The latest U.S stimulus package has triggered a ‘stimulus’ tantrum, with treasury yields rising rapidly on the back of rising inflation expectations and tightening fears. Overall, this may turn out to be counterproductive.
Sometimes less is more. In December 2019, we published the Julius Baer Secular Outlook for the decade 2020 for the first time. We predicted at the time that political priorities in wealthy Western democracies would shift in the direction of fighting inequalities. At the core of our forecasts was the expectation of the end of fiscal austerity and the transition to Modern Monetary Theory inspired macroeconomic policies (involving fiscal stimulus enabled by monetisation), hopefully in a moderate and sustainable way.
The stimulus package makes the transition more volatile
The pandemic has formidably accelerated this transition. Although the destination is unchanged, we are, however, increasingly concerned that the massive US fiscal response to the shock from covid-19 will make the transition more volatile. We can speculate about the political motivation to provide such a huge fiscal stimulus. Maybe the incoming administration was concerned about not being able to pass additional stimulus legislation later, or being judged to be doing too little; or, more pragmatically, it asked for USD 1.9 trillion hoping to get at least a reduced version of it approved.
A sustained regime change towards higher inflation requires a long-lasting supply shock in the economy and/or recurring public deficits that are largely monetised. Neither condition is fulfilled.
In any case, the size of the fiscal package is so large that the US economy will operate above potential in the second half of this year. The main reason behind this surge to unprecedented growth out of a very severe recession last year is that unlike in ‘normal’ downturns, the private sector has been largely shielded by government transfers and monetary stimulus from the usual income and wealth losses experienced by households and corporations when the economy contracts.
This situation has triggered an unfortunate consequence: the rise in inflation fears is leading to a rapid rise in US Treasury yields at the medium- and long-term end of the yield curve. Ten-year US Treasury yields have just experienced one of their fastest rises on record, from 0.7% last autumn to 1.6% in early March. Rates have more than doubled.
This is causing trouble at the central bank. The US Federal Reserve changed its reaction function in late 2018, following its last attempt at pre-emptively tightening monetary policy. At the time, fiscal prudence was still prevailing. As a result, the transition towards a mix of fiscal support facilitated by monetary policy is stress-tested.
Rising inflation should be regarded as cyclical
We believe the key is what will happen to fiscal policy when economies have normalised by the time the virus is under control. If fiscal rectitude returns, then the stage will be set for a boom-and-bust cycle. In any case, we remain in the camp of those who view any rise in inflation in the next few months as cyclical rather than structural in nature. A sustained regime change towards higher inflation requires a long-lasting supply shock in the economy and/or recurring public deficits that are largely monetised. Neither condition is fulfilled at this stage. The stimulus tantrum in the bond market is still of a self-defeating nature.
This is an extract of Julius Baer’s ’CIO Monthly’. If you want to learn more about our investment approach, get in touch with us.