Long live Jay Powell, the new monarch of the bond market

Scale of central bank action to fight pandemic emblematic of profound shift

Robin Wigglesworth

US Federal Reserve chair Jay Powell on a school visit last year. Interventions in bond markets are becoming more heavy-handed in successive crises © AP

Move over Bill Gross. Get outta here Jeffrey Gundlach.

There’s a new bond king in town. Over the years there have been many pretenders to the crown once worn by Pimco’s founder.

But the new monarch of the bond market is undoubtedly Jay Powell, head of the Federal Reserve.

Led by the Fed, central banks have now committed $17tn to fight the economic devastation wrought by the coronavirus pandemic, according to estimates from JPMorgan Asset Management.

That even overshadows the scale of measures taken through the entirety of the financial crisis in 2008-09.

The aggressiveness has led some investors to declare that central banks have in practice nationalised the bond market — fears the Fed chairman sought to allay in Congressional testimony last week.

“I don’t see us as wanting to run through the bond market like an elephant or snuff out price signals,” Mr Powell said.

Whatever Mr Powell may say, the Fed elephant has been doing a tap-dance all over markets.

Just last week, the average yield of US investment-grade corporate bonds hit the lowest ever level, at a time when many companies are seeing their revenues shredded. This may be a shortlived recession, but even optimistic economists reckon it could take years before activity is back at the levels reported when the last bond yield low was seen in early February.

This is natural. The Fed’s $250bn planned purchase of corporate debt alone is nearly as big as Mr Gross’s famous Total Return Fund was at its peak in 2013.

The US central bank’s balance sheet has since March grown by almost $2tn, more than Pimco’s entire assets under management. The enormity reflects the scale of the coronavirus crisis.

But perhaps more importantly, it is also emblematic of a profound but under-appreciated shift in the financial system, the consequences of which we are now starting to realise.

Banks have since their emergence in Renaissance Italy been the central locus of capitalism, the dominant lenders to people, companies and countries around the world.

But the bond market now accounts for well over half of all global debt, according to the Bank for International Settlements.

The magic of securitisation means that virtually any loan can now be packaged into a bond and sold on to investors.

This is a secular trend that shows no sign of slowing down. And for the most part this is a healthy development.

Capital markets are in many respects a better warehouse for the financial risk that any loan represents. When there are issues it doesn’t imperil depositors, or the functioning of the payment system that banks still dominate. But it also has major implications for the conduct of monetary policy — especially at times of crisis.

Central banks were originally set up to backstop commercial lenders and eventually began regulating the level of economic activity by controlling the price of their funding.

But the increasing importance of the bond market means that they have had to dabble far more in what would once have been considered radically unorthodox areas.

Think of central banks as old-school mechanics, but the current financial system as a modern Tesla. They may be able to pop the hood and do rudimentary repairs, but when a Tesla breaks down you’ll probably need an electrical engineer to understand the problem.

Similarly, to fix economic crises today, it is not enough to merely open the spigots to commercial banks. Central banks have to dive deep into the plumbing of the bond market to ensure that they are functioning properly.

Of course, the Fed has often intervened in markets in past crises. But the scale was humdrum compared with what we have seen this year. Although Covid-19 has been an exceptionally abrupt and brutal shock, we are likely to see more heavy-handed bond market interventions in any future downturns as well.

The result may well be far more political scrutiny and regulatory control of various parts of the fixed income industry. If banks had to accept more onerous shackles in return for their rescue in 2008, it makes sense that bond funds — which have now enjoyed an indirect bailout — are also subject to more control.

More immediately, the next natural step may be for the Fed to follow the Bank of Japan in instituting “yield curve control” — in other words dictating a specific target or ceiling for long-term Treasury yields and vowing to buy an unlimited amount of US government debt to keep it there.

Whatever happens in the short term, though, the Fed’s reign over the bond market is from now on likely to be even more total, and potentially permanent.

The COVID Shock to the Dollar

No country can afford to squander its saving potential – ultimately, the seed-corn of long-term economic growth. That’s true even of the United States, where generations of policymakers have come to regard the long-standing belief in American exceptionalism as though it applied to the laws of economics.

Stephen S. Roach

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NEW HAVEN – Pandemic time runs at warp speed. That’s true of the COVID-19 infection rate, as well as the unprecedented scientific efforts under way to find a vaccine. It is also true of transformational developments currently playing out in pandemic-affected economies.

Just as a lockdown-induced recession brought global economic activity to a virtual standstill in a mere two months, hopes for a V-shaped recovery are premised on an equally quick reopening of shuttered economies.

It may not be so simple. A sudden stop – long associated with capital flight out of emerging markets – often exposes deep-rooted structural problems that can impair economic recovery. It can also spark abrupt asset-price movements in response to the unmasking of long-simmering imbalances.

Such is the case for the pandemic-stricken US economy. The aggressive fiscal response to the COVID-19 shock is not without major consequences. Contrary to the widespread belief that budget deficits don’t matter because near-zero interest rates temper any increases in debt-servicing costs, in the end there is no “magic money” or free lunch.

Domestic saving, already depressed, is headed deep into negative territory. This is likely to lead to a record current-account deficit and an outsize plunge in the value of the dollar.

No country can afford to squander its saving potential – ultimately, the seed-corn of long-term economic growth. That’s true even of the United States, where the laws of economics have often been ignored under the guise of “American exceptionalism.”

Alas, nothing is forever. The COVID-19 crisis is an especially tough blow for a country that has long been operating on a razor-thin margin of subpar saving.

Heading into the pandemic, America’s net domestic saving rate – the combined depreciation-adjusted saving of households, businesses, and the government sector – stood at just 1.4% of national income, falling back to the post-crisis low of late 2011. No need to worry, goes the conventional excuse – America never saves.

Think again. The net national saving rate averaged 7% over the 45-year period from 1960 to 2005. And during the 1960s, long recognized as the strongest period of productivity-led US economic growth in the post-World War II era, the net saving rate actually averaged 11.5%.

Expressing these calculations in net terms is no trivial adjustment. Although gross domestic saving in the first quarter of 2020, at 17.8% of national income, was also well below its 45-year norm of 21% from 1960 to 2005, the shortfall was not as severe as that captured by the net measure. That reflects another worrisome development: America’s rapidly aging and increasingly obsolete stock of productive capital.

That’s where the current account and the dollar come into play. Lacking in saving and wanting to invest and grow, the US typically borrows surplus saving from abroad, and runs chronic current-account deficits in order to attract the foreign capital. Thanks to the US dollar’s “exorbitant privilege” as the world’s dominant reserve currency, this borrowing is normally funded on extremely attractive terms, largely absent any interest-rate or exchange-rate concessions that might otherwise be needed to compensate foreign investors for risk.

That was then. In COVID time, there is no conventional wisdom.

The US Congress has moved with uncharacteristic speed to provide relief amid a record-setting economic free-fall. The Congressional Budget Office expects unprecedented federal budget deficits averaging 14% of GDP over 2020-21. And, notwithstanding contentious political debate, additional fiscal measures are quite likely. As a result, the net domestic saving rate should be pushed deep into negative territory.

This has happened only once before: during and immediately after the 2008-09 global financial crisis, when net national saving averaged -1.8% of national income from the second quarter of 2008 to the second quarter of 2010, while federal budget deficits averaged 10% of GDP.

In the COVID-19 era, the net national saving rate could well plunge as low as -5% to -10% over the next 2-3 years. That means today’s saving-short US economy could well be headed for a significant partial liquidation of net saving.

With unprecedented pressure on domestic saving likely to magnify America’s need for surplus foreign capital, the current-account deficit should widen sharply. Since 1982, this broad measure of the external balance has recorded deficits averaging 2.7% of GDP; looking ahead, the previous record deficit of 6.3% of GDP in the fourth quarter of 2005 could be eclipsed.

This raises one of the biggest questions of all: Will foreign investors demand concessions to provide the massive increment of foreign capital that America’s saving-short economy is about to require?

The answer depends critically on whether the US deserves to retain its exorbitant privilege.

That is not a new debate. What is new is the COVID time warp: the verdict may be rendered sooner rather than later.

America is leading the charge into protectionism, deglobalization, and decoupling. Its share of world foreign-exchange reserves has fallen from a little over 70% in 2000 to a little less than 60% today. Its COVID-19 containment has been an abysmal failure. And its history of systemic racism and police violence has sparked a transformative wave of civil unrest.

Against this background, especially when compared with other major economies, it seems reasonable to conclude that hyperextended saving and current-account imbalances will finally have actionable consequences for the dollar and/or US interest rates.

To the extent that the inflation response lags, and the Federal Reserve maintains its extraordinarily accommodative monetary-policy stance, the bulk of the concession should occur through the currency rather than interest rates. Hence, I foresee a 35% drop in the broad dollar index over the next 2-3 years.

Shocking as that sounds, such a seemingly outsize drop in the dollar is not without historical precedent. The dollar’s real effective exchange rate fell by 33% between 1970 and 1978, by 33% from 1985 to 1988, and by 28% over the 2002-11 interval. COVID-19 may have spread from China, but the COVID currency shock looks like it will be made in America.

Stephen S. Roach, a faculty member at Yale University and former Chairman of Morgan Stanley Asia, is the author of Unbalanced: The Codependency of America and China.

Gold: ring the changes

If economies show signs of sustained recovery, expect the yellow metal to take a hammering

Gold has rallied 27% over 12 months, outrunning all other traded commodities in this Covid-stricken year © Bloomberg

Like the metal itself, reasons to buy gold are malleable. Own the yellow metal for its untarnishable beauty, or as a store of value, or both. Jewellery is the largest stable component of demand. But when gold soars, as at present, bling starts to lose its zing. This can presage a price drop.

Demand for gold as an investment had outstripped purchasing for jewellery manufacture just three times in the past decade. That was until the last quarter. The switch suggests a speculative bubble is building.

Gold has rallied 27 per cent over 12 months, outrunning all other traded commodities in this Covid-stricken year. The push has been driven by anxious investors snapping up gold bars, coins and exchange traded funds. Jewellery retailing has meanwhile been obstructed by the closure of shops and postponements of weddings, a trigger for purchases particularly in India.

These problems should be only temporary.

Bulls will offer as many reasons to invest in gold as there are carats. One of these is that the metal — primarily traded in dollars — performs well when real US interest rates (adjusted for inflation) decline. That has happened this year, as reflected in the collapse of US bond yields.

Since 2006, for every one percentage drop in real US Treasury yields, gold prices have increased by about a fifth according to Citi. The debasement of fiat currencies by central banks and world instability are other reasons for gold bugs to hoard the stuff. There is a case to be made that the metal is now overbought.

Real annual gold price returns are again approaching those in the 2008-11 bull run, which were in the 20-25 per cent area, after which gold slumped.

Perhaps the best reason to question gold’s rally is that it is hard to find bearish commentators these days.

Even crotchety Lex became a cheerleader early last year.

The current rally is yet young — less than two years old.

But if economies show signs of sustained recovery, expect gold to take a hammering.

What Today’s Bailouts Can Do for Tomorrow’s Economies

With governments around the world having already injected some $9 trillion into the economy, there can be no doubt that the COVID-19 pandemic has ushered in a new era in which public policy will play a larger economic role than seemed imaginable just a few months ago. How should governments embrace the opportunity?

Saadia Zahidi

zahidi2_seksan MongkhonkhamsaoGetty Images_sustainabilitygrowthmoneyplant

GENEVA – Last year, the World Economic Forum’s annual Global Competitiveness Report assessed 141 governments’ future-readiness and found that most rated poorly on this and other crucial long-term indicators.

Yet now that the pandemic-induced lockdown is wreaking havoc on the global economy and exposing the inadequacies of many institutions, an era of bigger – and perhaps bolder – government has arrived.

Already, an estimated $9 trillion has been pumped into the global economy to support households, stem job losses, and keep businesses afloat.

Now that some countries are beginning to emerge from lockdowns, their leaders have a unique opportunity to reshape the economy to provide better, greener, and more equitable outcomes for all.

The crisis offers an opportunity for what the World Economic Forum has deemed the “Great Reset,” starting not at some point in the distant future but right now. Building on the lessons learned during the 2008 financial crisis and its aftermath, many governments are attaching a range of meaningful conditions to bailouts and other rescue measures.

The short-term assistance being provided today can and should be leveraged to encourage more responsible business practices, save jobs, address inequality and climate change, and build long-term resilience against future shocks.

For example, owing to concerns about rising inequality and pressures on public budgets, France, Denmark, and Poland have denied government support to companies with headquarters in tax havens outside of Europe. And the United Kingdom has banned dividend payments and restricted bonuses in companies accessing its loan scheme.

Governments are also attempting to safeguard jobs by providing incentives for companies to maintain employment levels. US companies accessing Coronavirus Aid, Relief, and Economic Security Act funds must maintain at least 90% of their pre-pandemic employment levels until September 30.

Japan has applied similar conditions in extending its employee-retention assistance to both small and medium-size enterprises and large corporations. And Russia has introduced wage subsidies for companies that retain at least 90% of their workforce.

Meanwhile, Italy is implementing a temporary blanket ban on dismissals, not limited to companies accessing government funds. While it remains to be seen whether these temporary restrictions will be effective at maintaining employment after they are lifted, they are providing a cushion – and a “fighting chance” – to workers in the midst of this unprecedented crisis and ahead of a future recovery.

Even in deeply distressed sectors, rescue measures are being designed to emphasize social and environmental responsibility and encourage more long-term thinking. For example, now that the airline industry is facing a demand shock as a result of global travel restrictions, its pre-crisis business practices have come under scrutiny.

Over the past decade, the largest airlines in the United States spent 96% of their free cash flow on share buybacks, nearly double the rate of other S&P 500 companies.

Now, cash-strapped airlines wishing to access governments funds must not only cease stock buybacks and dividend payments until the end of 2021; they must also agree not to use involuntary furloughs or reduce pay rates until September 30.

Likewise, the French government has attached “green strings” to its €7 billion ($7.9 billion) bailout of Air France-KLM, requiring the airline to commit to halving its carbon dioxide emissions (per passenger and per kilometer), relative to their 2005 level, by 2030.

These instances of embedding long-term thinking into short-term measures are clearly steps in the right direction. But, given the sheer scale of fiscal support being provided and rising concerns about inequality, climate change, unemployment, and public debt, the next wave of recovery measures should go even further.

Here, the European Commission’s Next Generation EU crisis fund should be taken as a model for others to follow. With €750 billion ($845 billion) in grants and loans, it promises to usher in a fair and inclusive recovery by accelerating the transition to a green digital economy.

Its basic conditions would help European countries shift away from declining heavy industries while supporting vulnerable workers. But whether all EU member states will get on board remains to be seen.

The pandemic has thrust governments into a more proactive role than anyone would have imagined just a few months ago. As we move beyond the immediate health crisis, policymakers must seize the opportunity to implement bold, forward-looking reforms.

That includes redesigning social contracts, providing adequate safety nets, cultivating the skills and jobs that the future economy will need, and improving the distribution of risk and return between the public, the state, and the private sector.

But while governments must assume a leadership role, shaping the recovery and charting a new course for growth will require greater collaboration between businesses, public and government institutions, and workers. For the Great Reset to succeed, all stakeholders must have a hand in it.

By now, it should be obvious that we cannot go back to a system that benefited the few at the expense of the many. Forced to manage short-term pressures and confront long-term uncertainties at the same time, leaders find themselves at a historic crossroads.

Governments’ new clout gives them the means to start building fairer, more sustainable, and more resilient economies.

Saadia Zahidi is Managing Director and Head of the Center for the New Economy and Society at the World Economic Forum.

The Coronavirus Savings Glut

Normal consumption patterns are likely years, rather than months, from returning, meaning a boom in savings and depressed interest rates

By Mike Bird

Three months after Western nations began locking their cities down to prevent the rampant spread of the new coronavirus, and with many in East Asia further along in the recovery process, one enduring effect of the pandemic is becoming clear.

Consumer demand has been crushed, and savings are rising in an unprecedented manner.

That now seems likely to have long-lasting effects on financial markets, depressing interest rates for years and creating a beggar-thy-neighbor effect for the international economy.

Shoppers waited to enter a Bloomingdale's in New York on Monday. Only a fraction of savings would have to remain to keep it at historic highs. / Photo: Jeenah Moon/Bloomberg News .

The U.S. personal-saving rate—personal incomes less personal outlays and taxes—touched 33% in April. In the eurozone, the differently calculated household-saving ratio is expected to rise from 13% to around 19% this year and remain at historically high levels into 2021.

The accumulation of savings will undoubtedly slow sharply as purchases that were simply impossible during full lockdowns are completed. But only a fraction would have to remain to keep savings at historic highs.

Research published by the San Francisco Federal Reserve in March addressed the long-term economic consequences of pandemics from history. Unlike wars, where the destruction of physical capital means real interest rates tend to rise afterward, pandemics seem to cause real interest rates to slide for decades afterward, consistent with rising precautionary savings.

Developments in financial markets lend some credence to this theory, with assets both risky and low-risk feeling a relentless bid since the lows of late March. Investors have piled into money-market funds in extraordinary volumes, a development that usually signals a fearful atmosphere.

But the fear is harder to see in the equity market, with U.S. stocks lingering at roughly flat levels for the year.

Foreign investors flooded into dollar-denominated bank accounts in March in particular, driving the largest inflows into U.S. accounts and securities on record.

The makeup of the plunge in economic activity is another concerning signal on the prospects for a full rebound in consumption.

The J.P. Morgan Global Manufacturing PMI, produced by IHS Markit, has never been stronger relative to the equivalent index for services, in data going back to 1999.

In China, the picture remains the same even for a country that has largely exited coronavirus-related lockdowns and entered a partial economic recovery. In May, retail sales were still down 2.8% year over year, while industrial production was up 5.2%. Exports fell 3.3%, but imports fell by 16.7%.

These trends can’t be sustained. Some countries can export their way to growth, as China did from the late 1980s until the mid 2000s or as Vietnam does today. But as a matter of logic, not all countries can have export-led growth at the same time.

John Maynard Keynes wrote about a paradox of thrift. When everyone attempts to save or reduce borrowing at the same time, an economy must contract. Households don’t buy as much from businesses, which in turn don’t hire as many people, depressing tax revenue and government spending. The cycle is vicious and can be easily applied to an international arena. All countries trying to save at once makes the world worse off.

The original idea of the savings glut applied largely to East Asia, where precautionary savings built up after the 1997 Asian financial crisis were plowed into U.S. assets. That depressed U.S. interest rates, so the theory went.

Investors should be wary of overinterpreting the international push and pull of savings gluts.

The idea that when a country imports more than it exports it must sell its trading partners financial assets to fund its deficit is a mistake of international accounting.

Aggressive stimulus programs could counteract the pernicious effects of the beggar-thy-neighbor shrinking consumption, but to do that they must be continued in earnest for some time after the virus is fully defeated, not abandoned at the first plausible opportunity.

That is particularly important for the U.S., given its uniquely dominant role in providing consumer demand globally.

A change of course from China would also help. More generous expenditure on welfare, income support and health care could raise consumption. China’s government spends just 1.8% of gross domestic product on health care and 0.9% on social assistance.

That is not only far below figures in the rich world, but south of the respective 3.2% and 1.6% spent by upper-middle-income countries, those with gross national income of $3,996 to $12,375 per capita. Worryingly, the Chinese government is instead preoccupied with the scale of its fiscal deficit.

Even in the case that the most optimistic forecasts for economic recovery are fulfilled, normal consumption patterns will be the part of the economy slowest to return to normal.

And that means savings will likely remain elevated, leaving a lingering mark on global financial markets.