Listening to the testimony of the Fed Chair today, I could not avoid researching the parallels to the period between 1970 and 1978, when Arthur Burns was Fed Chairman, and which coincided with Richard Nixon as the President of the United States. Then, not unlike today, the White House sought to influence the Federal Reserve both directly and indirectly to keep interest rates low. Then, as today, it seemed that the Fed eventually capitulated. We might look back and count 2019 as the year where Fed independence was lessened substantially. If true, for market participants this could prove to be substantial and consequential.
Some comparisons before we dig in further. Between 1970 and 1978 the stock market had essentially ended unchanged. However, it rose for three years between 1970 and 1972 (about 25%), fell almost 40% between 1973 to the end of 1974, rose almost 40% in 1975, 18% in 1976 and then fell 17% in 1977. Inflation (as measured by the CPI), was relatively benign by historical standards (averaging about 5% between 1970 and 1973), but then spiked 12% in 1974, began to drift higher between 1975 and 1978, and then exploded 13% in 1979 and 12% in 1980. Correspondingly, the funds rate, after averaging in the mid to high single digits till 1977, jumped up to over 18% in 1980. Over the same period, the dollar lost almost 30% of its value as the gold standard was abandoned (Source: Bloomberg).
Before we start to push further on the comparisons, note that inflation today, as traditionally measured, is much lower than the 1970s. However, market participants know that the traditional goods and services inflation is usually the last data point to show the effect of financial conditions. Asset prices rationally react first to policy. To wit, the equity markets have rallied a lot this year as they correctly anticipated that the combination of no inflation and politics would push this Fed to ease. During crises, and when all else fails, as Ray Dalio observes in his recent book “Principles For Navigating Big Debt Crises”, they “print money”. The difference this time is that asset prices and prosperity are at all-time highs by most metrics.
One other important event that occurred in the 1970s was the closure of the gold window. Once this happened, currencies started to float, and as mentioned above, the dollar started a precipitous decline. Today there is no gold window to suspend, but the de-facto reserve currency is the dollar, and further, these dollars are held in Treasuries. In a sense, this is worse for the US, since Treasuries pay interest. We are in an era where “unthinkables” have become all too commonplace. Who would have thought that sovereign governments and even companies could “confiscate” money via negative nominal interest rates, as is true for over ten trillion dollars worth of global sovereign bonds, and as recently reported, for a number of junk bonds? Could we be in for a correlated exit out of dollar assets and Treasuries and the need to refinance the debt at higher interest rates?
The bond market’s reaction over the last couple of days seems to say as much. Long-end yields rose globally, even as short-end yields fell on the back of renewed dovishness from the Fed.
The history of bond markets suggests two things: (1) Don’t fight the Fed, (2) if the Fed is ready to inflate, don’t buy bonds that might lose a large portion of their principal (and especially negatively yielding bonds which don’t even provide any income and guarantee a sure loss of principal). Until recently, the Fed has been on a tightening path even as other Central Banks were easing. After this week, it’s “game on” towards lower short term rates. Currency markets could be in for a wild ride as could be the long maturity global bonds.
As a result of the foregoing, market participants may seek to allocate some of their risk capital in an effort to protect against inflation even though it has been pronounced dead. Half a century after Arthur Burns, we could be setting up for economic, financial and political conditions that have been unfamiliar and and unimaginable to investors for the last 25 years.