The Bond Market Is Broken; Long Live Fiscal Policy
As central bankers gather for the Fed’s Jackson Hole symposium, they’re getting tired of being the only game in town.
“The global bond market is broken,” Paul Singer reportedly wrote last week to investors with his hedge fund firm, Elliott Management. The extraordinary monetary policies of the world’s major central banks have prompted investors to chase yields deep into negative territory, producing an unsustainable bond bubble, he warned, adding, “The ultimate breakdown (or series of breakdowns) from this environment is likely to be surprising, sudden, intense, and large.”
Singer’s critique was just the latest in a long list of jeremiads against monetary authorities going back to the early days of the postcrisis world. Bill Gross sowed the seeds of his own demise at Pacific Investment Management Co. back in 2011, when he warned that U.S. interest rates would surge when the Federal Reserve ended its bond buying, and he unloaded his Treasury holdings. In 2014 Singer himself famously proclaimed to see “the leading edge of hyperinflation” in the lofty prices of East Hampton real estate and high-end art. Instead, rates have continued to plumb new depths, and inflation has remained below target — in the U.S. and many other countries — for years.
The idea that irresponsible central banks are distorting markets, driving down yields and forcing investors to take unwanted — and lowly compensated — risks is a comforting narrative for asset managers struggling to generate returns. But investors arguably have more to fear from central bank impotence than from hyperactivity. And ironically, it’s central bankers themselves who are proclaiming the limits of their powers to manage economies and deal with political risks like Brexit.
As Janet Yellen, Mario Draghi and other leading central bankers prepare to gather in Jackson Hole, Wyoming, tomorrow for the Kansas City Fed’s annual economic symposium, fears that monetary policy has been exhausted will feature prominently in the debate. John Williams, president of the San Francisco Fed, set the tone for the meeting with an August 15 paper pointing out that the natural rate of interest — the short-term rate that is neither expansionary nor contractionary for the economy — has fallen sharply in advanced economies since the global financial crisis. The natural rate, which was estimated at 2 to 2.5 percent in those economies before the crisis, now appears to stand at about 1.5 percent in the U.K., near zero in the U.S. and below zero in the euro area. In such an environment, central banks can’t stimulate growth with conventional rate cuts, making it more likely that economies will remain mired in slow growth with policy rates at, or even below, the zero bound — former Treasury secretary Larry Summers’ secular stagnation scenario.
Williams argued that a fundamental rethink of monetary policy is needed, and suggests two possible solutions: an increase in the Fed’s 2 percent inflation target, to reduce the risks of rates hitting the zero bound, and replacing inflation targeting with a policy targeting the growth of nominal GDP. But even those revolutionary changes wouldn’t be enough, he wrote: “There are limits to what monetary policy can and, indeed, should do. The burden must also fall on fiscal and other policies to do their part to help create conditions conducive to economic stability.”
Sounding a more optimistic note, Yellen’s deputy, Stanley Fischer, said in a speech August 21 at the Aspen Institute that the Fed was close to meeting its objectives of full employment and 2 percent inflation. But he, too, argued that monetary policy alone can’t get the U.S. out of its low-growth, low-productivity funk, saying the solution lies in better fiscal and regulatory policies.
Fischer seemed to be laying the foundation for a rate hike later this year — in September or, more likely, after the election, in December. Many Fed officials are eager to normalize rates to prevent the buildup of unseen risks and give themselves ammunition to counteract any future slump. Singer and many other investors would no doubt welcome a tighter Fed. But the odds that rates will return to anything like normal precrisis levels any time soon seem remote.
When the Fed made its initial 25-basis-point hike back in December 2015, members of the Federal Open Market Committee were predicting a further four hikes in 2016. Instead, they haven’t budged, holding off because of sluggish growth, a strong dollar and concerns about softness in the global economy. The market consensus sees one hike, at best, this year. Bond yields have plummeted, meanwhile, reflecting the impact of negative rates in much of Europe and Japan. The yield on the Treasury’s benchmark ten-year note has actually fallen by 75 basis points since that December Fed hike, to 1.55 percent.
The Fed won’t get any help from overseas. Look at the U.K., where the Bank of England has cut its policy rate by 25 basis points, to 0.25 percent, and embarked on a fresh round of quantitative easing — including buying corporate bonds — to support the economy in the wake of the June 23 vote to leave the European Union. Governor Mark Carney is determined not to follow the ECB down the negative rate path, seeing it as a counterproductive trap, but markets aren’t convinced that he will succeed. The ten-year gilt yield has plunged by 83 basis points since the Brexit referendum, to just 0.54 percent.
What Carney and the markets have succeeded in doing is to drive up the U.K.’s unfunded pension liabilities, a direct consequence of the plunge in rates. That gap has more than doubled since the start of the year, to £139 billion ($183 billion), according to consultancy Mercer, and exposed the irony of Brexit: A vote intended to enable Britons to take back control of their country has left them poorer and more exposed to the global low-rate, low-return environment.
Unconventional monetary policies have helped the advanced economies recover, but those policies have diminishing returns, particularly when rates go below zero. Inflation remains subdued, consumers are inclined to save as much as spend, and businesses are hesitant to invest. At a time when governments can borrow at a cost of literally next to nothing, maybe it’s time that they do so and invest the proceeds in infrastructure, education and other public needs. Prime Minister Theresa May is promising to do as much in the U.K., while infrastructure spending is about the only thing on which Donald Trump and Hillary Clinton seem to agree.
Paul Singer may rail against irresponsible fiscal policy in years to come, but if a shift to more public spending can lift growth and inflation — and bring an end to the era of zero rates — that may be a trade worth making.
Follow Tom Buerkle on Twitter at @tombuerkle.