US on Brink of Fiscal Dominance as Central Bank Credibility Fades

Alan Dunne, portfolio manager at Dunne & Co, believes that the US is one recession away from fiscal dominance. This shift in the macro regime has already begun to manifest itself through various indicators, including a rare coordinated yen intervention with Japan and the active management of the US bond market by Treasury Secretary Scott Bessent.

Dunne argues that this move towards fiscal dominance will have significant implications for investors. He notes that traditional 60/40 portfolios may face muted returns over the next decade due to increased debt levels and reduced central bank credibility. Dunne's own data analysis reveals that trend-following strategies have adapted well to the changed environment, profiting from bond market stress and commodity trends.

The US government's actions are also having an impact on the Fed's credibility. Treasury Secretary Scott Bessent's issuance tactics and the rare yen intervention with Japan have raised questions about the Fed's resolve to tackle inflation. Dunne notes that the current regime has three structural fractures: stickier inflation, debt sustainability concerns, and erosion of institutional norms.

The trend-following strategy has performed well in this new regime by profiting from bond market stress and commodity trends. According to Dunne's data analysis, trend following exhibits negative correlation to both equities and bonds, whereas in the 2010s it was positively correlated to both. The strategy has also capitalized on new themes emerging in markets, such as debt sustainability and deglobalization.