This article discusses the big divergence between U.S. fiscal policy and U.S. monetary policy over the past year, and how that impacts various parts of the economy differently.
It also takes a look at how the United States, Europe, and China have sharply diverged from each other on these policies.
The Fed vs the Treasury
The past several years have been ones where having an overall macroeconomic framework has been essential, but being nimble and flexible around that framework has been equally important. Speaking for myself, I got some things right, some things wrong, but what kept me largely on track was being willing to constantly update my view based on what various indicators are actively telling me in these turbulent times.
From 2019 into 2022 I was an inflation bull and a bond bear, and in particular emphasized how fiscal-driven inflation was likely to manifest. I described it as a shift from monetary dominance to fiscal dominance. That all was very much on-point. I laid out the scenario and its likelihood before it happened, and then as four-decade-high inflation and the worst bond bear market in modern history began to manifest, I was able to more closely track the timing and magnitude of it.
So far, central bank tools have not been inflationary because they have primarily benefited asset prices rather than middle class consumption. They printed money, but kept the money on the central bank balance sheets by buying bonds.
If central bank actions get more aggressive, combine with fiscal policies, and start targeting the middle class, they have the power to override these various deflationary forces with sheer monetary expansion. They can issue helicopter money to pay off debts, boost inflation, build infrastructure, bail out unfunded pension systems, and prop up the middle class if that’s what policymakers decide to do.
I wouldn’t want to be holding a 20-year or 30-year bond at super-low fixed yields in that kind of environment. Negative yields would be even more vulnerable.
-July 2019 “The Bond Market is Spookier Than the Stock Market”
When system-wide debt is high, interest rates run into the zero bound, and measured inflation is very low, monetary policy runs out of ammo. At that point, currency devaluation and outright fiscal expenditure (which the monetary authority purchases by increasing the monetary base, rather than the fiscal spending being drawn from real private lenders) becomes a more powerful tool for stimulus. Fiscal spending takes priority over monetary policy, and leads it. The 1940s and so far the 2020s were characterized by fiscal policy dominance in the United States.
-September 2020, “A Century of Fiscal and Monetary Policy”
Rapid increases in the broad money supply that boost demand for goods and services without boosting the supply of goods and services, result in supply shocks and cause price inflation. As the market adjusts over time, this price inflation becomes transitory in rate of change terms, but with prices that ultimately settle at a higher level, due to more money permanently being in the system. This second type of inflation is likely what we’re experiencing at this time.
-May 2021, “Fiscal-Driven Inflation”
By early-to-mid 2022, however, it became clear that the Fed was going to push back against inflation much harder than I had expected, and my view began to shift toward a cyclical period of disinflation and likely recession from that point, while still reiterating that I think the overall decade will have more inflationary cycles ahead. Most inflationary periods in history consist of multiple separate waves of inflation and disinflation, and this was shaping up to be no different.
I initially expected the top in year-over-year inflation to be in Q1 2023 with caveats about the right-tail risk from oil shortages that could extend it. Russia’s invasion of Ukraine in late February 2022 indeed activated that right-tail risk, and so that contributed to inflation peaking a couple months later in Q2 2023.
From base effects in the CPI calculation, there’s a decent chance that we’ll see a local top in official CPI sometime in Q1 2022 within the 7-9% year-over-year range.
-December 12, 2021 Stock Waves Report
The producer price index is showing signs of having reached a local top in year-over-year terms. I think we’ll probably see the same for headline CPI by late Q1 or early Q2. […] Basically, I think there is a good chance that year-over-year inflation will reach a local top in a couple months, and that we’ll have a period of flat or lower year-over-year inflation prints for a period of time, while still being above-target. […] The right-tail risk to that view is that if oil prices spike higher this summer due to lack of supply and solid emerging market demand, it can result in inflation (or more precisely, stagflation) that is even higher than my base case.
-February 2, 2022 Stock Waves Report
Overall, I continue to view the macro environment as being in a cyclically disinflationary period, amid an inflationary decade. This makes managing a portfolio dependent on one’s time frame; things I expect to do well for the next 5+ years could very well be weak over the next 6-12 months. When in doubt, I always stick with my longer-run timeframe, although I try to rebalance around the margins counter-cyclically.
-August 7, 2022 Stock Waves Report
Overall, the consumer price index is cumulatively up 19% since the start of 2020, which was four years ago now. Under normal conditions where the Fed meets their inflation target of 2% per year, it would instead be up by approximately 8% since then. This permanently higher plateau in prices is why, although prices are cooling down in rate of change terms, inflation still feels high for a lot of people:
In May 2022, when interest rates were still under 1%, my article at the time was called “Inflation Or Recession” where I provided a viewpoint that the Fed’s tightening would likely lead to a lot of outcomes:
The Fed can likely tighten for a period of time longer. However, if the Fed raises rates to 3%, 4%, 5%, and so forth when debt as a percentage of GDP is this high, the annual interest expense of the US Treasury would exceed $1 trillion, and many companies and households would run into trouble refinancing their debts. And by persistently drawing down their balance sheet with QT, it will be a negative drag on money creation and asset prices.
The dollar would likely strengthen further in that scenario, which would squeeze all of the countries that have a lot of dollar-denominated debt (which is primarily owed to places like Japan, Europe, and China). The foreign sector in aggregate would likely stop buying Treasuries, and might have to sell Treasuries to get dollars, like they did during March 2020.
US corporations would have unfavorable exchange rates on their exports, and export volumes would probably decrease.
The various yield curves would likely invert, the Treasury market would likely become illiquid, the high yield credit market would likely become illiquid, and recession indicators would probably worsen. Demand will have been reduced, but at the cost of a recession, and the financial system would start to seize up.
-May 2022, “Inflation or Recession”
Almost all of that happened… at first. As the Fed continued to sharply raise rates, the Treasury’s annualized interest expense exceeded $1 trillion, many non-investment grade companies and real estate owners ran into major refinancing challenges, the dollar index strengthened to twenty-year highs through September 2022, exports stagnated, manufacturing contracted, the foreign sector in aggregate reduced its total holdings of Treasuries, the Treasury market became very illiquid in September 2022, the yield curve inverted, and the full year 2022 was terrible for most asset prices.
However, there were two important areas that held up much better than I personally expected: large investment-grade companies and homeowner consumers. That’s because they had locked in so much long-term fixed rate debt at low interest rates, that they were mostly immune to the Fed’s aggressive interest rate increases. And to the extent that upper middle class homeowners and large corporations had a lot of cash-equivalents, those cash-equivalents started to give them more interest income (largely from the U.S. Treasury) even as their interest expenses were locked in place, which ironically can be economically stimulating for them even as their weaker counterparts suffer.
The Fed’s aggressive interest rate increases mainly hit small businesses (which typically rely on shorter-duration bank loans), non-investment grade corporations (which issue shorter-duration bonds), commercial property developers and operators (which rely on shorter-duration leverage than residential real estate owners), and ironically the federal government itself (which uses rather short-duration debt on average).
Starting in Q4 2022, when market conditions and liquidity conditions were at their worst, the U.S. Treasury department began to override the Fed. The Treasury began rapidly drawing down their Treasury General Account, which began pushing money back into the financial system as fast as the Fed was removing it with quantitative tightening. Some of this was done of their own accord, but then the January-to-June 2023 debt ceiling impasse forced them to drain all of their spare liquidity into the market.
That period in January 2023, especially when seeing the debt ceiling liquidity drain ahead, is when I began to wake up and pivot again in my analysis and writings. My bearishness for the next six months decreased, because I saw these pro-liquidity moves from the Treasury. And then by spring 2023 I began to see how the larger and larger fiscal deficits were stimulating some parts of the economy despite the Fed’s hawkishness. And ironically the more the Fed raises rates, the more it increases the federal government’s deficits, which increases that stimulus and thus counteracts part of the Fed’s tightening.
Domestic liquidity in the United States has been rather sideways since the start of Q4 2022. This metric (blue line below) represents the Fed’s balance sheet minus the Treasury General Account and minus reverse repos, with the S&P 500 (red line below) shown for comparison purposes:
The Fed has been the primary reducer of liquidity as it lets bonds mature off of its balance sheet each month, which is a form of quantitative tightening. On the other hand, as the Treasury Department has drawn down its Treasury General Account since mid-2022, this has added some liquidity back into the market. The net result has been rather sideways liquidity lately.
Going forward, this sideways liquidity situation is likely set to continue for the next few months. The Fed is still reducing its balance sheet (negative for liquidity) while the debt ceiling issue is likely to result in lower Treasury General Account balances (ironically positive for liquidity) until the debt ceiling is resolved, as described in the next section.
-January 8, 2023 Stock Waves Report
This was where being nimble with my view was important. Back in 2022 I had originally doubted that the Fed would be able to raise rates past 3%, but seeing all of these actions and impacts by the U.S. Treasury starting in Q4 2022 and then moving into 2023 balanced out my view. It’s important to respect the power of fiscal dominance.
In my April 2023 article, I laid out some of the forward paths for when the debt ceiling is lifted. The main question is what would happen to liquidity in June 2023 when the debt ceiling impasse was resolved, and I laid out three primary options. The answer ended up being Option 2), where the Treasury issues an atypically large ratio of T-bills:
Option 2) The U.S. Treasury Department could issue a ton of T-bills to refill its general account, rather than issue long-duration bonds. This would reduce the average duration of government debt, and is currently the most expensive part of the Treasury curve to issue debt on, but it would likely suck cash out of reverse repos and allow the Treasury to refill its account without damaging commercial bank liquidity. There is about $2.3 trillion in reverse repos that could find a home in T-bills specifically. The Treasury Department could also keep its cash balance low for a while and try to refill it very gradually.
-April 2023, “Navigating the Debt Ceiling Impasse”
The following chart shows the Fed’s reverse repo facility being drained. As it falls back down, it pushes liquidity back into the financial system:
And commercial bank liquidity has indeed avoid being damaged. Bank reserves reached a local bottom in Q1 2023 just prior to the March 2023 banking crisis, and have been on a mild uptrend since then:
Ever since the fourth quarter of 2022, and extending all throughout 2023, the U.S. Federal Reserve and the U.S. Treasury have been operating opposite policies from each other. And the Treasury has had to pull two different levers to keep up with the Fed.
-From September 2022 through May 2023, the Treasury drained their own cash reserves back into the financial system, which offset the Fed.
-From June 2023 to the present, the Treasury rapidly increased their T-bill issuance as a percentage of their debt issuance and thus drained reverse repos back into the financial system, which offset the Fed.
This following chart shows the Fed vs Treasury liquidity actions in year-over-year change terms. For this chart, higher means more liquidity, and lower means less liquidity. The Fed in blue has been doing its part to reduce liquidity in the financial system since early 2022. The Treasury in red (reflecting both their own cash balances and their ability to affect the reverse repo facility based on their ability to issue T-bills) has been doing its part to increase liquidity in the financial system since late 2022.
The net result is that domestic liquidity was decreasing until Q4 2022 but then began to flatten out and turn slightly upward when the Treasury began its inverse operation:
And for global liquidity indicators, the bottom also occurred in Q4 2022 and has been flat-to-up ever since. My preferred metric for global liquidity is the global broad money supply of major currency blocs, denominated in dollars. Credit growth, certain types of quantitative easing, and/or a weaker dollar index drive it higher, while credit contraction, certain types of quantitative tightening, and/or a stronger dollar drive it lower:
Summing Up This Section
The last several paragraphs had quite a bit of financial jargon, so here’s a quick recap and simplification of all of that:
-From 2020 through 2021, the combination of fiscal and monetary stimulus (along with supply chain disruptions) in response to the pandemic lockdowns caused a surge in most asset prices and then a surge in consumer prices.
-From early 2022 to the present, the Fed has been trying to reduce inflation by tightening monetary policy as much as possible. Their main tools to do this are raising interest rates (which increases the cost of debt for borrowers) and reducing their balance sheet (which drains liquidity from the financial system).
-Starting in Q4 2022 and continuing to the present, however, the Treasury has been doing the opposite; they’ve been pulling their various levers to put liquidity back into the market, and thus offsetting the Fed’s actions. As a result, total liquidity was bad for the first three quarters of 2022, but has been neutral or slightly upward starting in the fourth quarter of 2022 and continuing throughout all four quarters of 2023.
Liquidity Leads the Economy
When the Fed or Treasury perform actions that affect overall financial liquidity, it impacts financial markets first and foremost, but it also impacts the real economy to a certain extent.
If we look at U.S. manufacturing activity, it was decelerating throughout 2022 and entered mild contraction, but has been trying to stabilize here in 2023:
The same is true for the Conference Board’s broad set of leading indicators:
Many investors assume that economic performance affects equity prices, and to some extent it does. But in recent decades, the reverse direction is of similar importance: equity prices affect economic performance heavily as well. And changes in liquidity tend to precede it all.
In the United States, the wealthiest top 1% hold 32% of total net worth, and the next 9% hold another 36% of total net worth, and so collectively the top 10% hold 68% of net worth.
But the numbers are even more skewed for the equity portion of net worth. The top 1% hold 54% of equities, and the broader top 10% hold 92% of equities. Swings in equity value matter greatly for people who have most of the country’s wealth, and affect their spending, investing, tax payments, and other things.
In addition to the fact that a large portion of wealthy peoples’ net worth is subject to changes in equity prices, for many of them their annual income is also highly tied to equity performance. Back in the 1990s, there were some tax reforms that led to CEOs and other executives getting a lot more of their compensation in the form of stock rewards and stock options than in cash. In other words, executives effectively get paid a lot more when their stock prices are high and rising.
Over 70% of S&P 500 CEO compensation is in the form of stock rewards and stock options:
The numbers are a bit lower for non-CEO executives at those large companies, and a bit lower for CEOs and executives at smaller companies, but the overall percentage of equity compensation is quite high across the board among the top percentile of earners in the United States. In addition, fund managers’ compensation is often tied to equity performance as well, via carried interest.
Corporate executives in Europe and Asia are not generally compensated like their American counterparts:
As a result of these and other factors, U.S. tax receipts tend to be highly correlated with year-over-year stock performance:
This fact creates a feedback mechanism where downward or stagnant equity prices contribute to larger fiscal deficits, and those larger fiscal deficits can be stimulating to the equity market and the economy, and help pump those equity prices back up or at least prevent them from falling as much as bears might expect. And that feedback mechanism grows stronger over time as debts and deficits grow, and as the stock market is larger relative to GDP. Thirty years ago, the U.S. stock market was valued at about 70% of U.S. GDP whereas today it is valued at about 170% of GDP.
Additionally, the world has $13 trillion in dollar-denominated debt outside of the United States (and unintuitively, mostly owed to non-U.S. creditors). A sharply rising dollar relative to their currencies effectively hardens their debt, which tightens their financial conditions and slows down their economy. A falling dollar relative to their currencies effectively softens their debt, which loosens financial conditions and gives their economy a boost. And the global economy feeds back into the U.S. economy in various ways.
The dollar index peaked at the start of Q4 2022, which coincided with the bottom in global liquidity and the bottom of many asset prices.
The United States, Europe, and China
Throughout 2023, the major economic blocs have diverged sharply from each other in terms of policy and economic outcomes.
For example, the United States spent 2023 running loose fiscal policy (large deficits) but tight monetary policy (rising interest rates), whereas China ran tighter fiscal policy (smaller deficits) but loosening monetary policy (cutting interest rates).
Regarding fiscal policy vs monetary policy, I’ve been arguing for a while that fiscal policy tends to be a lot more potent than monetary policy. And we’re seeing that manifest in the difference between the U.S. economy and the Chinese economy this past year.
Europe has been hit the hardest overall, with relatively tight fiscal policy, relatively tight monetary policy, and much higher energy costs. By decommissioning functional nuclear plants and relying heavily on Russian gas, they exposed themselves to the risk of external energy shocks and then were given exactly that after Russia’s invasion of Ukraine. Part of it was relieved by higher imports of (expensive) liquefied natural gas, and part of it was relieved by energy-intensive sectors leaving Germany and moving to China, the United States, and elsewhere, which is recessionary and negatively impacts the long-term prospects of the European economy.
Overall, the state of affairs for these three economic blocs is:
- The United States has weak production but strong consumption.
- The Euro Area has weak production and weak consumption.
- China has strong production but weak consumption.
Summing This All Together
What all of this means is that monetary and fiscal policy, which are centralized forces, have a big impact not just on financial markets, but also on economic performance.
Especially in recent years where accumulated fiscal debts, ongoing fiscal deficits, and the regular usage of unconventional monetary policy are part of the mix, these forces and their impact on liquidity are major drivers of financial markets and the economy to be aware of.
From 1980 through 2007 in the United States, monetary policy played a bigger role than fiscal policy. From 2008 through 2019, both fiscal policy and monetary policy greatly affected markets and the economy. From 2020 to the present, fiscal policy has been the more dominant side of the equation. I expect fiscal dominance to continue throughout the 2020s and into the 2030s, because the structural deficits both in absolute terms and as a percentage of GDP are set to continue:
Overall, I expect that the 2020s decade will be one where U.S. nominal GDP runs hotter than expected, real assets globally do pretty well (e.g. energy, infrastructure, commodities, hard monies, and some emerging market equity regions), and the most financialized assets (e.g. the S&P 500) have lackluster performance in real terms.
Regarding the S&P 500, equity valuations are high, U.S. household allocations to equities as a share of their net worth are high, and foreign allocations into U.S. markets are high. It’ll be hard to find a lot of new capital that wants to come into U.S. equity markets that isn’t already here.
This chart shows the percentage of financial assets that U.S. households currently have in stocks in blue (i.e. their relative to exposure to stocks vs other financial assets), and shows the inflation-adjusted value of equities in red:
As a reader of a lot of financial analysis, I find that inflexible thinking is a key limitation for many analysts and investors.
People get stuck into certain viewpoints, and so they end up being very right for a cycle and then overextending their stay and then being very wrong for a cycle.
-There were analysts and investors with a disinflationary outlook throughout 2018-2020 that were absolutely denying any significant impact from huge monetized fiscal deficits on inflation, and then were caught completely off-guard when inflation reached four-decade highs over the next few years, which contributed to the worst performance in U.S. bond market history while these types of analysts and investors were generally overweight bonds.
-Similarly, there were analysts and investors with an inflationary outlook that just kept pounding the table on more and more runaway inflation even as it neared its peak, without realizing that things were cooling off and that base effects were becoming much harder. Even inflationary periods tend to have disinflationary cycles within them.
History rhymes, but it doesn’t repeat step-by-step. Macroeconomic cycles generally take longer to play out than people expect, and no matter how many variables you consider in your analysis, there will always be some variables that you’ve missed. So, it’s useful to have a framework and to be a student of history, but to keep analyzing the current situation and constantly look for invalidation points or pivot points or new variables to scoop up and incorporate into your framework, so that your framework is always evolving and taking into account new information as it comes in.