December 30, 2020
As we close calendar year 2020, $18 trillion of investment grade debt trades at a negative yield. This is primarily a consequence of the major central banks purchasing their own sovereign debt. This is a weird closed loop. The left hand(The US Treasury) borrows money to fund Congressionally authorized fiscal deficits while the right hand(The Federal Reserve) creates the money to fund incremental Treasury bond issuance. In essence, the central banks are fixing interest rates at low levels. Whether one agrees with this policy or not, it has second and third order effects, intended or unintended.
Of consequence, the hurdle rate for investments is artificially low, dis-incentivizing low-risk savers while encouraging higher risk investments which elevates asset prices. Secondly, the role of government in the economy grows and the corresponding reduction of liberty persists. During the Clinton presidency, the “bond vigilantes” became a governor on excessive spending. If bond investors collectively viewed prospective spending and government deficits as excessive, they could and would sell down the bond market, driving up interest rates and the cost of federal debt and deficits. However, today’s Modern Monetary Theorists remove the market based discipline of the bond traders. They are kryptonite to the bond vigilantes.
The Congressional Budget Office estimates a federal government budget deficit of $3.3 trillion for the fiscal year ended September 30, 2020 or 16% of GDP. Federal government spending has climbed to 32% of GDP from its prior level of about 21% of GDP. Compare this to federal spending from the country’s founding until 1930 of about 3% of GDP. Indeed, 2020 was a pandemic year, but it remains to be seen if bureaucrats have the discipline to return federal spending to pre-Covid levels.
We are challenged to see a way out of this closed loop without the authorities resorting to inflating away some of the country’s debt burden. As such, we believe investors should take a cautious approach entering 2021 while increasing allocations to assets that perform well during periods of currency debasement.