Today’s post is an important one. I might have put Grandma in the trunk, but the coming struggle between generations is no laughing matter. It very well might end up being the defining theme for financial markets in coming decades.
And this was signed by some heavy hitters. Cliff Asness from AQR, Jim Chanos from Kynikos, Niall Ferguson from Harvard, James Grant from Grant’s Interest Rate Observer, Seth Klarman from Baupost, Paul Singer from Elliott and John Taylor from Stanford, just to name a few. These are serious folk who do not idly throw around open letters to the Federal Reserve Chairman. It’s one thing when Peter Schiff screams about the coming inflationary crisis, but it’s a completely different animal when this list of individuals takes the time, and the risk to their reputations, to write an open letter. No, they did this because they were convinced currency debasement and inflation would be the result.
Well, we should get them some napkins to clean the egg off their faces. Let’s have a look at how their prediction panned out.
Contrary to all their dire warnings, the US dollar did not collapse. In fact, apart from a six month period after their warning, when investors were still heeding the elites’ advice, the US dollar did the exact opposite and instead soared higher. Ooops. And neither did inflation explode upwards. Double ooops.
And let’s make no mistake. It wasn’t just these few that felt this way. It was a widely held consensus view. And as much as I like to think of myself as a contrarian, I swallowed the theme hook, line and sinker. Yup, if they had wanted the MacroTourist’s John Hancock on the open letter, I would have gladly supplied it.
What went wrong?
Why didn’t all that quantitative easing cause the inflation so many were so worried about? Assuming Milton Friedman’s famous equation MV = PQ (where M is money supply, V is velocity and P is Price and Q is Quantity) holds true, the dramatic increasing of M (money supply) should have created a corresponding increase in P (Price).
The mistake was that (most) everyone assumed the velocity of money was much more stable than occurred in reality. Money was shoved into the financial system, and instead of being taken up and lent, it sat inert on banks’ balance sheets.
So instead of the MV=PQ equation balancing from an increase in the M with a big increase in P, instead V just collapsed.
There were few market forecasters who thought the massive quantitative easing programs would simply result in higher financial asset prices, with desperately little inflation, rock bottom rates and lacklustre growth. Yet that’s exactly what we got.
Instead of the Central Bank liquidity going into the real economy, it has fueled a desperate yield chasing, risk extending food fight. In the process, it has exacerbated the growing inequality problem within developed economies’ societies. After all, who owns the majority of financial assets? It’s certainly not the middle and lower class.
We have all seen the various charts that show the increasing inequality, but this one stood out to me.
The rich keep getting richer, while the poor keep getting poorer.
I don’t want this to become a political piece. I am not here to get on my soap box. As traders, we don’t care what should be, but need to be laser focused on what is. And the reality is that this growing inequality affects markets. To ignore it, or get into an argument about proper government policies is imprudent and unproductive. It is what it is.
Central Banks’ reaction to the 2008 Great Financial Crisis worsened this situation, and we need to understand how this might change in the future.
The rise of populism
Regardless of what you think of Trump, there can be no denying that he was elected on a rising populist wave. Too many regular working Americans have been left behind, and they elected Donald on hopes for some real change. Ironically, they elected Obama on a similar frustration, but unfortunately, he was not able to affect the change they hoped.
And just like how Obama was a disappointment, Trump will be an even more bitter pill for the average working class person to swallow.
Trump might mouth words about fighting for the little guy, but he has proven time and time again, he is nothing more than a shill for the big business interests that have encumbered previous administrations.
Trickle down economics is no way to run an economy suffering from a balance sheet recession. Do you really think giving the rich a tax break will cause them to spend? Not a chance. All it will do will raise financial prices even further into the stratosphere.
Now don’t bother arguing with me about the morality of who deserves the tax break. I don’t care. All we care about is what this means for the markets.
Which brings me to the main point of this post. Whereas in 2010 everyone believed quantitative easing would cause inflation, it’s failure to occur has flipped sentiment 180 degrees. Now, no one believes QE causes inflation.
This might be true. I don’t believe it, but that’s what makes a market. If the market believes it, that’s all that matters.
The dramatic collapse in the velocity of money over the past decade has more to do with the clamping down on bank regulations in the wake of Great Financial Crisis than anything else. Following the banksters egregious mistakes, regulators were determined to never let it happen again. The BIS tightened capital requirements, credit controls were increased, in short, supply was withdrawn.
Many will argue that the supply of credit wasn’t the problem, but instead there was limited demand. They point to the excess reserves piling up on banks’ balance sheet and argue; banks didn’t lend because there was no one to lend to. And yeah, like all things in life, the truth lies somewhere in the middle. Following the Great Financial Crisis, I am sure there was a decline in the demand for funds. Individuals were reluctant to borrow after being so badly burned. But at the same time, banks were even more reluctant to lend. Who can forget Bernanke not being able to refinance his mortgage in 2014?
Between lack of demand for credit, along with tightening lending conditions (curtailing the supply of credit), it is now easy to understand why quantitative easing did not cause the increase in inflation and collapse of the US dollar.
Actually, the story gets even worse. At the Federal government level, instead of engaging in pro-cyclical spending, the Tea Party successfully caused the total amount of discretionary spending to decline during the entire Obama administration.
Again, leaving politics aside – it is what it is. But no wonder there has been no inflation. Private individuals have either not wanted to, or not been able to, spend. Same with governments. All that left was corporations, and they don’t see any decent business prospects, so instead of spending, they simply engaged in financial engineering, issuing debt and buying back stock.
Yet even in the face of this dire outlook, eventually the easy money works. Make money cheap enough, someone somewhere will spend it. Slowly, the American economy has recovered, and since then, the Federal Reserve has successfully tapered their QE program. They are even attempting to pull off the never-before-accomplished feat of successfully shrinking their balance sheet. As a reminder, this has never been done. If the Fed manages to pare back their balance sheet, they will be the first modern day Central Bank to do so.
Although the Fed is preparing to enter into a phase of quantitative tightening; the ECB, SNB and BoJ have taken over balance sheet expansion by a large enough degree to offset the Federal Reserve’s withdrawal of liquidity.
Do not be fooled. The Fed is tightening, but global financial conditions are still extraordinarily loose.
Putting it all together
If you believe that QE did not cause inflation because there is no demand for credit, then all the quantitative easing in the world will not change your mind. If that’s the case, then you should run out and buy super-long dated zero coupon sovereigns.
I don’t buy that argument. Yes, I admit that credit demand is much weaker than previous cycles. That’s what happens in a credit super cycle. Each subsequent economic downturn needs to be met with ever-easier credit conditions to achieve the equivalent amount of economic growth.
Yet I don’t see any signs that Central Bankers are not willing to do whatever it takes to create inflation. Even in the midst of a falling credit demand and tightening credit conditions, instead of just allowing the natural economic cycle play out, Central Banks have taken unprecedented steps to create inflation. Whether it is negative rates, mind boggling amounts of quantitative easing, or even moves out the risk curve, there can be no denying that Central Bankers are not willing to do whatever it takes.
Do you really have any doubt that if inflation sunk back down to 0% in the United States that the Federal Reserve wouldn’t be there with a stack of blue tickets?
So I ask you this; with 10-year US treasury notes yielding only 35 basis points over the Fed’s 2% inflation target, aren’t you betting on the Federal Reserve failing? It seems to me that you have to be awfully confident that quantitative easing doesn’t eventually create inflation to make that bet for so little.
I think it’s a dumb bet. Wagering on the continuation of a 30-year bond bull market, with both nominal and real rates at rock bottom levels, seems foolish. Especially given the attitude of global Central Bankers. If there was a willingness to accept a much more German attitude towards Central Banking, then maybe I would be sympathetic to the argument. But if anything, it’s the exact opposite. It’s inflate at any cost.
I can already hear the pushback, “but, but, but, Central Bankers are pushing on a string, and won’t be able to create this inflation…”
Maybe… A good trader learns (usually the hard way) never to say never, so I shouldn’t dismiss this possibility out of hand.
But now that we understand why there hasn’t been much inflation so far, let’s ask ourselves about the forecast going forward.
Either way – inflation
Let’s start with my hypothesis that it’s the supply side of the credit market that has caused the decline in the velocity of money. What has been Trump’s number one priority? Deregulation! He wants government to get out of the way of business, and this includes the banks.
In the aftermath of the GFC, a strange financial anomaly occurred when swap spreads went negative. Theoretically, this should never happen because the rate on risk free US government treasuries should never be more than the rate on an income stream from a bank. Yet, swap spreads did the impossible and went deeply negative.
This happened because banks withdrew their balance sheet from the market. So participants, faced with dwindling supply, paid up for that service.
If we assume that swap spreads to some extent reflect a willingness of banks to engage in lending, then when we compare US 30-year swap spreads to the velocity of money, we see a loose relationship.
Yeah, yeah, I know – I am pushing it with this argument. But I think the recent rise in swap spreads is reflective of an increasing willingness of banks to return to their more traditional role as credit creator. Swap spreads have gone positive all the way out to 10 years. Banks are back in the lending business.
Don’t forget – the Central Banks do not make money. It’s only money when someone takes it up and spends it. That can be private individuals, corporations or government.
Under a Trump administration, I suspect it will be a combination of all three. The supply of credit will be opened up. Trump wants it, the Republicans want it, the banks want it. It’s going to happen.
Which then brings me to the next problem. What if there is no demand for credit? What if Trump allows the banks to lend, but no one wants any?
Well, I recently listened to a great interview on Financial Sense Radio of the charming market historian, Russell Napier. Now, Russell is much more of a deflation-first kind of guy than me, but his views were so important on why, even if we get a mini-deflation scare first, ultimately the end game is for it all to be inflated away. Consider this to be the other side of my argument. I don’t agree with some of his points, but where Rusell ends up, I can’t say I am in any disagreement on.
Why are we so worried about deflation? We aren’t worried about deflation unless it creates falling cash flows that support debt. And if it does that, then it can tip you back into a financial crisis. Obviously there are lots of reasons to be very positive about these companies that are creating cheaper things for all of us, and creating great growth for their shareholders, people listening to this will have to make their own minds up about whether the valuation of those stocks warrant that growth or not, but we need to look at the other side of this. What damage to the solvency of the financial system when cash flows leave one sector of the economy, and head to the other. So that’s creative destructive destruction. We shouldn’t be frightened of creative destruction per se, but clearly our Central Bankers are frightened of creative destruction and that’s why we are where we are. They simply will not permit that old economy to bear the cost of the development of the new economy, and they are determined to sustain it. And how on earth that is going to work out, it is incredibly difficult to see in how they are going to succeed in that.
I know the world absolutely believes that Central Bankers can create inflation, but they are fighting this battle – not that the echoes are creating cheaper prices – which it is, but it’s undermining the business model, and the financial stability of a host of business models, that will end up creating a financial crisis somewhere in the system and I don’t think the Fed can stop that.
Only after a crisis do you get real change. We might have thought that the previous crisis was big enough, but it clearly has not been.
I want to stress that although I have made what seems like an overwhelming case for deflation, Central Bankers cannot beat inflation (or at least I don’t think they can), but that’s not to say that governments can’t beat deflation. I strongly believe that when we need a reaction to the next deflation, it will be there in the form of government.
I would bet strongly that; if the government of the United States decided tomorrow morning that all student debt was being transferred to the state, that everybody who had student debt was effectively debt free and that became the debt of the government, then I would bet strongly on inflation. I would not be talking about deflation because I think the students, and past students, those with debt, would respond to being free of that leverage, would respond by basically running up leverage to a similar level. You would probably get a trillion dollars of growth in bank debt. Individuals primarily borrow from banks. They buy homes, they buy automobiles – we would have a reflation.
The key point to stress is that when Central Bankers fail, that just brings you more government. More activist government, more bigger government, and on the whole, that has not been good for returns on equities. The failure of Central Bankers creates a whole new paradigm, and that new political paradigm, in some way that it is a reversal of the Reagan era, cannot be good for a return on corporate capital.
It’s a very difficult call whether it is a series of mini-crises, or one big crisis. I firmly believe that in the long run, student debt will be forgiven and I advise all students not to repay their student debt. I am more of the view of a big crisis, but the thing that changes the view on student debt is actually a political change. And that political change can obviously be triggered by a major political crisis, or it can just be triggered by an election. I have no strong views on who will be the next United States’ President, but if it was a swing away from the Republican party, then I think it will become very easy for a Democrat to run on the forgiveness of student debt.
So I think the credit system is incredibly fragile. Not necessarily the US, but the global financial system and we might have a crisis that will clearly be the trigger, but it maybe something slower. It might be a gradual change in the United States and the United Kingdom where we come to realize that we cannot redistribute wealth amongst the population – the number one way to redistribute wealth from old to young, from savers to workers, is through higher inflation. And the Central Bankers don’t do that. They fail. It’s a fairly surreptitious way, a slow way, and not a good way to redistribute wealth from the old to the young, and if they fail then we will just get more radical policies from government to make that redistribution. So I don’t have a strong view on whether it is a big or small event that triggers this, but this redistribution of wealth from old to young will become a main political target. Central Bankers will not become the main way through this redistribution will be delivered. And nor should they be either. If this is what the people want and what they vote for, they should have it, but trying to do it through unelected representatives such as Central Bankers is not the way about to go through such a major, major change in how we allocate wealth in society.
The important part of Russell’s point is that although he argues that you usually need a crisis to institute big change, it might be simply sneaked into policy through a gradual changing of the political landscape. And I would argue, this might be already happening.
Bringing Grandma back into this
The older generation has the wealth. Even the baby-boomers without big portfolios have benefited through a social security system that will enable them to retire far earlier than the next generations. Yet we all know the math – there is no way there is enough to go around.
So what’s the solution? There are those who believe we should raise rates, cut spending to the bone, and try to grow our way out of the problem. Well, that might have worked in 1996, or maybe 1986, but it ain’t working now. We are way too far gone.
That leaves two options; default on the debts through a 1929 style credit contraction, or inflate our way out.
Well, we had our chance with a credit event solution. In 2007 the government could have let it all go, but they didn’t have the stomach for it. And since then, they have only become more gun shy. Therefore it is obvious that inflation is the end game.
The only question is timing. The post-GFC environment was a perfect storm for credit constriction through regulation and fear, combined with an unprecedented shrinking of discretionary government spending, that made the ideal recipe for collapsing monetary velocity. I actually think it is amazing that they got any inflation at all in that environment.
But all that’s changing. And it’s not just Trump. Even Europe has realized the heavy cost that austerity took on the Greek economy. Governments throughout the globe are embracing spending and we have a whole new set of young people (who happen to be the largest age group) snaking their way through the demographic curve that will increase economic activity (The Millennials are coming for the Houses).
The fall in monetary velocity over the past decade has convinced everyone that more QE does not equal higher prices. I don’t think they are correct. They are mixing cause and effect. More QE might mean no inflation, it might mean more. It all depends on velocity. And I am not sure it is such an easy call to forecast that monetary velocity will stay down here forever. Animal spirits are difficult to predict.
Yet even if I am wrong, then as Russell Napier so eloquently mapped out, the current policies are sowing the seeds for the next true inflationary reset.
All the economic doomsdayers will spout out all the reasons why the economy cannot grow and why we have far too much debt. But in the next sentence, they will tell you how you should invest in sovereign bonds because of all the risk. What if the risk is not what they fear? What if the governments themselves are the source of the next crisis? We all agree that the government balance sheets are terrible, and that through Central Banks, they will print whatever it takes to inflate their way out of this mess. Why on earth would you want to buy something like that? You are relying on governments to make sure the value of your money stays sound. OK Grandma, hop into this trunk, we’ll take good care of your money while you are in there.
Thanks for reading,
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