Bending the Economic and Fiscal Rules

The Great Financial Crisis (GFC) market turmoil was spread over many months with no end in sight, with a sense of belief that in cutting rates to zero that monetary policy was extinguished. It was a truly scary time with thoughts that the banking system would collapse under Non-Performing Loans. Compare that against the current climate where markets dropped very quickly, followed by the current relative period of calm as participants took comfort in the knowledge that governments would support economies at any cost, crucially with the backing of Central Bankers in “my size your size” amounts that will not have negative economic consequences.

Like many during the GFC, I thought it inconceivable that Central Banks in Developed Markets (DM) would expand their balance sheets. I had read numerous books on financial history and had followed the travails of various Emerging Market (EM) countries who had printed money. Debt monetisation was bad – history showed it was a terrible policy with important negative consequences - full stop.

The lesson from the GFC was clearly that future recessions would be met by expansive fiscal policies financed by Central Banks expanding their balance sheets. As expected, therefore, Governments have announced huge fiscal policies to counter the effects of the Covid19 pandemic, which coincided with an initial rise in government bond Real Yields. This rise was stopped in its’ tracks by Central Banks announcing balance sheet expansion policy to buy government bonds, and this was crucial to subsiding risk asset volatility. Policy makers have seemingly restrained the bears, but what next for policy and asset prices?

Financial Experts

There has been an abundance of former Central Bankers giving credibility to the announced huge expansion of CB balance sheets – see articles by Bernanke and Yellen, Draghi, Charlie Bean and Philipp Hildebrand. They are rolling back years of economic thinking, going against the fiscal rules that they espoused as Central Bankers and ignoring promises they made that QE was temporary in nature (in Bean’s case, he still suggests that this new financing is in temporary in nature despite his previous unkept promises). But their credibility must be working when commentators write: “it must be borne in mind that all the world’s major central banks are creating vast amounts of money, which proves that this is the correct strategy in this situation”. Like QE being sold as “temporary” in nature, vast expansions of balance sheets are now taken to be the “correct strategy” with little actual debate whether it is or not.

The “Only Solution”

The reality is that as soon as Governments had taken the political decision to tremendously expand their fiscal policy, there was no alternative option but for Central Banks to announce that they would monetise that debt. There are no excess savings or buffers for rainy days that can be diverted to fund the government. Private sector leverage is as high as it has been post-war so the only way to fund extra debt without causing private sector assets to fall further is for Central Banks to leverage their own balance sheets to buy the government debt issuance.

So the question is not whether the bonds issued to finance the deficit will be funded by the Central Bank or not. The lessons post GFC, backed by the ex-Central Bank experts, is that it will. If there is any doubt about this, look at the net US Treasury debt issuance and Fed “QE” data for the last 2 months.

The Fed’s balance sheet expanded by $1.45trillion since the beginning of February, of which $778bn was to purchase US Treasuries under its’ QE program. This $778bn swamps the “mere” $600bn of net supply, so the Fed has already taken $178bn of net bond free float out of the market. $178bn is a huge number - to put it into perspective, it is almost identical to the US Treasury’s net supply of debt for the ENTIRE year of 2007.

Debt monetisation has already started in the US BEFORE the $2trn of extra supply to fund the new Covid19 fiscal spending comes to market.

But there remain some important unanswered questions

The important unanswered questions that need answering to determine risk asset valuations are

· how large will fiscal policy really be?

· where will the money be spent?

A recent article by Willem Buiter, who understands the risks of over indebtedness as well as the risks to the breakup of the Eurozone from too much fiscal spending (1), estimates some numbers for the potential declines to GDP (10-20%), lost tax revenue (30-40%) and rises in fiscal deficits (10-20%), which contribute to significant rises in debt/GDP ratios (~30%) by the end of 2020. These ratios are not that distant from the “conservative” numbers that I have calculated.

Whilst the indications are that the US Government will spend at least $2 trillion, there is a question whether the $500bn for distressed companies and $350bn earmarked for small businesses will be enough (total US Corporate debt stands at $16,058bn). It would not come as a surprise if that aid was increased, which should result in a serious increase in the FED’s balance sheet over time as the issued debt gets financed by them. Who will receive the money and in what form remains very open to debate - will cash flow negative zombies get help and at what equity/senior debt level with what strings attached? Where and how the aid then gets spent by consumers and corporates is hard to fathom until the money gets distributed – what if it is used to deleverage as society becomes more conservative? If pre Covid19 leveraging of balance sheets increased the values of companies, does a deleveraging of balance sheets lead to the opposite?

The Eurozone is far more complex due to the Deficit rules in place to protect confidence in the single currency. Whilst there have been announcements to increase fiscal deficits, it is clear that much more is required and there is no agreement on how this money will be raised (ESM, EIB, Coronabonds), what limits need to be respected, and who will finance the increased debt issuance. Today’s EU Finance Minister meeting will try and hash out a solution, but there remains a stark contrast between the roads that the US, China and Japan are taking, and the road taken by the EU.

Market Correlations

Correlations between different risk asset classes remain very high. Credit, equity and levered FX move all together, but there are some correlations that have changed.

Although still relatively high, EM Correlations to DM risk assets have started to decline. The correlations between the S&P and EM FX and EM Equity indices (FXJPEMCS and MXEF) have declined as the latter have not managed to rebound as much as Developed market equity indices. EM fiscal and central bank firepower is more limited, and some countries don’t have the same infrastructure to combat the Covid19 pandemic as efficiently as DM counties.

The strong positive correlation between 10year UST Bond yields and the S&P has been slowly eroding and has now broken down – they are no longer correlated. The same happened when the equity market started recovering in Jan19 after the 4Q18 sell off. This fits very well with the macro theme of debt monetisation and stable lower for longer yields.

Another important correlation to have changed is Gold. Below left shows that since the S&P put in a bottom, Gold has now become positively correlated to the equity index, flipping from being negative, just like it did in Jan19 after the S&P’s 4Q18 losses. This is not necessarily due to CPI inflation - inflation breakevens have continued to hold their positive correlations to the S&P – more likely this is about debt monetisation supporting the “real” value of gold.

It’s tempting to say that there is a new market environment where risk assets rebound following the tailwind of huge sums of money being spent, whilst interest rate curves remain low and gold appreciates to bring a “real” value when currencies are being debased. But the pressing issues remain of how the money will be spent and whether Europe will really be able to come to a proper agreement that will allow market participants to feel as comfortable as those in the US.

The probable divergence between German and Italian, Spanish and French Debt/GDP ratios will lead to very tough decisions needing to be made once again on the future of Europe. Past Euro crises over the last 10 years suggest that a compromise is eventually fudged and agreed upon, but also that it takes time over much wrangling political negotiation.

I wonder if current market conditions really allow for that time. If the Europeans do not manage to bend the rules quickly enough and/or in the right size, then surely European assets will underperform assets in other currencies where governments and central banks are already entwined? Concerns over European debt issuance and debt financing will naturally be expressed in more volatile and perhaps rising government bond real yields, which would bring renewed volatility to European risk assets.

CONCLUSIONS :

• The lesson from the GFC was that increased fiscal spending would be financed by Central Banks expanding their balance sheets through Quantitative Easing (QE). At the time, Heads of Central Banks distinguished these QE operations from debt monetisation by saying they were “temporary” in nature, whilst calling for fiscal prudence.

• These same Central Bankers are now calling for rule bending via large scale fiscal spending to be backed by further Central Bank balance sheet expansion.

• Given the nature of the Covid19 pandemic economic crisis and the lack of private sector reserves, there is no other political option than to follow this course of action. It will have consequences, but that’s not today’s debate.

• In the last 2 months the Fed has already bought $178bn more US debt than the net supply – its’ intentions are very clear. The $1.5trn increase in its balance sheet in the last 2 months is only a start given the expected c.$3trn of net supply over the next 12 months ($2trn Covid aid plus $1trn exisiting defict).

• Whilst the Japanese, Chinese and UK have shown equal vigour and coordination in Government spending and CB financing, the Europeans have some very difficult ideological hurdles to overcome and bend the rules.

• Since the 19 March equity low, risk assets have traded in a very correlated fashion. However government bond yields are no longer positively correlated to the S&P (they are not correlated at all) and Gold’s correlation to the equity index has flipped sign to positive.

• These changes to correlations happened in Jan 19 after the bottom of the 4Q18 sell off and would suggest equity recovery. But questions remain about Europe, and more globally speaking, where fiscal policy will be directed and what will be done with it. The market will eventually get answers to both questions and price assets accordingly.

• The correlation changes perhaps are more a reflection of the behaviour of interest rate curves and gold rather than equity.

Edward Ballsdon 07 April 2020

1.Research published at Citi by Willem Buiter :“The Debt of Nations” and “Roublification of the Eurozone”