The Emerging Hangover
As the world continues to move past the global pandemic with rollouts of vaccinations and rollbacks of social distancing restrictions, we are entering a period many strategists/economists are (affectionately?) observing as the ‘base effect.’ Beyond year-over-year inflation readings but more broadly across capital market and economic conditions, we are moving further away from the worst of last year’s global shutdowns on the path towards normalization.
Starting this month, we will begin to anniversary the worst of the pandemic shutdown (capital markets turmoil and severe economic contractions) as financial markets and consumers / businesses yearn for the return to pre-COVID normalcy. Credit to global central banks (notably the U.S. Federal Reserve) and government spending stimulus (notably China and the United States).
U.S. Financial Conditions (Figure 1 – a loose measure of risk appetite) have recovered to pre-pandemic levels, which can also be seen in other ‘risk-on’ appetite measures such as risky corporate credit spreads (Figure 2) and municipal borrowing spreads (Figure 3). Risk appetite continues to recover despite a rise in long-term interest rates, which have only marginally affected financial conditions as relative borrowing costs for riskier borrowers remain at cyclical low levels. If you are an institutional-level borrower (balance sheet strength need not matter), now is as good of a time to borrow as evidenced by Verizon’s $25 billion jumbo-sized debt issuance from last week.
Figure 1 – GS US Financial Conditions Index Tighten from Post-Pandemic Lows But Remains Comfortably Loose
Figure 2 – Riskier Corporate Borrowing Costs Relative to U.S. Treasuries Remain Historically Low
Figure 3 – Despite the Rise in 10-Year Treasury Yields, Municipal Borrowing Costs Remain at Historically Low Levels Relative to U.S. Treasuries
Indeed, we are seeing more evidence of the ‘base effect’ materializing, whether in consumer comfort (Figure 4) or travel activity (Figure 5), even though one can argue that, at least with broad-based activity measures, we have only recovered half of pre-pandemic peak activity levels. As many left-leaning politicians, central bank officials and economists have argued, monetary and federal support measures must continue at a pace to ensure a higher probability of returning to pre-pandemic activity in short order. This means maintaining dovish central bank policies of quantitative easing and zero-rate targeting and additional government spending, whether pandemic relief support or infrastructure spending (likely to be attempted later this year when Congress can resort to budget reconciliation to push through another major spending initiative).
Figure 4 – Bloomberg Consumer Comfort Index Recovers from Last Year’s Pandemic Lows But Remains at Half of Pre-Pandemic Peak Levels
Source: Bloomberg (Weekly Consumer Comfort Index)
Figure 5 – US TSA Travel Checkpoints Continue To Point Towards Travel Recovery But Still Remain Below Pre-Pandemic Peak Levels
Source: Bloomberg (TSA Travel Checkpoints)
The Fed increasingly finds itself backed into a corner trying to meet conflicting goals of 1) maintaining financial market stability, 2) encouraging employment to reach pre-pandemic levels, and 3) supporting profligate government borrowing through balance sheet expansion and yield curve control (and not compromising its independence) while 4) ensuring it doesn’t lose its inflation fighting credibility fought so hard to obtain from the late 1970s/early 1980s Paul Volker era.
Readers of our past blog articles going back to July’s piece, “Pig in the Python: The Growing Threat of Inflation”, will note we’ve been documenting a rising risk from the road to pandemic recovery: namely the emerging bottleneck risk, as in capacity constraints across raw material inputs, global shipping, housing, and travel/leisure. As more these risks come to fruition, the global economy is facing a new potential risk: that of hitting a deflationary wall once the euphoria of the post-pandemic recovery wears off, the base effects normalize, and the financial tab comes due for all the monetary and public borrowing initiatives to support the recovery. The challenge we may face as we look ahead beyond the urge for pre-pandemic normalization is an economic cliff-drop of deflationary countermeasures imposed by either central bank/government policies or compelled by the financial markets (a.k.a. the return of the Bond Vigilantes). This morning, the Biden Administration floated a trial balloon of raising $2-4 trillion in higher taxes over a decade to fund infrastructure and climate initiative spending.
As we wrote in our February 2021 Market Commentary, we believe the Federal Reserve is particularly sensitive to the state of financial conditions and the health of capital market activities – the last thing the Fed wants is a repeat of last year’s capital markets meltdown. Hence, U.S. dollar appreciation (Figure 5) and a rise in real (inflation-adjusted) interest rates (Figure 6) could indicate two early warning signals of financial system stress. We got a glimpse of this at the end of February following a disastrous Treasury auction that was met with U.S. dollar and interest rate volatility.
Figure 5 – US Dollar Appreciates from Post-Pandemic Lows – A Volatile Rise Could Indicate Financial Market Stress Figure 6 – Real (Inflation-Adjusted) Interest Rates Are Rising But Remain Well Below Pre-Pandemic Highs – Further Volatility Could Indicate Stress in U.S. Government Borrowing
Source: Bloomberg US Treasury 10-Year Real Interest Rates
So far, at least, inflation conditions remain ‘transitory’ despite upcoming base effects that foresee higher inflation over the next several months (Figure 7). Notably, the base effect is expected to show up more in overall readings (due to higher energy and food costs) rather than ‘core’ readings. The Fed remains committed to keeping their benchmark rate near the zero level despite Fed funds and Eurodollar futures pricing in a rate hike a year sooner than what is implied by Fed forecasts (2022 versus 2023 at the earliest).
Figure 7 –The Expected Base Effect in Upcoming Consumer Price Index (CPI) Releases
However, the tab of deficit-financed spending and profligate private borrowing may come due just as monetary authorities hit the theoretical wall on how much government borrowing (Figure 8) can be supported through central bank balance sheet expansion (Figure 9), as higher interest rates only pressure the U.S. government’s net interest burden (Figure 10) due to historic levels of borrowing. Can the Fed temper market expectations for higher interest rates just as government borrowing accelerates with this year’s $1.9 trillion pandemic spending package and a likely infrastructure spending package to come next year?
Figure 8 – U.S. Federal Debt Expected to Exceed 200% of GDP by 2051
Figure 9 – US Debt Issuance in 2021 Expected to Exceed Fed’s Ability to ‘Monetize’ Government Borrowing
Figure 10 – US Net Interest Burden to Become a Greater ‘Burden’ Should Interest Rates Continue to Rise
So far, there is little indication of ‘hangover’ stress implied by financial market risk appetite (which remains at euphoric levels). But whether through higher taxes and/or a pivot towards hawkish rate policies compelled by bond market vigilantes (attempts at yield curve control notwithstanding), hangover risk occurring sometime in 2022 may start to emerge as this year’s primary risk once the euphoria of post-pandemic normalization starts to wear off. And the risk of an emerging hangover is not what is fully appreciated by current financial market pricing.
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By: Benjamin Lavine