We are currently seeing a tug-of-war play out in bond markets. Inflationary forces are battling policy makers and a multi-decade entrenched disinflationary mindset. The gyrations of the interest rate scuffle are affecting every asset in the world with particular impact last week. The ultimate long-term outcomes will be driven by mass psychology, politics, and policy. The exact timing and magnitude of the swings, and the path taken by the eventual transition to more systemic stability are all unknowable unknowns.
In a fractional reserve banking system, money is created by lending. At the heart of the financial system sits the central bank which creates a digital entry of a certain number of dollars and then lends those dollars into existence by depositing them into an account. For example, when the US Treasury issues a bond that is purchased by the US Federal Reserve (Fed), the Fed creates some digital dollars with a keystroke. It then deposits those dollars into the Treasury's account and now holds the Treasury Bond as an asset in exchange. The US Government has just added to its debt and now has cash to spend. That cash didn't exist before the keystrokes that created it via an accounting entry and then made the initial deposit transfer.
What happens in the economy as a result of money creation depends on what happens next with the newly created dollars. Specifically who gets the new money, if it is spent, and how it is spent. The money might not be spent at all. In the aftermath of the 2008-2009 Great Recession, this was largely the dynamic. The newly created money often replaced assets that had lost all or most of their value. By purchasing those assets with newly created dollars, the Fed allowed the system to deleverage without experiencing a deflationary collapse. You could picture it as if the Fed went door to door handing out money to people who had just lost money in the market and were frightened. The recipients chose to keep it in their basement safe rather than spending it. Therefore it wasn't out in the economy competing with other dollars and bidding prices up. The money supply went up, but little consumer price inflation was experienced in the economy.
“Everyone loves an early inflation. The effects at the beginning of an inflation are all good. There is steepened money expansion, rising government spending, increased government budget deficits, booming stock markets, and general prosperity, all in the midst of temporarily stable prices. Everyone benefits, and no one pays. That is the early part of the cycle.”
Over the subsequent decade plus, the situation began to slowly change. As the Fed created money and bought bonds this artificial buying pushed up the price of bonds (lowered interest rates) and made bond holders wealthier. Some of the bond holders whose bonds were bought by the Fed now had cash and needed to reinvest. They bought other securities and bid prices up and lowered interest rates further. The initial money creation went to banks and other financial institutions who were "bailed out" of busted assets. The new money replaced bad assets. Then the money began to flow to those who already had assets. This generated investment returns for asset holders. drove down interest rates and drove up stock, bond, and real estate prices. Asset inflation also contributed to increasing economic inequality. Newly created money bid up asset prices rewarding the wealthy owners of assets who then recycled their returns into the markets in a benevolent spiral for investors. While not showing up in most measure of consumer price inflation, capital markets were warped and the rich got richer as a direct result of Fed monetary policy. The corruption of capitalism commenced.
“It is a disturbing flaw...to equate sound money to relatively contained consumer price inflation. After all, asset inflation and Bubbles are this era’s greatest threats to monetary stability and sound money more generally. Unfettered “money” and Credit is the root cause. Massive monetary inflation and fiscal deficits are categorically incompatible with sound money. And unsound money is incompatible with social and political stability. Inequality, speculative Bubbles and manias, resource misallocation, wealth redistribution and destruction, and deep economic structural impairment are all consequences of years of unsound money. An insidious corruption of price mechanisms over time jeopardizes the very foundation of Capitalism. And as Capitalism decays Democracy flounders. Society frays, while insecurity, animosity, anxiety, and the forces of distrust are left to fill the void. And as we continue to witness, the consequences of unsound money incite only more perilous inflationism.”
When money gets created, buying power increases. What happens to prices at that point depends a great deal on the specific demand (what types of things, services, and experiences people want) and available supply. In the rebuilding post-WWII West, population was rapidly expanding and quality of life improvements mostly resulted in demand for things that were manufactured and built. Families were growing and they upgraded to two cars and increased average home sizes. They then filled those homes with TVs, microwaves, refrigerators, and air conditioning. So the money creation ran up against real material constraints. The result was consumer price inflation.
Conversely, in recent decades, demographics have resulted in slower population growth. Much of the population of wealthy countries already had enough house, cars, and refrigerators. experiences (social media, streaming music, video games), technology (PCs, mobile phones) were relatively more sought after. Technology led to fairly elastic supply (i.e. each unit of social media costs very little in terms of money or resources). Wealth and retirement security continued to be sought after, but as we've seen, that demand funnels money into financial assets and not real assets. So the combination of demographics and technology in recent decades resulted in money supply growth primarily going into financial assets and having a resulting muted impact on consumer prices.
In 2020 the dynamics shifted. Following the market crash at the outset of the COVID related economic shutdowns, governments and central banks jumped into market support in a huge way. Initially the money propped back up asset markets by bidding stock and bond prices up (as covered in last summer's newsletter The Dirt and The Hole). But with unemployment benefits, stimulus checks, forgivable PPP loans to small businesses, and the anticipated coming infrastructure spending much of the newly created money is being spent in the economy rather than being mostly confined to asset markets. This is new and is potentially a big deal. Keystroke conjured dollars are now competing directly with pre-existing dollars for the supply of food, metal, energy, unfinished and finished products of all types. About one forth of all of the dollars ever created were created in the last 12 months.
This new money buying things has spiked commodity prices. According to Bloomberg (Gerson Freitas Jr.), “Commodities rose to their highest in almost eight years amid booming investor appetite for everything from oil to corn. Hedge funds have piled into what’s become the biggest bullish wager on the asset class in at least a decade, a collective bet that government stimulus plus near-zero interest rates will fuel demand, generate inflation and further weaken the U.S. dollar as the economy rebounds from the pandemic. The Bloomberg Commodity Spot Index, which tracks price movements for 23 raw materials, rose 1.6% on Monday to its highest since March 2013. The gauge has already gained more than 60% since reaching a four-year low in March 2020.”
As commodity prices rise, the threat of inflation (in consumer prices now, not just in quantities of dollars) has gained attention. Over the past several weeks, this attention has resulted increasing interest rates. From last week's Credit Bubble Bulletin (Doug Noland) "Ten-year Treasury yields closed out a tumultuous week at 1.41% bps, pulling back after Thursday’s spike to a one-year high 1.61%. Ten-year Treasury yields are now up 49 bps from the start of the year and almost 100 bps (1 percentage point) off August 2020 lows. More dramatic, five-year yields jumped 16 bps this week to 0.73%. Surging yields are a global phenomenon. Ten-year yields were up 12 bps in Canada (to 1.35%), 30 bps in Australia (1.90%), 28 bps in New Zealand (1.89%), five bps in Germany (-0.26%), and five bps in Japan (0.16%) - with Japanese JGB yields hitting a five-year-high."
The threat of increasing price inflation and rising interest rates is a threat to the value of all assets that are based on current and future cash flows. As interest rates rise, the value of future cash flows falls. In particular highly priced stocks where investors are valuing the prospects of far-off future profitability, are vulnerable. We can expect interest rate increases at some point to be met by official attempts to control rates by creating money and buying more bonds (AKA yield curve control). This is where mass psychology comes into play. As long as investors collectively expect a low price inflation future and think that policy makers have things well under control, they will investment decisions that mostly align with the recent past. But at the point where confidence yields to concern, and investors collectively move to protect themselves, we could see a transition to a more ugly downside of the inflationary cycle.
“In the later inflation, on the other hand, the effects are all bad. The government may readily increase the money inflation in order to stave off the later effects, but the later effects patiently wait. In the terminal inflation, there is faltering prosperity, tightness of money, falling stock markets, rising taxes, still larger government deficits, and still roaring money expansion, now accompanied by soaring prices and the ineffectiveness of all traditional remedies. Everyone pays and no one benefits. That is the full cycle of every inflation.”
References:
http://creditbubblebulletin.blogspot.com/2021/02/weekly-commentary-regime-change.html?m=1
Dying of Money, Jens O. Parsson
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