February 25, 2024
This February newsletter issue is supported by YCharts.
People that have read my work for a while know that I’ve used YCharts in my various reports for years; they’re some of my favorite tools for showing both stock-specific and macroeconomic data. They provide great resources for analysts, portfolio managers, and other investors, and you can access a free trial here.
The topic for this issue focuses on the ongoing tug-of-war between loose fiscal policy and tight monetary policy in the U.S. economy, with updates on how the fiscal side seems to be taking the lead lately.
An Unstoppable Force
What happens when an unstoppable force hits an immovable object?
We find out which of them isn’t really unstoppable or immovable, is what happens.
For nearly a year and a half, there have been opposing forces of loose fiscal policy and tight monetary policy playing out in the U.S. economy, and navigating the interaction of these forces has been a big part of success or failure for investors during this period.
-Fiscal policy includes the size of the sovereign government’s deficits, who is on the receiving side of those deficits, whether those deficits are funded primarily with short duration or long duration government bonds, and how the government manages the size of its cash balance at any given time.
-Monetary policy includes the size of the central bank balance sheet, the level of short-term interest rates set by the central bank, and any other special liquidity facilities that they offer to financial institutions.
From 2017 until mid-2019, the U.S. central bank (the Federal Reserve) began gradually tightening monetary policy at the same time as U.S. fiscal policymakers (Congress and the President) started loosening fiscal policy via tax cuts. President Trump publicly criticized Fed Chairman Powell on multiple occasions in and around 2018 for counteracting his administration’s policies rather than being monetarily accommodative.
And then by mid-2019 as the economy began to decelerate and as various liquidity problems emerged, the Fed began to loosen policy, first by cutting interest rates and then by shifting from quantitative tightening to a mild form of quantitative easing.
In early 2020 and continuing into 2021, in response to pandemic lockdowns and seized-up capital markets, both fiscal policy and monetary policy became looser (i.e. more stimulative) than they had been in modern history. Enormous amounts of monetized fiscal deficits and monetary liquidity backstops flooded the financial system and directly made their way into the main street economy over the subsequent years.
After major inflation began to take hold in the United States and other developed countries in 2021, the Fed and other central banks began to push back with tighter monetary policy in early 2022, to try to contain it. And once again, there was some frustration directed at the Fed Chairman Powell by fiscal policymakers. Although President Biden was publicly supportive of the Fed’s actions, various senators including Elizabeth Warren publicly criticized him for similar reasons that President Trump had.
Partially by late 2022 and especially by early 2023, ongoing loose fiscal policy in the United States began to balance out that tight monetary policy, resulting in a tug-of-war of sorts.
And as an update here in early 2024, the fiscal side is showing evidence of winning. The unstoppable force is moving the immovable object, although we need to see if the data continue to confirm it in the months ahead. This chart doesn’t show the whole picture but shows how the two forces impact liquidity primarily:
History does show that between the two, the fiscal side almost always wins. It can be a bumpy ride at times, but as long as a country controls its own currency, when problems really hit the fan, they almost always print.
When the Fed Blinked
There is a difference between you and me. We both looked into the abyss, but when it looked back at us, you blinked.
-Batman, referencing Nietzsche
The Federal Reserve Act mandates that the Fed must act in such a way to “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” While this technically refers to three different things, it is commonly referred to as the dual mandate.
And implicit in this dual mandate (triune mandate?) is an additional shadow mandate: financial stability. If a financial system is not relatively stable, then the official mandates are hard to achieve. And so the Fed also sees it as their job to maintain financial stability.
In March 2023, Silicon Valley Bank went under, and this was one of the largest bank failures in American history. They had previously purchased a lot of low-yielding long-duration Treasuries and similar assets, and as those yields rose their prices fell. Seeing the on-paper insolvency of the bank, many depositors pulled their money out, potentially forcing the bank to sell those assets at a loss and lock in those losses with negative bank capital. Many deposits were above the FDIC limit of $250,000 and so amid the rubble of the bank, some depositors would potentially not be made whole.
The Fed was in the middle of fighting inflation, which was officially still around 5% for the consumer price index. If bank deposits are defaulted on, it means a reduction in the broad money supply, which means less spending power by businesses and individuals that lose those deposits, and that generally means less inflation around the margins.
But a lot of deposits in the country are over the insurance limit, and especially many business deposits. Letting deposits go “poof” at Silicon Valley Bank and a handful of other banks in the cascade that followed could have resulted in every high net worth depositor and every business depositor throughout the country re-evaluating their banking relationships and pulling funds out at the smallest whiff of insolvency.
When it came down to it in the aftermath of the collapse of Silicon Valley Bank as contagion began to spread, the Fed blinked. Rightly or wrongly, they and the Treasury (monetary and fiscal policymakers respectively) worked together to open up various generous facilities to provide under-collateralized loans to banks (the Bank Term Funding Program), and in addition to that, even depositors that were over the $250,000 FDIC insurance limit at failed banks were made whole. Confidence and stability in the banking system was prioritized over everything else. They stopped short of confirming that every uninsured deposit would be made whole for all depositors at failed banks in the future, but instead they let their actions speak for themselves.
There are certain “priority items” in the U.S. financial system that the Fed is quick to step in for, even at the risk of contributing to moral hazard. This includes the liquidity and functioning of the U.S. Treasury security market, the liquidity and functioning of very adjacent markets to the Treasury market such as the repo market between financial institutions, and the assuredness and confidence of deposits at major banks. These types of markets represent the core of the financial system, and fall within the Fed’s shadow mandate of maintaining financial stability. Even if inflation is high, they will provide liquidity as needed for these core areas.
In contrast to that, things like the price level of the stock market, the functioning of the corporate bond market, the solvency of commercial real estate operators, and the overall activity of small business lending, are not immediate priorities. They can be left to flail in the wind for a while when they run into a problem, at least as long as the problem doesn’t start to spread to the aforementioned core priority markets.
Right now, the Fed is back to a tight policy stance of high rates and ongoing balance sheet reduction, but is still talking about rate cuts more-so than rate hikes, even as official inflation measurements are currently above their official target level. Some Fed officials have also talked about tapering their rate of balance sheet reduction once the reverse repo liquidity is mostly drained.
I expect there to be some bumps in the road ahead, as the Fed tries to stay tight amid a loose fiscal situation and still-too-high official measures of inflation, but it’s clear that when the liquidity and functioning of the core financial markets are threatened, the Fed will blink or be forced to blink.
And in addition to that, the Fed’s tight monetary policy is now feeding into even looser fiscal policy, because their tools are designed to suppress lending-driven inflation rather than fiscal-driven inflation, and yet this cycle has been primarily defined by fiscal-driven inflation.
And this is starting to show up in the economic data. Manufacturing PMIs for example are showing signs of economic re-acceleration after a year and a half of deceleration:
The Conference Board‘s leading index has been flashing recessionary conditions for quite a while, but lately has been turning back up:
Month-over-month price inflation is not heading down as quickly as policymakers would like, and remains above the target level:
Insufficient Tools and Spiraling Loops
The broad money supply is a major input into the aggregate prices of goods and services, and the broad money supply usually grows in one of two main ways.
- When banks originate new loans, they increase the broad money supply but not the base money supply, and therefore increase the overall ratio between broad money and base money. In addition, when banks buy newly-issued debt securities, it serves a similar function.
- When the central bank creates new reserves and uses them to buy securities from non-banks, such as government bonds, they increase both the base money supply and the broad money supply by doing so.
This sounds like jargon, but it can be represented by two tangible examples:
-In the 1970s, the majority of broad money supply growth was from bank lending. That decade had the highest sustained growth rate of bank loans because the Baby Boom generation was beginning to enter its home-buying years. The earliest Baby Boomers (a particularly large generation) were born in the late 1940s, and they began reaching their mid-twenties in the early 1970s and thus started buying homes. The 1970s then saw a wave of Baby Boomers born in the 1950s continue to enter their homebuying years. The building and mortgaging of new homes results in a lot of lending-driven growth of the broad money supply. When this rapidly-increased money supply ran into tight limits of oil supply and other real-world constraints, price inflation ensued.
-In the 1940s, banks were hardly lending at all and yet the broad money supply and consumer prices grew rapidly, because the federal government was running huge fiscal deficits and having the banking system and central bank buy a large portion of the government debt issuance used to finance those deficits.
Here in the 2020s, we are firmly in the latter camp. The majority of money supply growth in recent years came from large fiscal deficits that were monetized by the central bank and broader banking system, while private debt issuance in the form of bank loans and corporate bonds was rather normal.
A straightforward way to illustrate most of this is to compare the absolute size of annual federal deficit vs private debt issuance. There are multiple ways to measure private debt, and so for this exercise I will limit it to private debt that impacts the end-users on main street in a rather cyclical way (bank loans and corporate bonds) and factor out interbank lending and other financial plumbing details. And I’ll use a nearly 70-year period from 1955 to the present, representing the majority of the post-war era.
This chart shows the period from 1955 to 1990, representing three-and-a-half decades. The red line is the size of the annual federal deficit (or surplus, when negative) in absolute dollar terms, and the blue line is the annual increase (or decrease, when negative) in the amount of bank loans and corporate debt securities in absolute dollar terms. The yellow areas indicate periods where the red line is higher than the blue line, meaning that public deficit spending is bigger than end-user private debt creation in absolute dollar terms. The vertical gray bars represent recessions:
And this chart shows the period from 1990 to the present, representing (almost) another three-and-a-half decades:
The first observable trend is a cyclical one. During economic expansions, cyclical main street private sector debt (blue lines) tends to grow considerably. And then it tends to shrink a lot during and shortly after recessions, as some borrowers default and as lenders are more reticent to make new loans or buy new bonds. Acting somewhat countercyclically to that, fiscal deficits (red lines) tend to be lower during economic expansions, but tend to shoot up in the aftermath of a recession. This is partly because tax receipts tend to decline from weaker capital gains and weaker employment, and partly because fiscal policymakers enact various bursts of spending to try to stimulate the economy.
The second observable trend is a structural one. Over time, fiscal deficits have outpaced cyclical main street private sector debt. It’s far more common for the annual amount of fiscal deficits to exceed the annual combined amount of new bank loan and corporate bond issuance. Investors and analysts that are primarily monitoring the bank sector and credit markets as it pertains to the economy are going to be less accurate at forecasting things than investors and analysts focusing more-so on the fiscal side of things, because the fiscal side is a bigger force in this current era.
And this likely isn’t going to stop anytime soon according to the CBO and according to most realpolitik assessments. Congress is highly polarized, with little incentive to either raise taxes or cut spending. The bulk of the spending goes to Medicare, Social Security, the military, and interest expense. The former three are all extremely unpopular to cut and generally considered the “third rail” of politics, and the fourth one generally goes up as the Federal Reserve raises interest rates or reduces its holdings of government bonds. So, tighter monetary policy directly feeds into looser fiscal policy (larger deficits).
These CBO charts assume no recessions in the next three decades, and assume lower interest rates than the current levels, and yet still show spiraling fiscal situation:
The Fed’s primary way of meeting its dual/triune mandate is to try to modulate the rate of bank lending. When they want to stimulate the economy, they try to encourage more lending and borrowing. When they want to slow down the rate of inflation, they try to discourage lending and borrowing. And back in the 1970s, that was a big deal, because lending/borrowing was indeed the majority of where the new money creation was coming from.
But here in the 2020s, that’s not where the majority of new money creation comes from. Fiscal deficits are larger than most other sources of money creation, and their spending plans are not affected much (if at all) by the Federal Reserve’s tools. Congress and the President are not going to pass legislation to structurally change Medicare or Social Security in any meaningful way based on whether interest rates are 2% or 5%. The same is true for Defense. And they’re not going to cite high interest rates as a catalyst to raise taxes by hundreds of billions of dollars per year. And if one political party tries to do any of these things, the other party is likely to heavily resist it. A large portion of the structurally rising deficit was baked into the cake decades ago, due to the specific design of the entitlement systems and the demographics of the country.
And interest expense stands out because more-so than just being unaffected by higher interest rates, it is pro-cyclically affected. The tighter that the Fed gets in terms of monetary policy, the more it increases the government’s interest expense, which leads to larger overall deficits, which is generally stimulatory and inflationary for the economy. And if the large deficits eventually result in a liquidity issue for the market of Treasury securities, the Fed will be practically forced to accommodate it with more liquidity.
Back in the late 1970s when federal debt was only 30% of GDP, raising interest rates to high levels slowed down bank lending more-so than it increased federal interest expense. However, now that federal debt is over 120% of GDP, when the Federal Reserve raises interest rates it increases the federal interest expense (and thus overall fiscal deficits) at a faster rate than it slows down bank lending and corporate bond issuance.
In other words, the Fed’s control loop is less effective in high public debt environments than it is in low public debt environments, and beyond a certain point can even be counter-effective. This is because their tools don’t address the fiscal side, and in some cases they can even contribute to a federal debt interest spiral, where more debt needs to be issued to fund larger interest expense, which in turn further increases the interest expense and requires more debt issuance. All the meanwhile, the entities on the receiving side of that interest are able to spend much of that interest income into the economy, which depending on their propensity to spend is somewhat stimulating and inflationary for the economy.
Investing Implications
Fiscal-driven economic reacceleration does not necessarily mean that all asset prices will benefit.
Some sectors are very sensitive to interest rates, and thus more negatively affected by tight monetary policy than they are assisted by loose fiscal policy. Specifically, any industry that uses a lot of debt relative to its assets and cash flows, and especially with short or intermediate-term durations for that debt, are very vulnerable to high interest rates. The commercial real estate industry and regional banks that lend to commercial real estate operators are the main example of this right now. And it can take a while for those high interest rates to fully impact those industries, because it takes time for more and more of their debt (bank loans and corporate bonds) that was issued years ago to mature and get refinanced at these higher interest rates.
Other sectors are not very sensitive to interest rates, and so if they are directly or indirectly on the receiving side of some of these large fiscal deficits, then they are fundamentally on the right side of what’s happening now. This includes profitable technology stocks (currently reaching new all-time highs), healthcare stocks (currently reaching new all-time highs), defense and aerospace stocks (currently reaching all-time highs), travel and dining (American Express and Booking Holdings at or near all-time highs), and basically anything that upper-middle class people and/or retirees in general spend money on.
The ongoing strength of those sectors that are supported by fiscal deficits is directly harmful to the weaker sectors such as commercial real estate, because those strong sectors keep the economy afloat and therefore keep the Federal Reserve from loosening monetary policy much if at all for those weaker sectors. The cavalry is likely not coming to save commercial real estate, in other words.
So, unless something meaningfully changes, I expect to see continued strength in sectors that are not very sensitive to interest rates, and continued weakness in sectors that are sensitive to interest rates, speaking in terms of their fundamentals (revenue and earnings). With a bigger-than-normal divergence between loose fiscal policy and tight monetary policy, comes a bigger-than-normal performance gap between sectors that are more tightly correlated with fiscal policy and monetary policy respectively.
Now, to translate that economic outlook into a longer-term investment outlook, we need to then consider a valuation overlay. Valuations can’t tell us almost anything about what will happen over a given 1-year period, but they have a lot of correlation regarding what will likely happen over a 5-year period or longer.
For example, I expect tech stocks to continue to perform quite well fundamentally (higher revenue, earnings, and so forth), but that’s already baked into the price for most of those stocks with high valuations. And I’m not exactly jumping to buy various high-valued non-tech stocks like Costco (COST) at this time even as I expect their underlying revenue and earnings to do well.
My preferred sector in terms of risk/reward is the energy sector. Various energy producers with long-lived reserves and strong balance sheets are priced at very attractive levels, and would stand to benefit if economic re-acceleration continues.
I also like certain industrial companies, payment service companies, and basically anything that’s on the benefiting side of the country’s current fiscal dominance and that is trading at a reasonable valuation. The United States is increasingly running a fiscal-driven protectionist industrial policy with high nominal growth, and this affects which sectors are likely to do well.
Portfolio Updates
I have several investment accounts, and I provide updates on my asset allocation and investment selections for some of the portfolios in each newsletter issue every six weeks.
These portfolios include the model portfolio account specifically for this newsletter and my relatively passive indexed retirement account. Members of mypremium research service also have access to three additional model portfolios and my other holdings, with more frequent updates.
M1 Finance Newsletter Portfolio
I started this account in September 2018 with $10k of new capital, and I dollar-cost average in over time.
It’s one of my smallest accounts, but the goal is for the portfolio to be accessible and to show newsletter readers my best representation of where I think value is in the market. It’s a low-turnover multi-asset globally diversified portfolio that focuses on liquid investments and is scalable to virtually any size.
And here’s the breakdown of the holdings in those slices:
Changes since the previous issue:
- No major changes.
Bitcoin Note:
I use allocations to bitcoin price proxies such as MSTR and spot bitcoin ETFs in some of my portfolios for lack of the ability to directly buy bitcoin in a brokerage environment, but compared to those types of securities, the real thing is ideal.
I recommend holding actual bitcoin for those that want exposure to it, and learning how to self-custody it. I buy mine throughSwan.com.
I don’t have a firm view on the bitcoin price over the next few months, but I am bullish with a 2-year view and beyond.
Other Model Portfolios and Accounts
I have three other real-money model portfolios that I share within mypremium research service, including:
- Fortress Income Portfolio
- ETF-Only Portfolio
- No Limits Portfolio
Plus, I have personal accounts at Fidelity and Schwab, and I share those within the service as well.
Final Thoughts: To Cut or Not to Cut
Earlier this year, the market was pricing in about seven interest rate cuts (1.75%) for the 2024 calendar year, whereas now it is pricing in about three interest rate cuts (0.75%).
If the Fed holds rates steady where they are (or raises or cuts them a little bit), interest expense will keep climbing as older bonds continue to mature and get refinanced into currently high rates. This will keep feeding into larger fiscal deficits which are stimulatory for certain sectors, and the U.S. economy will begin approaching all-time highs in terms of interest expense as a share of GDP.
The federal government’s absolute interest expense is currently over $1 trillion per year and climbing, and if the current level of public debt (>$34 trillion) gets refinanced to an average of 5% rates over time, it would be >$1.7 trillion in annual interest expense or >6% of current GDP. In reality, by then both the debt level and GDP would be higher, and the overall ratio of interest expense to GDP would be significantly up:
On the other hand, if the Fed meaningfully cuts rates, then it would slow down the rate of growth in federal interest expense, but potentially lead to other outcomes.
Right now, the dollar index is nearly 104, which is rather strong. This is helping keep the global price of oil in check (as most of it is denominated in dollars), and puts a lot of downward pressure on various developing countries around the world that have considerable dollar-denominated debt, which impairs their growth rates and overall oil/resource consumption. Taken in isolation, this is a disinflationary force.
If the Fed cuts rates despite signs of economic re-acceleration, then in addition to helping some of the U.S. sectors that are vulnerable to high interest rates, it would likely weaken the dollar index around the margins and relieve some of the pressure from dollar-indebted developing countries and thus allow for an uptick in growth and oil/resource consumption. While this would be a good thing for many people, it also would increase the probability of the oil price rising again, which would reinforce some of the sticky inflation trends and increase the probability of long-duration Treasury yields rising.
While I do not have a firm view on what the Fed will do, I’m paying close attention to this scenario, since either way it seems constructive for assets such as energy and industrials that benefit from this current era of fiscal dominance. I like cash-equivalents, TIPS, and gold for the defensive side of a portfolio, and broad equities including energy exposure for the growth side of a portfolio.
Best regards,
