Weekly Commentary: The New Massive

A most pivotal election is now only 10 days away. Joe Biden has a commanding lead in the polls. Moreover, betting sites are indicating rising odds of the Democrats taking control of the Senate (PredictIt: 64% Dems vs. 41% Republicans). The Democratic “clean sweep” scenario has become a distinct possibility.

U.S. daily COVID cases have spiked to over 80,000, with Friday setting a new single-day record. Unlike the first two “waves,” the surge in new infections is not dominated by particular metropolitan areas or a few large states. COVID has methodically dispersed throughout the heartland, with rural America in the crosshairs. This is a particularly troubling development for small town hospitals and healthcare systems facing limited capacity and scarce resources. Ominously, outbreaks have slammed many northern states early in the winter season. Over the coming weeks, the virus can be expected to shadow cooler weather advancing south.

Meanwhile, odds have tanked for stimulus legislation to be wrapped up prior to the election. Bloomberg: “Pelosi, Mnuchin Trade Blame as Stimulus Negotiations Stall.” The President’s chief of staff remains hopeful for a deal, though signs are not positive. An aid to Nancy Pelosi commented Friday evening that the Speaker also remains hopeful for a deal “soon”. Perhaps willing to be more candid, Secretary Mnuchin blamed the stalemate on Pelosi being “dug in.”

At this point, the Democrats have an incentive to dig in and hold out. If they don’t get the stimulus package they desire right now, they’re increasingly confident of moving forward when they gain control of the purse strings.

October 19 – Bloomberg (Brian Sozzi): “Break out those shovels, picks and the debit cards if a blue wave of Democrats washes into D.C. come Election Day. Goldman Sachs said… in a new note that a blue wave could lead to a whopping $2.5 trillion new stimulus plan. ‘This would likely include a stimulus package in Q1, followed by infrastructure and climate legislation. In this scenario, we would expect legislation expanding health and other benefits, financed by tax increases, to pass in Q3,’ explained Goldman’s Jan Hatzius.”

As crazy as it may sound, might Goldman’s “whopping” $2.5 TN stimulus forecast prove “conservative”? There’s a not unlikely scenario that would spur even grander spending plans. Would a Democratic “clean sweep” mean no meaningful stimulus legislation during the lame duck session? And in the event of a severe COVID winter, how voracious might the appetite for stimulus spending be by late-January?

October 21 – Financial Times (Stephen King): “In a world in which government debt is rapidly rising, it’s hardly surprising that there’s growing interest among investors in Modern Monetary Theory. After all, one of its central claims is that budget deficits are, from a financing perspective, an irrelevance. So long as increased government borrowing doesn’t lead to inflation — and, at the moment, there really isn’t much of it around — we can all afford to relax. As Stephanie Kelton notes in her book The Deficit Myth, governments with access to a printing press are ‘currency issuers’ (exceptions include, most obviously, members of the eurozone). As such, all their spending could, in principle, be financed via the creation of cash. Taxes may serve other purposes — the redistribution of income and wealth, the discouragement of ‘sinful’ behaviour — but, in the world of MMT, they serve no useful macroeconomic role.”

We’re drifting ever deeper into dangerous territory. The economy sopped up last year’s $3.1 TN federal deficit like water into a dry sponge. The conventional narrative holds that the pre-COVID economy was robust and healthy. It was neither. Instead, years of loose finance cultivated a “Bubble Economy” - a maladjusted structure that evolved into a ferocious Credit Glutton. This has become much more than some theoretical precept from Austrian economics. It’s a pressing reality, with momentous ramifications for politics, the markets and American society more generally.

Especially in the “clean sweep” scenario, it’s not inconceivable the federal government follows up last year’s 15% of GDP deficit with another 15%. My baseline deficit guesstimate would be annual deficits over the next few years in excess of 10% of GDP.

The analysis is turning quite intriguing. Humdrum is how I would characterize today’s popular “big stimulus is good for stocks” narrative. The system has commenced a grand experiment in New Massive deficit spending. This follows years of very large (formerly known as “massive”) deficits. And, of course, this fiscal experiment follows on the heels of the Fed’s decade-long QE experiment - that this year supplanted previous “massive” balance sheet growth with the New Massive.

Ten-year Treasury yields jumped nine bps this week to 0.84%, the high since June 8th. The dollar index declined 1.0% this week, trading Wednesday to the low since September 2nd. Thirty-year “long bond” Treasury yields traded as high as 1.69% in Friday trading, the high going back to March 19th.

I’ll assume a Democratic-controlled Washington – in a crisis backdrop - would likely ensure upwards of a $3 TN stimulus program – just to get started. COVID has pushed many over the edge – and it’s poised to push only harder. Millions have lost their jobs and scores of businesses have failed. Many organizations are in the process of going bust. Large numbers of state and local governments are being pushed to the brink. Many so-called “blue” cities and states came into the pandemic already financially challenged. But few state and local governments will come out of this crisis unscathed. Many colleges and universities and scores of hospitals – to the brink. Schools across the country will need assistance.

A tragedy of a black hole of financial need. Traditionally, there would be budgets, priorities and compromises. Market discipline would be lurking – the old “bond vigilantes.” James Carville from the early-nineties: “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”

There is an optimistic view: with economic recovery so far exceeding expectations, the longer fiscal stimulus is delayed the less of it that will be needed. But I fear there’s a major shoe still to drop. Over recent months, bubbling markets generated some forceful economic tailwinds. Wealth effects have boosted confidence and spending. More importantly, the loosest financial conditions imaginable have supported a record $1.4 TN of corporate debt issuance. Easy Credit Availability has supported economic activity – funding new investment as well as keeping vulnerable companies afloat. The booming MBS market and record low mortgage rates have pushed strong housing markets into Bubble territory.

All bets are off when markets falter. Sinking securities markets would see a hit to perceived wealth and confidence – while a tightening of financial conditions would choke a structurally frail economic structure. Recovery would give way to another economic leg down, with a further hit to employment, state and local finances, and general hardship throughout the economy. Such a scenario would see even greater financial shortfalls and resulting federal deficits. And what is California’s fiscal position following a financial markets downturn? In such a circumstance, where might a Democratic controlled Washington draw the line on spending? New Massive spending, deficits and Treasury issuance.

Massive new supply risks a Treasury market backlash – and we’re already seeing some backup in long-term yields. And I do appreciate the bullish view the Federal Reserve would simply step in to buy all the Treasuries necessary to ensure yields remain pegged at minimal rates.

I just don’t believe this would be a slam dunk for the Fed. For one, confidence in the dollar has begun to wane. Significantly expanding QE risks unleashing dollar and market instability. Analyzing the potential course of policymaking - New Massive fiscal and current account deficits along with potential for general U.S. instability - a crisis of confidence in the dollar cannot be ruled out.

Importantly, Federal Reserve QE resolve has yet to be tested by either dollar or Treasury market instability. A combination of both would surely have the Fed moving more gingerly on QE than markets currently anticipate.

How might a momentous political shift in Washington impact the Federal Reserve? The Fed has bestowed Washington a blank checkbook. Going forward, how might Republicans view enormous handouts to the troubled blue states that are being monetized by the Fed?

It was inevitable – and pushed forward by the pandemic: The Federal Reserve interjected itself into the deepening divide of social and political acrimony - and conflict. From 2008 to the present, the Federal Reserve has faced no serious pushback to its QE experiment. This may be about to change. I can see the Republican Party emerging from a traumatic election with a much more suspicious eye toward Federal Reserve “money printing” and deficit monetization.

I expect strong Republican pushback when it appears the Fed is monetizing the Democrats' state and local government bailouts and liberal agenda. While Republicans in such a scenario would have limited legislative recourse, the Fed does not want to be in the middle of such a hostile partisan clash. The Federal Reserve will be taking significant institutional risk, with the conservative media and a major segment of the populace adopting a critical view of the Fed’s non-traditional policy course.

For now, markets are distorted and dysfunctional. There are huge costs associated with the markets’ failure to discipline even the most egregious excess. Systemic stress is mounting rapidly, and a destabilizing bout of Market Discipline Lies in Wait. The Treasury market is vulnerable. At least for now, market faith in the almighty power of the Fed’s balance sheet holds firm.

But what about the dollar, a complex global market beyond the Fed’s control? And Washington is doing everything imaginable to put the dollar’s global reserve currency status in serious jeopardy. Almost 30 years of persistent Current Account Deficits. The New Massive ensures dollar vulnerability. Twin Deficits (fiscal and Current Account). Fed holdings expanding almost $3.2 TN over the past year. M2 “money” supply inflating $3.6 TN in the last 52 weeks.

The dollar is really lucky it has a bunch of marred competitors. But I’d still rank dollar instability near the top of the list of potential recipients of market discipline in the event of a Democratic “clean sweep.”

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Disclosure: Doug Noland is not a financial advisor nor is he providing investment services. This blog does not provide investment advice and Doug Noland's comments are an expression of opinion ...

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