Fed doublespeak

Traders with long US equity and long dollar positions that laughed all the way to the bank after the Fed’s latest rate hike might have missed another important headline that came out of the treasury department.

Just days before the FOMC (Federal Open Market Committee) greenlighted the 25-basis point hike, perhaps the last of the most hawkish cycle since the Volker fed of the 1980s, and when pundits were betting that the extraordinary stock market rally had rubbished earlier predictions that 2023 would be ‘year of the bond market’, the government reported that US national debt had crossed the $32 trillion mark for the first time.

This happened less than two weeks after President Joe Biden signed the Fiscal Responsibility Act of 2023 into law – a compromise with Republicans, led by House Speaker Kevin McCarthy — to trim spending by a projected $1.5t over 10 years and suspend the country’s debt limit until January 2025.

“The $32t mark arrived nine years sooner than pre-pandemic forecasts had projected, reflecting the trillions of dollars of emergency spending to address Covid-19’s impact along with a run of sluggish economic growth,” the New York Times noted amid calls by fiscal hawks to build on the momentum of the Biden-McCarthy deal.

“We can’t even get through a single fiscal year anymore without adding a trillion dollars in debt, and $33t is likely just around the corner,” said Maya MacGuineas, president of the non-profit committee for a responsible federal budget.

You don’t have to be an Ivy League graduate calling the shots in treasury to know this deficit is not sustainable, of course, but trimming it is still easier said than done; as Mr Market knows only too well.

And it’s not going to react too well once it digests the fact that there are not too many options on the table. American markets have a tendency of blinding people to some of the most obvious facts, especially in the middle of bull runs that feed bubbles. That’s why it is very interesting that the only investor willing to call a spade a spade so far has been billionaire David Rubenstein, former government official and co-founder and co-chairman of the Washington-based private equity firm The Carlyle Group.

Rubenstein believes that the best bet to climb out of the $32t debt is to lean on inflation. “We aren’t going to cut expenses in the government. We aren’t going to increase taxes that much. We aren’t going to go to a bailout with the IMF, that’s not realistic. And we’re not going to default,” he told Bloomberg TV.

“The only alternative is to inflate your way out.”

He’s got a point. Increasing taxes is a long-run negative because its burden, especially considering the makeup of western democracies, falls mainly on lower- and middle-income groups, even the upper class to an extent, but the super-rich are always able to weasel their way out of the net. At the end of the day, it’s the people that consume the most that get squeezed by the taxman. And that does not balance your budget.

Cutting spending could be desirable, both in US and Europe, where transfer payments are huge, and they could spend money on infrastructure and productivity and improve capital spending. But that’s all theory. In practice transferring money from here to there by way of a fiscal deficit is of little use macro-economically because a deficit that leads to inflation is a tax on the entire system.

That’s probably why some investors are beginning to fear that Rubenstein might be right and even though inflation figures might improve for a few months, as the Fed’s deep bite takes effect, in the long run they could, and most likely would, reverse very sharply.

Thailand-based Swiss investor and author of the famous the Gloom, Boom & Doom Report, Marc Faber, believes inflation and interest rates will eventually exceed the peaks seen in 1980-81, when 10-year US treasury notes yielded in excess of 15 percent – they peaked at 15.84pc on 21 September 1981.

This crisis, he believes, has its roots in the years following the Clinton-era surplus, beginning with the tech bubble when the Fed helped build the mania by believing that asset price inflation was not the same as traditional inflation and all concerns about bubbles, etc., were unfounded.

It turned out to be wrong, of course, and the roller coaster ride in financial markets since then has built up the kind of debt that mandates more and more money printing – quantitative easing in fed lingo – “to finance this mess”.

But isn’t the Fed doing exactly the opposite? Isn’t its uber-hawkish policy, the kind of which has not been seen in 40 years, meant precisely to blunt inflationary tendencies in the US economy?

“It’s lying,” claims Faber. Just like other government agencies and politicians on both sides of the divide, “the Fed is also lying”, he says, because “they only tell the public what it wants to hear” and “it’s in their interest to maintain the financial market at a very high level”. In short, they avoid deflation in financial assets like the plague and they would rather also prevent deflation in real assets if they could, but the latter is tricky and difficult to control.

“Basically, they can’t afford the stock market to drop 50pc, so they will print money whenever they have to.”

If these concerns are indeed true and all this monetary tightening is only a breather before the feedback inflationary spiral takes effect, then it’s Washington’s fiscal recklessness – advocating financial market bubbles and costly wars more than the Covid crunch – that will dictate the future of interest rates rather than the Fed’s doublespeak.

And that is very bad news for dollar longs as the debt mountain grows taller than ever before.

Copyright Business Recorder, 2023