rather than the gains investors enjoyed in the middle of that decade.
We see worrying parallels emerging in the US. Unlike the deleveraging seen in most previous recessions, US debt levels have increased sharply in the Covid-19 recession. Private sector debt increased by 9.5 per cent of GDP last year, pushing the 10-year growth rate up to 15 per cent of GDP (the fastest debt growth in 50 years).
As the IMF noted in its Financial Stability Update, policymakers have no alternative but to do what it takes to create “a bridge to the recovery”. The worry is this also creates conditions for medium term financial instability. In which case, it could turn out to be “a bridge to nowhere”.