BlackRock: Fiscal boost is not a market risk – yet

The prospect of another large U.S. fiscal package has fed debates about potential economic overheating. We believe central banks for now have strong incentives to lean against any rapid rise in nominal yields even as inflation rises, supporting our tactically pro-risk stance. Yet rising debt levels may eventually pose risks to the low-rate regime. This is part of why we strategically underweight government debt.

Chart of the week

Estimated U.S. cumulative GDP loss and fiscal support, GFC vs. Covid

Sources: BlackRock Investment Institute and the International Monetary Fund, with data from Haver Analytics, February 2021. Notes: The orange bars show the discretionary fiscal boost following the GFC and Covid shocks. The GFC measure is captured by the change in the cyclically adjusted budget deficit in 2008 and 2009 calculated by the IMF. We use broker estimates of discretionary fiscal measures explicitly introduced in response to Covid for 2020-21. The yellow bars show the cumulative sum of the difference between actual U.S. GDP and where it would have been had it grown at its pre-shock trend rate prior to the Covid-19 shock and the GFC., based on the Refinitiv poll of economists on Jan. 22.

The policy revolution to cushion the Covid shock has driven a record surge in public debt. This is a huge fiscal impulse on its own – but even more so relative to the size and the nature of the shock. We assess that the ultimate cumulative economic loss – what we have long held matters most for financial markets – will be roughly a quarter of that seen after the global financial crisis (GFC). Yet the discretionary fiscal response today is about four times larger, we estimate. See the chart above. Not only is the policy response this time far more overwhelming, but a large part of economic activity will restart on its own once the pandemic is under control, in our view. This is a key difference with the GFC. The objective of the current policy response has been different: it is not to stimulate growth, but to provide a bridge to the post-Covid world. Policymakers, academics, taxpayers and markets have been surprisingly relaxed about the large increase in debt – also a stark contrast to the aftermath of the GFC, when the focus shifted to austerity.

Record-low debt servicing costs help explain more relaxed attitudes to high public debt levels. Public debt in the U.S. is set to reach a record 135% of GDP, according to IMF forecasts. This is twice as high as in the 1990s, but financing costs are only half what they were then. How long will the tolerance of high debt – and the low-yield regime – last? For now we see the new nominal theme in play: a more muted response in nominal government bond yields to rising inflation. Central banks have committed to look through above-target inflation for a while. They may find it politically fraught to raise rates, even if inflation starts to look more concerning. The scars from 2013’s “taper tantrum,” against a backdrop of even higher indebtedness, also create inertia. And if a tantrum were to occur, central banks would quickly be forced to lean against it, in our view. This is why we have conviction the new nominal regime will last for some time – and are tactically pro-risk.

We had stressed in 2019 the importance of clear guardrails around the joint monetary/fiscal policy action. Without them it would be politically challenging to put the fiscal genie back in the bottle and allow central banks to rein in inflation. Over time, this could challenge the demand for government bonds as safe and liquid assets. Investors today pay a premium for holding government bonds for these perceived benefits. We don’t expect central banks to raise rates any time soon. Yet government bonds’ perceived safety could eventually come into question if a narrative took hold that high debt levels and rising inflation make it more risky. Longer-term yields may then start rising as investors demand a greater term premium – the excess yield that compensates them for holding long- over short-term debt. Central banks would initially lean against any yield spikes, in our view, but their ability to sustain such policy would be limited. Issuance of low- or zero-coupon longer term debt – as governments lock in historically low rates – makes bond holders more vulnerable to losses. Example: A one percentage point rise in 30-year German bund yields would spark twice the price loss today than a decade ago, we estimate.

The bottom line: Recent events have strengthened our new nominal thesis: real yields have declined even amid the prospect of almost $3 trillion in additional U.S. fiscal support. This supports our pro-risk stance over a tactical horizon. Whether the low-rate regime lasts will depend not only on monetary policy but on the perceived safety of government bonds. Markets may eventually demand a higher premium for government bonds, even if central banks are more tolerant of higher inflation. This, and reduced ballast properties with yields near lower bounds, is why we strategically underweight the asset class.