Bretton Woods Committee | Wed, Feb 24, 2021
by Jason Schenker
First Comes the Feeding…
COVID-19 was the greatest public health crisis in a century, and it engendered the greatest economic crisis since the Great Depression. By some measures, the economic dynamics in the second quarter of 2020 were even worse than those of the Great Depression. Against such a backdrop, unprecedented fiscal and monetary policies were necessary to preserve jobs, prevent financial market collapse, and keep the global economy afloat.
Thankfully, worldwide increases in government deficit spending and accommodative monetary policies kept the global economy from collapse. Fortunately, economies are now in recovery and the labor market, however weak, has improved greatly from Q2 2020 levels. But a new specter is haunting global markets.
The necessary and effective accommodative monetary policies designed to buoy the global economy in crisis have been crowding out investors of risk-free assets. The logical follow-on of investors chasing yield has engendered a tectonic shift across financial markets as the prioritization of investment returns now greatly supersede concerns of risks.
Everything Seems Expensive
With a lack of return in risk-free assets, traditionally risk-averse investors have shifted to much riskier assets. This, in turn, has pushed investors with higher risk tolerances further up the risk curve. For some seeking high yields no matter the risk, there may be almost no limit to the level of risk they will take. This is something that could create imbalances with significant future negative outcomes.
During the week ending 19 February 2021, the Dow and NASDAQ hit new all-time intraday highs. Copper prices skyrocketed above $4 per pound, LME aluminum prices traded up to almost $2,150, WTI crude oil prices traded briefly over $62 per barrel, and Bitcoin hit a new all-time high around $57,500. Real estate prices are up significantly across many markets, steel prices are soaring, agricultural prices are up significantly, and Bloomberg published an article highlighting the value of investing in sports trading cards.
What’s next – a return to speculative investing in Beanie Babies?
High Yield Debt Market Imbalances
Most worrisome in this recent trend of asset inflation is the fall in yield for the lowest quality bonds junk bonds. Last week, the ICE BofA CCC and Lower U.S. High Yield Index Effective Yield was at a record low of 7.17%. CCC bonds are often defined as having a 50% chance of default. And yet, those are the highest rated bonds in this series for CCC and lower. This is a clear sign of risk imbalances and an extreme search for return.
Asset Inflation is Not Consumer Inflation
Even though asset values have risen, this is not the kind of inflation that impacts central bank policy. But it still presents risks that cannot be ignored – at least not for long. Although effective in the deepest throes of the COVID crisis, unimpeded central bank policies of high accommodation could continue to fuel further asset inflation.
Based on Fed Chair Powell’s statement on 23 February 2021, the Fed is still quite intent on bolstering the labor market further by letting inflation run above its long-run 2 percent target in the short run. In many ways, this makes all the sense in the world because inflation was so low in 2020 – and because the latest jobless claims report from 18 February 2021 shows that 18.3 million Americans were still collecting some level of unemployment benefits as of 30 January 2021.
But will the Fed stick to the policy of letting inflation run hot when it actually happens? It is easy to assert with CPI and Core CPI inflation in January 2021 at only 1.4 percent year on year. But those consumer inflation rates could be a lot higher in Q2 2021 due to a year-on-year base effect. With the risks of higher policy rates at some point, one also has to wonder, will financial markets be prepared to absorb the inevitable shocks that come with the end of an era when almost the entire economy seemed too big to fail?
…Then Come the Morals
Investors are making increasingly risky investment decision, and the Fed is facing an increasingly difficult choice.
On the one hand, the FOMC can stay the course articulated in its December 2020 FOMC member forecasts and keep rates near zero past the end of 2023 – even in the face of higher inflation rates. This seems to be what Fed Chair Powell’s statement seemed to indicate on 23 February 2021. But if that happens, what will it mean for asset inflation?
On the other hand, the Fed could begin planning the removal of monetary accommodation that goes against its recent guidance. Such action could cause a swift repricing of assets in equity markets, while causing bond market prices to fall – and yields to surge. Of course, markets may begin sharply repricing assets before the Fed even has a chance to take any initial steps to slow QE or raise rates. A shakeup across asset classes may come regardless of Fed policy if investors see high enough inflation rates. This could also be enough to greatly impact global capital flows and liquidity in emerging markets.
No matter the short-term strategy, Fed accommodation will slow at some point. And when it does one thing seems certain: the longer asset inflation continues, the greater the reverberations across global financial markets will be when monetary policy tightens.
Jason Schenker is President of Prestige Economics and Chairman of The Futurist Institute. He is the author of 32 books, including The Future of Finance After COVID. He is currently ranked the #2 major currency forecaster in the world by Bloomberg News and he has frequently appeared on Bloomberg Television, CNN, and CNBC.