Inflation, deflation, interest rates, currencies, derivatives and more…

The cross currents that drive the current financial markets

By now, inflation as an event is well established (by data). Curiously, inflation as a mindset is absent (there is no mass panic buying and hoarding before prices go further up). Why? Because many believe inflation has already peaked (i.e. the worst is behind us), and deflationary forces will soon overwhelm inflation. While acknowledging these deflationary forces, I opine that greater inflationary forces remain, and that inflation has not peaked but will worsen. Let's examine these opposing forces going forward:

Deflationary forces:

1. Rising interest rates: The stated purpose of interest rate hikes is to kill consumption demand and tame CPI inflation. Actually, it deflates an asset (real estate, equities, bonds) bubble blown by over a decade’s QE/ZIRP policy.
2. Rising U.S. Dollar against other currencies: We are a net importer so a rising dollar is obviously deflationary. (The more accurate explanation: Inflation is not rising price of goods but the rising money supply; global supply of U.S. dollars in quantity is shrinking, so we are by definition in deflation, albeit with rising price of goods. As well, rising dollar against other currencies ameliorates asset inflation from debasement of the dollar’s purchasing power, — as described in point 1 under Inflationary forces.)
3. Recession: We are already in recession (2 consecutive quarters of GDP decline). Orders are down and inventory is up in virtually every sector, and the recession will likely last 2 years. Recessions are inherently deflationary because they kill both demand and supply. (Companies start laying off employees at the first sign of slowdown in profit growth, — not even a full blow profit recession.)
4. Capitalism: Free market capitalism (constant strive towards efficiency and productivity) is inherently deflationary.
5. Aging demographics: Conventional wisdom says retirees consume much less and therefore are a deflationary force. (The more accurate explanation: In a debt-fueled economy with declining labor participation rate due to aging demographics, money-printing by central banks becomes “synthetic” debt-creation to “make up the difference” to curb dreaded deflation. This is what the BOJ and the Fed both have been doing all along.)

Inflationary forces:

1. The $8T printed out of thin air by the Fed since 2008 is still a pig passing through the python. The resultant asset (both equities and real estate) inflation maps faithfully to the amount of money printed (i.e. the extent of central bank “balance sheet expansion”). This suggests that currently elevated asset prices are mere reflection of the denominating dollar being debased, and not the result of incremental purchases. This is the same as saying a $60K house in 1970 is now priced at $2M not because the house is that much more demanded, but because the currency is worth that much less. This profoundly implies assets (especially equity) values may not drop much further from here (remember Venezuela’s stock market went sky high with currency debasement until the Bolívar finally collapsed). Only if the Fed meaningfully reduces its balance sheet (proceeds with QT) will assets materially deflate. So far QT is just all talk and no significant action.
2. China’s “rolling COVID lockdown”: This hitherto deflationary force is about to turn. When China opens up, it will unleash huge demand on energy resources. Since energy is input cost to everything everywhere, this will be stoke (further) inflation all over the globe.
3. Government deficit spending: Biden’s hugely inflationary $6 trillion of COVID relief spending is still a pig passing through the python. Even though this was a one-off, government deficit spending will continue, — with money printed out of thin air by the Fed. This is all inflationary, notwithstanding deceptive labels like “Inflation Reduction Act”.
4. De-globalization: Globalization, through optimal utilization of capital, labor and natural resources, was huge deflationary. The world is currently de-globalizing (i.e. fractionalizing and regionalizing). Economic efficiency is sacrificed for the sake of national security, and the price is inflation (an anecdote of this is backwardation of commodities, despite China's zero-COVID rolling lockdown). Under globalization, one monetary policy (set by the Fed) drove the entire world (otherwise local currencies would rise, making those host countries uncompetitive). This gave rise to a reversion-to-means regime (i.e. the world self-corrected as if run by a single country, — the USA). Moving from this unipolar setup to a multipolar setup under de-globalization, politicians of different states have their own policy ideas, and the global regime changes to a reflexive one (trends self-reinforce and worsen because of “every man for himself”). Since shortages and inflation are already established trends, they will worsen and become more entrenched.
5. “Wars”: Global conflicts, not necessarily hot wars, are inherently inflationary. Think of this as fractionalization and regionalization supercharged with animosity (typically expressed by sanctions, trade barriers, and other punitive measures).
6. Policy interventions: Government interventions have been visibly on the rise all over the globe (by way of handouts and bailouts with money printed out of thin air, and/or restrictions like trade barriers). This counter force to free market capitalism is inherently inflationary (because it introduces mal-investments, misallocation of resources, and other inefficiencies in otherwise free markets).
7. “Peak Debt”: Logic dictates the incessant and exponential growth ( see chart below) of global debt (i.e. “printing” fiat currencies out of thin air) since the 1980s is a “kick the can down the road” practice that eventually results in default. Every sign points to the fact that eventuality is here and now; and the only way to default on government debt is to inflate the debt away. Some posit inflation is (a stealth) policy (Recall the Fed was desperate to create 2% inflation before its current rhetoric of fighting inflation), despite the current drama of fighting it.

To me, the proper way to view the inflation/deflation dichotomy is:

Ever since the 1980s, deflationary forces have been at work, primarily due to demographics (another subject for another time time). The whole purpose of increasingly reckless rounds of QE/ZIRP by central banks ever since Greenspan in 1987 was to flood the financial markets with free money to “tranquilize” the deflation dragon. Unfortunately, this policy created a new inflation dragon which central banks now have to fight with interest rate hikes and QT.

This brings us to the subject of interest rates.

Up till now, despite sharp and rapid rate hikes, real interest rates are still negative. Negative real rates are inflationary because they discourage savings and investment, and encourage borrowing and consumption. To combat persistent (and worsening) inflation, real interest rates must be positive. The highest interest rate along the yield curve right now is only 4.6% (see chart below). Rates will have to rise significantly from current levels in order to combat current inflation level of 8 to 9% (never mind worsening levels).

We have been lulled for over a decade by the Carnage and Shriek of central banking — Bernanke and Yellen — that zero interest rate is “normal”. It is extremely deviant. The average Fed Funds Rate (the lowest of all rates) in the 1960s was 4.2%. It was 7.1% in 1970s; 10% in 1980s; 5.15% in 1990s and 4.14% in 2000s (including Bernanke’s ZIRP post- 2008). The Fed Funds Rate is currently at 3.15% and we have inflation comparable to the 1970s but higher than all other decades, and we have MUCH higher debt than all those decades. Some say the extraordinarily high debt level is precisely what inhibits the Fed from hiking rates to where they need to be (the federal government is already struggling with current interest payments; higher interest rates will increase the chances of unthinkable sovereign default). In making this argument, they contrast the 1940s (a period of high debt level in which the Fed held interest rates low despite inflation) to the 1970s ( a period of low death of high inflation in which the Fed hiked rates commensurate to inflation):

I would argue that the Fed had already lost control of the bond market to the “bond vigilantes”, as I mentioned in my monthly October update. Highly leveraged entities (whether government, enterprise or household) are high risk. In lending to the highly risky, “bond vigilantes” will demand high interest rates, irrespective of Fed action. And we have to remember, “bond vigilantes” include the dozen or so primary dealers to whom the federal government auctions new Treasury issuance. It is from them that the Fed buys Treasuries. If the Fed is on QT, then the primary dealers’ appetite for absorbing new Treasury issuance diminishes in accordance, — UNLESS the new issuance offers a much higher interest rate.

So interest rates will continue to rise, sooner or later “breaking something” (i.e. causing insolvencies). Where will the breakage most likely be? My bet is derivatives — highly leveraged off-balance-sheet contractual “bets” — taken on by global financial institutions (there is a global shortage of pristine collateral — U.S. Treasuries, and Eurodollars with which to purchase them — in order to keep this inverted pyramid structure intact):

Unless the insolvency involves a systemically important institution, the Fed will likely not intervene. After all, it repeatedly warned in advance of impending pain, and cannot just pivot at the first sign of a slight “ouch”. If the insolvency involves a big pension plan (dragging along a big insurance company because of derivatives, — such as AIG in 2008), the Fed will probably inject liquidity as a one-off emergency measure (read: Duct tape over a gash it created in the first place), rather than reinstating QE/ZIRP as a policy pivot (in which case it will lose all credibility). Not until mass unemployment results from severe recession will the Fed exercise policy pivot. This scenario will not happen anytime soon, considering the “Great Resignation” hasn't even begun turning into the “Great Termination”.

Thus, in the next few months, we will likely have a malaise of continually rising interest rate against the backdrop of lingering inflation, recession, and persistent high debt level. In other words, all of the problems caused by Bernanke and Yellen will remain unsolved. Indeed, the only solution for these problems is robust economic growth, — which is impossible given the economy is dragged down by the very same problems. Bernanke and Yellen had inflicted permanent damage to the US economy, dooming future generations to a lower standard of living. For a long time to come, the things we need will get more expensive while the things we own (including cash) will be worth less. To allay inevitably louder outcries from les misérable, the government will no doubt again resort to the “tried but never true” practice of price control. Price Control never mitigates inflation, as advertised. It merely transforms inflation into shortages, which exacerbates further inflation.

Obviously, this malaise as described will not bode well for financial markets. We are nowhere close to the bottom of either the equity or real estate market. The road there seems bumpy (down one day, up the very next) right now, but it can quickly turn precipitous (as it did in 1987). Better still, a look back to 2008 may prove insightful at this juncture:

If this analog pans out, capitulation (aka “the stuff hits the fan”) may happen as soon as Q1–2023. The trigger will no doubt be Minsky Moments (debt defaults implode in domino fashion). This is the other scenario by which the Fed will likely exercise policy pivot. It is the anticipation of this pivot that drives current equity market rallies. The irony is, when a Minsky Moment actually happens, the equity market will crash before the Fed can even say “pivot”.

Meanwhile, ongoing U.S. dollar shortage in the rest of the world (a big subject deserving of another article) will persist for awhile, driving the US dollar further up. Coupled with higher-than-elsewhere interest rates in the US, capital flight to the US will continue. Finding a home in both the U.S. equity and treasury markets, this capital inflow will cushion the decline of those markets (as discussed in my October update). But decline they still will. And when “Lehman” finally appears, this foreign capital will go to money heaven alongside domestic capital in a big “whoosh” (read: we're not yet done with the drawdown on the far right of the chart below)!

Here is the final rub: Let's say none of the bad things previously mentioned happens and central banks accomplish the 100% impossible task of slaying the inflation dragon with “soft landing”. Or more likely, the current inflation, which is far more supply pushed than demand pulled, is cured by recession. The deflation dragon will then awake with more vigor and the central banks will be back to square one. Funny how policy intervention works.