Do the Right Thing
This week, International Monetary Fund Managing Director Kristalina Georgieva observed a critical change in the global fiscal tide. Servicing U.S. debt now consumes more than 17% of federal revenue and is rising rapidly. That compares to the good old days, as recently as 2015, when debt servicing was still too high, but stable at under 7%. To underscore the meaning of her message, the IMF Managing Director clarified that paying “17-plus percent in debt service is just mind-boggling.”
In HAI’s view, Georgieva’s remarks serve as both a warning and a marker of the times. The warning is that debt servicing at over 17% of revenue risks spawning debt spiral dynamics if high interest expenses on a huge debt load can’t be offset by continuously falling interest rates. The marker of the times is that when a managing director of the IMF describes fiscal policy in the U.S. (the world’s largest economy and issuer of the global reserve currency) as “mind boggling,” that’s akin to warnings from economists and numerous market professionals of dangerously outrageous valuations and “irrational exuberance” leading into the disastrous dot.com bubble-bust.
U.S. policy makers seem to have tied themselves up in a Gordian knot. Inflation is a scourge that brings great people, economies, and empires to their knees. In the era after the gold standard with its checks on policy malpractice and inflation, it’s now only the will of error-prone policymakers that stands between inflation and the American people.
With unprecedented wartime-like deficit spending at 6-7% of GDP and no signs of sustainable slowing, the fiscal side of the policy matrix is already off the rails. Recently, however, we have seen that the Federal Reserve and its monetary policy toolkit appear to be broken as well. The Fed, it seems, still has a monetary policy accelerator, but no longer the brake historically needed to combat ruinous bouts of consumer price inflation.
That “mind boggling” 17%-of-revenue debt-service charge is now, fairly or unfairly, the responsibility of the Federal Reserve and its interest rate policy. Now that fiscal largesse has accumulated a nearly $35 trillion public debt pile, even small increases in the fed funds rate can balloon interest expenses and trigger a debt doom loop. Since the Fed began raising rates to fight inflation in 2022, we’ve witnessed the start of just such a mind boggling debt spiral. At this point, despite non-cooperative rates of inflation still well above target, the Fed is certainly reluctant to raise rates further due to the seriously negative impact on government finances. In HAI’s view, we are at the start of a new age of spiraling debt, secular inflation, and compromised monetary policy that’s effectively unable to raise rates sufficiently to suppress that inflation.
HAI believes that Powell’s 2022 hawkish rate-hike blitzkrieg was a one-time party trick. It seems Powell gave it one shot to aggressively hike interest rates, put up a bold Volker-like stand against inflation, tighten financial conditions, discipline markets, and save Fed institutional credibility—for a time. HAI is not critical; it was an admirable effort amid very difficult circumstances. But it now seems undeniably clear that circumstances have materially changed since the Volker era. The old central bank policy playbook is no longer tenable. Powell gambled on an outside shot he could raise rates enough to bring inflation to target and then quickly cut them before they sparked a debt-spiral doom loop.
You’ve got to play the hand you’re dealt, and, post-Covid, it seems Powell had one long shot to play. But inflation began to inflect higher before Powell could credibly cut rates, so it seems the market is calling his bluff. Fed pretense and hawkish lip service are slowly losing sway as a strong unconditional easing bias and reinvigorated Fed put seem to be the message between the lines. Whenever financial conditions tighten beyond critical levels in the equity and bond markets, US policymakers seem inclined to ease financial conditions and lower rates again, despite inflation.
This week, CNBC host Joe Kernen asked first-ballot hall-of-fame investing legend Stanley Druckenmiller the following questions: “I’ve been perplexed about the unwavering focus the Fed has had on cuts. It’s been difficult to understand because it’s been the entire time. And I’m just wondering, how do you view this period, that six-month period, where the focus [has been rate cuts?] That’s all we’ve heard about. Did cuts make sense the whole time? What’s causing that?”
In HAI’s view, Druckenmiller’s response summed up the last six months in central banking beautifully; “I was perplexed with the December pivot, if that’s what you’re referring to. It seemed to me the Fed was in a perfect position. Inflation was coming down. Financial conditions were tightening. And to some extent, I feel like they fumbled on the five yard line with the game on the line… They set financial conditions on fire again.”
Druckenmiller continued, “they worked so hard, and they did so much work when they went from basically zero to five percent. I’d hate to see them all throw it away here.”
Realistically, we can imagine the Fed doesn’t wish to acknowledge that the increasingly bloated interest expense on nearly $35 trillion pile of public debt has become deeply problematic and has compromised monetary policy. Higher interest rate policy to fight inflation has meaningfully fast-tracked a serious debt spiral and ultimate fiscal crisis in the U.S. In HAI’s view, the Fed fumbled on the five because, in that moment (a moment that ended the effective Fed Standard era), the Fed realized that scoring a touchdown in the inflation fight would create a bigger crisis on the fiscal side.
It seems the American people are starting to pick up on the inflationary consequences of compromised Fed policy as well. As inflation hit 9.1% in 2022, consumer sentiment slumped to historically low levels previously associated only with recession. After Powell and the Fed began vigorously fighting inflation and CPI began to drop significantly, consumer sentiment rebounded as confidence in Federal Reserve inflation fighting buoyed sentiment. Now, with inflation rebounding and remaining elevated as the Fed appears to lose its inflation fighting resolve, consumers sentiment is beginning to tank again.
This week, the latest University of Michigan Consumer sentiment survey turned notably ugly. Consumer sentiment this week delivered the “triple crown” the Fed never wants to see. The index of Consumer Sentiment plunged 12.7% month-over-month (M/M), the gauge of Current Economic Conditions similarly fell through the trap-door with a 12.9% drop (M/M), while the index of Consumer Expectations also went for a dive with a 12.5% re-rate lower (M/M).
As UMich Surveys of Consumers Director Joanne Hsu put it, the latest “decline is statistically significant and brings sentiment to its lowest reading in about six months. This month’s trend in sentiment is characterized by a broad consensus across consumers, with decreases across age, income, and education groups.” Hsu continued, “While consumers had been reserving judgment for the past few months, they now perceive negative developments on a number of dimensions.”
The survey also revealed that, inversely proportionate to the Fed’s increasingly obvious easing bias, inflation expectations are threatening to break anchor. Year-ahead inflation expectations jumped from 3.2% last month to 3.5% this month, accelerating above the 2.3-3.0% range seen in the two years prior to the pandemic.
In short, the American consumer suddenly seems increasingly uneasy with the Fed’s predicament. Hsu noted that consumers expressed worries that both inflation and unemployment may be moving “in an unfavorable direction in the year ahead.”
That’s not a ringing endorsement of Powell’s recent claim that “I don’t see the ‘stag’ or the ‘flation’.” This is a mess, and people are increasingly catching on.
Returning for a moment to Stanley Druckenmiller’s interview, the investor offered a powerful reflection: “My favorite central banker was Paul Volcker. He put us into a terrible recession and we got 20 years of prosperity because of the pain we took for 18 months…because he did the right thing.”
But that was then. This is now. We are much further down the unsustainable path at this point, with nearly 125% debt-to-GDP vs. 35% early in Volker’s inflation fight. Doing the right thing now, regrettably, is a far more complicated task, complete with many new trade-offs.
So, what are the implications of a fiscal road to ruin, a seemingly trapped Fed, and palpable policy uncertainty over what to do about it? What are the investment implications of our new age of policy trade-offs?
This week, Guan Tao, global chief economist at BOC International in Beijing, told the New York Times that, the “foundation of trust for the current international monetary system” has been shaken. As a result, he continued, “We can see this wave of gold’s rise may be different from the past.” If we’re entering the age of trade-offs, then we’re entering the age of uncertainty. By extension, we’re also entering the age of financial insurance. In HAI’s view, there’s none better than gold.
For policymakers, already this far down the fiscal and monetary plank, doing the right thing is admittedly much more complicated than it was back in the Volker era. That said, a good start would be to recognize that “The era of procrastination, of half measures, of soothing and baffling expedients, of delays, is coming to its close.” It’s now well past time for policymakers to elevate their concerns. First, as difficult as it may be, forthrightly and honestly commit to identifying the right thing to do. Next, do the right thing.
Weekly performance: The S&P 500 was up 1.85%. Gold was up 2.88%, silver surged 6.80%, platinum was up 4.34%, and palladium was up 3.51%. The HUI gold miners index gained 4.88%. The IFRA iShares US Infrastructure ETF was up 3.07%. Energy commodities were, again, volatile on the week. WTI crude oil was nearly flat, up 0.19%, while natural gas surged 5.14%. The CRB Commodity Index was up 1.03%. Copper continued its rally, up 2.32%. The Dow Jones US Specialty Real Estate Investment Trust Index was up 2.62%. The Vanguard Utilities ETF was up 3.97%. The dollar index was up 0.24% to close the week at 105.18. The yield on the 10-yr U.S. Treasury held nearly steady, down less than 1 bp to close at 4.502%.
Have a wonderful weekend!
Best Regards,
Morgan Lewis
Investment Strategist & Co-Portfolio Manager
MWM LLC
