Written 1/30/2021
In a concerted fashion, the major central banks of the world (the Federal Reserve, European Central Bank, and Bank of Japan), via “QE Infinity” and Zero Interest Rate Policy, created trillions of money (i.e. debt) outside the physical economies and artificially kept interest rates at near zero for 12 years since the 2008 crisis. This combination inflated asset prices and enriched the financial elite, and allowed corporate CEOs to hyper-borrow for stock buybacks thus inflating their own stock prices and bonuses. Meanwhile, there was no growth in broad money or the general economy because the trillions of new money stayed on the books of commercial banks as “reserve” physically kept at the Federal Reserve (i.e. the money never left the central bank to begin with) earning interest.
Since none of the “printed” money made it into the economy, the economy never recovered from “The Great Recession” of 2008 for lack of money in circulation (despite misleading GDP numbers). See chart below:
This game of asset inflation but economic deflation (record low velocity of money means money is not circulating in the economy, which is deflationary) is what created sharp and felt wealth divide in recent years.
Meanwhile, the government’s deficit spending and public debt keep growing for lack of true economic growth and thus tax receipts. Excluding social security and medicare expenses, almost 1/4 of government expenditures now go to pay interest on debt. The debt keeps getting larger, needs to be rolled over (refinanced) continuously, and even the slightest increase in interest rate will bankrupt the federal government.
Throughout modern history, when a nation is so indebted that it risks sovereign default, its preference is always to “inflate away existing debt” with “cheaper money” created out of thin air. Toward this objective, a torrent of the money on “reserve” at commercial banks will be unleashed. This money will be injected into the general economy and multiplied.
Early signs of this, via broad money supply M2, are already here:
As a result, decades of deflation (i.e. consumer prices staying stable while asset prices rose) will rapidly pivot to consumer price inflation. Here is a step-by-step account of the mechanics and anticipated market participants’ responses:
- “Stimulus” (read: Subsidy) money gets in the hands of households. This new money will multiply by way of the commercial Fractional Reserve Banking system and quickly drive up consumer prices (especially as lock down lifts).
- As money velocity grows with broad money (M2), inflation will be increasingly felt, which will encourage taking money out of speculation and be spent (before prices go further up). This will have a downward pressure on a 12-year long bull stock market.
- “Smelling” the same inflation the bond market will demand higher interest rate on longer dated bonds. Since reaching a 40-year low on 7/31/2020, the 10-Y Treasury (benchmark for mortgage and other business lending rates) yield has already started to rise. The Federal Reserve (the Fed) does not like this because it is another force to drive the stock market down. It will circumvent this free-market corrective mechanism and brute force the long term rates down to continue its financial repression (keeping interest rates below inflation), most probably by way of Yield Curve Control (YCC).
- Liquidity “front runs”. In anticipation of inflation, money gravitates toward inflation-proof assets. This means money will leave paper assets for physical assets ranging from gold (biggest beneficiary because unit price appreciation is the most pronounced in a small market), food and energy (most price rises of all commodities due to necessity and scarcity), copper, lithium and rare earth metals (because of the “Green revolution”), all the way to collectibles with anonymity value (baseball and Pokemon cards, art, etc.).
- A commodity boom obviously benefits natural resource producing countries like Canada and Australia. A declining U.S. dollar (in tandem with inflation) also encourages capital flow from the U.S. into emerging markets like India, Vietnam, Mexico, African countries, etc.
- If the Fed fails to drive long bond rates back down, inflation will accelerate (corporations are quick to pass on higher input cost, thus there won’t be any cushioning of CPI rise). In that scenario, 4% real inflation in 2021 is highly likely. Discounted Cash Flow models using 4% inflation rate will render already overpriced stocks grossly overpriced. The stock market will crash.
- Meanwhile, there will be increasing awareness that “cash is trash” in that environment. Money exiting U.S. stock market will seek safer havens like European inflation-linked bonds (pricing in very low levels of inflation and bound to go up with inflation), Japanese and Swiss equities, etc. In any case, nobody will buy U.S. government bonds.
The Pivot from Deflation to Inflation is a secular global phenomenon. Pretty much the entire developed world will be on this course, not just the US. This means the UK, the Eurozone and Japan. From the 1980 to 2020, the U.S. had enjoyed a 40+ years bond bull market. People like PIMCO’s Bill Gross built entire careers on just riding that one wave. But nobody pointed out that a bond bull market means steadily declining bond yields, which is inherently deflationary. Fortunately, starting from super high inflation levels in the 1970s, the runway was long. We enjoyed “dis-inflationary boom” for 40+ years without actually suffering outright deflation. But now we have run out of runway.
To avoid outright deflation, central banks (led by the Fed) are trying to generate inflation while circumventing the natural free-market corrective mechanism of higher interest rates. Except maybe for Switzerland and Singapore, all major countries will implement some sort of financial repression. This is a slippery slope from market economy to command economy (aka “capitalism with Chinese characteristics”).
Citizens of the West, accustomed to 40+ years of dis-inflationary boom where markets were in control, will now be shocked by more government interference and control. Certain industries and social classes are bound to be favored over others, further reducing the quality of life for the bottom rung of society (if only by invisible “taxation by inflation”). Meanwhile, investors and savers alike now need to think like Chinese investors and savers, whose country imposes financial repression, Credit Control and Capital Control routinely.
If the inflation train ride with controlling conductors get bumpy, we may well see price and rent control, high transaction taxes, and commodity (food and energy) rationing. Buckle up.
