The dollar picked up momentum this week on much firmer Treasury yields as we have seen the first real signs of monetary policy divergence, with the European Central Bank and Bank of Canada signalling they won’t be held back by the Federal Reserve. But gold too has continued to advance to fresh record highs.

This week has raised a few very interesting questions about monetary policy and the fiscal-debt dimension.

– Are central banks now on diverging courses?
– Are we witnessing fiscal dominance?

Fiscal dominance?

“The depth and magnitude of the economic drop-off took modern monetary theory—or the direct monetization of massive fiscal spending—from the theoretical to practice without any debate.”

• Paul Tudor Jones, May 2020

Are we in an era of fiscal dominance? Will the fiscal taps continue to prevent CBs from taming inflation, and do they really care?

Fiscal dominance refers to the possibility that the accumulation of government debt and continuing government deficits can produce increases in inflation that “dominate” central bank intentions to keep inflation low. With the US adding about $1 trillion in debt every 100 days, it’s hard to see how the Fed can stay the course to tame inflation properly. Tacit acceptance of higher inflation is the price to pay for financing entitlement programmes and wars. Whether that implies a cut or a hold next time is up for debate. As Charles Calomiris notes: “Ultimately, the US may face a political choice between reforming entitlement programs and tolerating high inflation and financial backwardness.”

Why can’t government stop spending? A year ago I spotted a speech by ECB president Lagarde, which I said was “a signal that we are about to go into a protracted economic (and maybe real) war and it will require the mobilisation of the state and people – developed world central banks (Fed, ECB, BoE, BoC, RBA) will act together to orchestrate fiscal spending and suppress yields”.
Essentially, I felt that the view was that even if inflation is too high, no one was going to bust a gut going the ‘last mile’. Debts need to be financed; monetary policy needs to be levered to the benefit of spending more. Inflation will take a back seat.

And the market was in favour of rate cuts, even if it was based on a sense that inflation was coming down and a belief in the dot plots – the view was for the Fed to cut rates in June despite core inflation annualising around 3-4%. Tacit toleration of higher inflation. (Of course, in respect to the first question, we are seeing divergence in the inflationary regimes of the Eurozone and US, with the former considerably lower).

This week of course saw that hot US CPI print and the market repriced aggressively – seemingly on the assumption that the Fed had changed its spots.

US CPI inflation came in hotter than expected at +0.4% month-on-month, sending traders to the exit bets on a June rate cut. Year-on-year rose to 3.5% from 3.2%, ahead of the 3.4% expected. Core was up 0.4% on the month, +3.8% YoY. The headline 3-month annualised rate jumped to 4.6% (prior 4.0%), with the 6-month at 3.2%. Core 3-month annualised was rose to 4.5% from 4.2%, with the 6-month steady at 3.9%.

Supercore was +0.7%, or 5% YoY. Fundamentally, it’s as expected on the longer time frame – expectations and the reality are both totally unanchored and have been since the Fed said it would let inflation run hot in August 2020 (remember AIT?). It’s still trying to put the genie back in the bottle.

The data sparked sharp repricing in rates markets – the Treasury market had it worst day since the Kamikwaze Budget sparked turmoil in gilts. The 2yr jumped about 20bps, the most since the regional banking crisis a year ago. The 10yr yield has also risen more than 20bps since the data was released and traders have now priced out a June rate cut – just 16% implied probability vs 60% a month ago. That has come in a bit since a softer PPI on Thursday, with the chance of a June cut up to 24% today. PPI rose 0.2% month-on-month in March, compared with +0.3% expected.

Bumps in the road

“We don’t really know if this is a bump on the road or something more. We’ll to have to find out.” – Jay Powell, Wednesday March 21st.

Could it be something more? Probably. I have long argued that we are in a new inflationary paradigm – 3% is the new 2%. Running a 6% budget deficit a decade out with full employment is BOUND to be inflationary. Fiscal deficits in the US are powering stock markets and growth – ie fiscal dominance, which explains why inflation is persistent, growth continues, long yields higher and stocks don’t care.

“Under current policy and based on this report’s assumptions, [government debt relative to GDP] is projected to reach 566 percent by 2097. The projected continuous rise of the debt-to-GDP ratio indicates that current policy is unsustainable.” —Financial Report of the United States Government, February 16, 2023.

But does the Fed care if inflation is a bit high? Higher inflation and suppressed yields is positive for the debt burden…financing wars, immigration and ‘domestic bliss’ (in the words of BofA) is what it’s all about. And currently the FOMC thinks the neutral rate is about 2.5%, which means there are 300bps of cuts just to get to neutral. Remember the last projections from the FOMC raised the core PCE inflation rate for 2024 but stuck to the same number of cuts (3).

I think if the Fed cuts in June we know what they are all about. There is an added complexity to this – it’s an election year. In December the Fed and the White House though inflation was coming down and they could deliver rate cuts. Now inflation is rising again – cutting rates may no longer be what the White House wants right now – even if longer term it does. So far, we are yet to really hear from the main policymakers – chiefly Jay Powell. When he next speaks, we should learn for sure whether the Fed is going to tolerate higher inflation as the price to pay for a strong jobs market and to cap the debt burden – remember rising deficits are now being driven by interest expenses which don’t get fed back into the real economy like primary deficits do. Rising debt interest will reduce the fiscal impetus to growth despite its size – markets will be sensitive to the changes even if the absolute level is BIG. So, the fiscal may become a lot less dominant over time, which may make taming inflation a lot easier, and therefore make it an easier decision for the Fed to be cutting.

In the meantime, markets see divergence.

The market has decided to price out a June cut by the Fed whilst sticking to the view that the ECB will cut then. Yesterday’s communication from the ECB was quite nuanced, but definitely signalled a cut in June. Overall, if global CBs are starting to diverge from the Fed this can offer further support to the USD – however this may not fully materialise until we actually get some cuts.

Lower potential growth in the UK and Europe may be more inflationary, but demand is also lower. The growth outlook is less impressive and I think they are clearly on course to cut. The question is whether the Fed has its blinkers on and plans to cut despite inflation.

Finally, a word on gold. Again turning to Paul Tudor Jones, who wrote in 2020:

“A simple metric based on the ratio of the value of gold above ground to global M1 suggests gold could rally to 2,400 before it reaches valuations consistent with the lowest of the last three peaks in this valuation metric and 6,700 if we went back to the 1980 extremes.”

Spot prices have today risen to $2,400.

Gold was slow to catch up to the great inflation but have finally made it. More spending, more debt, and watch the geopolitics. Ever since Oct 7th there has been a decoupling from real yields as geopolitical risks rose. 10yr TIPS yield has jumped to 1.250%, the dollar (DXY) is at 105 and its highest since mid-November…all the usual influences don’t seem to matter… – fears about an Iran strike on Israel, or maybe a US plan to raise even more debt for Ukraine?

Debt upon debt upon debt. No wonder gold is roaring.

Reference:

CPI Home : U.S. Bureau of Labor Statistics (bls.gov)

CME FedWatch Tool – CME Group

Treasury yields turn mixed after modest March producer-prices data | Morningstar

Fed Remains On Hold, Keeps Forecast For Three Rate Cuts In 2024 | Bankrate

Fiscal Dominance and the Return of Zero-Interest Bank Reserve Requirements | St. Louis Fed (stlouisfed.org)

Neil Wilson

Chief Market Analyst at Finalto

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