The trade de jour is the steepening yield curve and rising inflation. I have noted many times that the inflation narrative is much more cyclical than it appears owing to early cycle constraints that will fade relatively quickly into 2022. The other driver, so say the narrative, is MMT and runaway US fiscal support. Goldman hoses that today:
US overheating risks
Despite recently raised concerns that substantial additional fiscal stimulus on top of an already-recovering economy could push demand above potential GDP, leading to a sharp rise in inflation, we’re less concerned about this risk, for several reasons. First, although we expect that the passage of a $1.5tn Phase 5 fiscal package as well as an infrastructure bill later this year will push GDP close to potential, we think the risk of overheating from these measures is limited because much of the spending is one-off, and some of the items such as unemployment (UI) benefits will shrink if the economy recovers more quickly than expected. Indeed, as our chart of the week shows, we believe the impact of fiscal stimulus on growth will peak in 2Q21 and then decline over subsequent quarters. Second, we estimate that only roughly 20%of the sharp run-up in “excess” household savings built up during the pandemic will be spent in the first year after reopening given their composition and distribution, with lower-income households more likely to spend down this savings than higher-income ones. And, third, we believe that current estimates of the amount of slack in many major DM economies are understated, suggesting less risk of overheating from continued expansionary policies. In particular, we think output gaps are 3-4pp larger than the average official estimates in the US and the UK, and as much as 5-6pp larger in France, Italy, and Spain.
Sharper yield moves, higher risks
Continued improvement in the near-term virus situation and the increased likelihood of a larger fiscal stimulus package have led US real yields to rise again, and we continue to expect a fairly modest rise in 10yr real yields through the course of 2021 as the growth recovery gathers steam. However, we believe that a sharper-than-expected move higher in real yields is a plausible risk, which could have negative implications for asset markets depending on the source of the real rates move and the broader macro backdrop. For equities, we believe that a sharp rise in real rates driven by an increase in growth expectations—the risk that is most consistent with our forecasts—is more likely to flatten overall equity returns than to lead to a sustained correction, although it would likely lead to pressure on the Nasdaq/tech complex. But rising real rates driven by concerns over more hawkish monetary policy—less likely in our view, but possible through miscommunication—would likely put pressure on US equities and credit spreads, and we would expect the S&P 500 to fall and US credit spreads to meaningfully widen in such a scenario. We would also expect EM equities to underperform in that scenario, although that underperformance would likely only be substantial in the case where China growth expectations also slow. And for FX, we predict that the sharpest pressure for many currencies would occur on a combination of a real rates increase and a slowdown in China growth expectations, with pressure particularly substantial for EM Asia and commodity currencies. Broadly speaking, we believe that the simplest portfolio protection against large real rates increases comes from Treasury markets themselves, although tilting portfolios towards less rate-sensitive areas may also help, and note that gold and USD/JPY may also offer good optionality against real rate risk.
That’s roughly my view. MMT is not embedded enough yet to drive inflation higher beyond 2021. That said, I think markets are going to tantrum a little as the real inflation numbers come in.
Sadly, I am giving up on gold. The real rate risk is obvious now and it has decoupled completely. The only thing I can point to is Bitcoin. As ridiculous as that is, it’s a ridiculous world and fighting that is ridiculous.