Archaic perhaps, but I am an impassioned proponent of sound money – and have been for a long time. It’s vital – fundamental. The Austrian School of Economics heavily influences my analytical framework. I focus first on Credit inflation – the expansion of new financial claims. This new purchasing power has varied inflationary effects – including consumer and producer price inflation, asset price inflation and Bubbles, over/mal-investment, trade and current account deficits…
Prolonged periods of excessive Credit growth ensure Bubbles (i.e. Credit, asset, speculative and investment) and progressively destabilizing Monetary Disorder. Inflation is insidious, pernicious and poorly understood. Policy and economic circles will continue to debate “r-star” (the so-called “natural rate”). Others will waste time debating the appropriate inflation target rate. Two or 3% doesn’t matter at this point. Decades of damage have been wrought to financial, market and economic structures.
We’re now three decades into history’s greatest Credit Bubble, which, not by accident, coincided with radical monetary management experimentation. I often refer to the “Terminal Phase” of Bubble excess, with systemic risks rising exponentially as the cycle comes to its fateful conclusion. That these dynamics have unfolded on an unprecedented global scale only makes the backdrop more perilous.
The consequences of decades of unsound money are coming home to roost. Our nation is hopelessly divided in an increasingly decoupled world. Predictably, inflation and Bubbles are sowing inequality, insecurity, hostility and conflict – at home and abroad. Trust in critical institutions continues to wane.
The costs associated with this epic policy failure will be enormous – possibly catastrophic. There are no quick fixes. Markets are dreaming if they actually believe inflation will soothingly return to the previous cycle’s relative quiescence. The ongoing toll on society will be tragic – the triple trouble of destabilizing inflation, bursting Bubbles and disorienting monetary disorder. And since this historic Credit Bubble and inflations have been global phenomena, geopolitical hardship could prove even more consequential.
I contemplate how the world would be these days had not trillions of monetary inflation (i.e. U.S. current account deficits, central bank QE, fiscal deficits) created massive international reserve holdings for both China and Russia. I ponder the scope and duration of China’s Bubble inflation without the endless fuel of loose U.S. finance and Trillions of trade deficits. It may seem crazy to many, but I see a direct link between Trillions of QE, years of zero rates – runaway inflationist monetary policies – and China’s perilous Bubble and the rise of the aspiring heroic autocrat, Xi Jinping. And I don’t see Putin invading Ukraine without his $500 billion international reserve stockpile, inflated global energy prices, and a powerful (enemy of my enemy) “partner without limits” with global superpower and new world order ambitions.
It was an eventful week. The brutal Ukraine War reached its one-year mark. President Biden made a surprise visit to Kiev to signal unwavering support. In Moscow, Putin threatened nuclear escalation, while backing away from the START nuclear non-proliferation treaty. And as U.S. concerns mount over more direct Chinese war support for Russia, Xi Jinping presents himself as a peacemaker. Prospective BOJ governor Kazuo Ueda testified before a lower-house Diet committee. In the U.S., there was additional corroboration that inflation and the economy maintain significant momentum in the face of higher policy rates and market yields.
A much stronger-than-expected Services PMI (8-month high); a revised higher Q4 Core PCE (4.3% from 3.9%); lower-than-expected weekly initial and continuing jobless claims; stronger-than-expected January Personal Spending (1.8%); and higher-than-expected monthly January PCE (0.6%) and Core PCE (0.6%). Wow.
Blockbuster January jobs data were no aberration, leaving markets increasingly dazed and confused. Wednesday’s release of the minutes from the FOMC’s February 1st meeting provided no relief. Seemingly at odds with Powell’s press conference focus, the minutes passed on “disinflation” while noting concerns for easing financial conditions.
Ten-year yields jumped another 13 bps this week to 3.94%, the high since November. Two-year yields surged 20 bps to 4.81%, surpassing the November peak to the highest yield since pre-crisis June 2007. The market is now pricing peak Fed funds at 5.40% for the June 24th FOMC meeting, up 12 bps this week and 56 bps since February 2nd. Expectations for the December meeting policy rate jumped 22 bps this week (up 88bps in three weeks) to 5.28%. Market pricing now has consecutive rate increases at the March, May and June FOMC meetings, with about a 20% probability for a 50 bps hike next month.
Rising yields is a global phenomenon. Italian yields rose another 14 bps this week to 4.44%, with Italian two-year yields surging 28 bps to 3.58% – the high since the summer of 2012 crisis period. UK two-year yields jumped 23 bps to 4.00% – trading this week above 4% for the first time since post-BOE emergency operations in October. Two-year German yields rose 15 bps, surpassing 3% (3.02%) for the first time since just before the wheels came off in October 2008. Outside of the euro zone, Swedish two-year yields gained 34 bps to 3.18%, also the high back to October 2008. Two-year yields rose 12 bps this week in Canada to 4.27%, matching the peak since 2007.
February 24 – Reuters (Takaya Yamaguchi and Leika Kihara): “Japan’s core consumer inflation hit a fresh 41-year high in January as companies passed on higher costs to households… The data underscores the dilemma policymakers face as soaring prices of fuel and daily necessities hit households… The nationwide core consumer price index (CPI), which excludes volatile fresh food but includes energy costs, was 4.2% higher in January than a year earlier, matching a median market forecast and accelerating from a 4.0% annual gain in December. January’s rise was the fastest since September 1981…”
February 24 – Bloomberg (Toru Fujioka): “Bank of Japan Governor nominee Kazuo Ueda warned against any magical solution to produce stable inflation and normalize policy as he largely stuck to the existing central bank script in the first parliamentary hearing to approve his appointment… Ueda said the BOJ should continue with stimulus for now, while flagging the need to consider returning to a normal policy approach if the outlook for prices clearly improved. He said it would still take some time to reach stable and sustainable inflation in Japan… ‘If I’m appointed BOJ governor, my mission isn’t to come up with some kind of magical, special monetary policy,’ Ueda said. ‘As I’ve mentioned before, if you look at the trend in prices, there are improvements we’re seeing, but the situation remains that it’ll still take some time until we’ve securely achieved 2% inflation.’”
Observers were left pondering the meaning of “securely achieved 2% inflation.” A Friday Reuters headline: “Japan’s Consumer Inflation Hits 41-year High, Keeps BOJ Under Pressure,” following data showing 4.3% y-o-y Nationwide CPI (10th straight month above 2%). Ueda, understandably, didn’t want to rattle markets with any hawkish talk. Currency traders were ready, salivating.
The yen dropped 1.3% in Friday trading, boosting the loss for the week to 1.7%. The dollar versus yen ended the week at 136.48, the high since Kuroda’s December 20th yield curve control (YCC) adjustment.
Once inflation dynamics become firmly embedded, a return to stability becomes extremely difficult. This is the case for inflationary monetary policy, such as the Bank of Japan’s years of reckless QE and YCC. It’s also true for asset inflation and speculative Bubbles, and certainly with consumer and producer price inflation.
Suddenly, it’s as if global markets have awoken to the risk that central bankers might be battling stubborn inflation for several years. What a difference a few weeks make.
I certainly have my doubts that consumer inflation will conveniently return to previous dynamics. New cycle dynamics are at play. Indeed, there is today every reason to expect ongoing deterioration in the geopolitical backdrop. The forces of “de-globalization” and, more specifically, decoupling from Russia and China gain momentum by the week. In the U.S. and elsewhere, there are powerful investment booms associated with domestic manufacturing, renewable energy, infrastructure, defense spending and climate change. And there aren’t enough workers. These are patently not elements of previous cycle dynamics.
And on the subject of nascent new cycle dynamics.
February 19 – Wall Street Journal (Editorial Board): “California Gov. Gavin Newsom’s budget last month projected a $22.5 billion deficit, but apparently his forecast was too sunny. The Legislative Analyst’s Office (LAO) warned last week that the state’s budget hole may be a lot bigger owing to plunging revenue. Look out below. The state’s monthly tax revenue in January was about $14 billion lower than during the same month last year. Tax revenue in the current fiscal year that started last July is running about $23 billion lower than in the previous year… The top 0.5% of California taxpayers pay 40% of state income taxes. Volatile equity prices and layoffs at Silicon Valley companies are hitting capital gains. Companies are also cutting bonuses. Corporate tax revenue came in about 20% lower in January than during the previous year… As a result, LAO estimates tax revenue during this fiscal year and the next will likely be $10 billion lower, and the budget gap will likely be about $7 billion larger than the Governor forecasted last month…”
California was on the right side of previous cycle inflationary dynamics. Asset inflation and the technology Bubble inundated the Golden State with “money.” With coffers overflowing (capital gains and Silicon Valley pay packages as big contributors), the state spent lavishly. Years of heady inflation ensured California became a very expensive place to live and operate a business. High costs and extreme inequality created deep-rooted problems. Now there’s a persistent exodus of workers and companies. Tech and real estate Bubbles are faltering, leaving a legacy of high costs and declining tax revenues.
I expect California to illuminate a fundamental Bubble maxim: inflation may appear the great wealth creator during booms, but when Bubbles burst the true scope of wealth destruction is revealed. California has plenty of company. Bursting Japanese and Chinese Bubbles, in particular, will expose epic inflated perceived wealth, mal-investment and wealth destruction.
It was interesting to see China’s renminbi drop Friday concurrently with the Japanese yen. The dollar index gained 1.3% for the week (largest weekly gain since September), as contagion gathers momentum. The combination of a rising dollar and surging global yields risks restarting problematic de-risking/deleveraging dynamics. It was interesting to see Chinese sovereign and big bank CDS prices jump to highs since the first week of the year. For the most part, however, my mosaic of financial conditions indicators signaled only a moderate “risk off” dynamic. But the risk of a highly destabilizing de-risking/deleveraging dynamic materializing is high.
It’s been an interesting few months. There was a big squeeze. Folks got all bulled up again. Buy the dip; stocks always recover. A few months of “risk on” ensured that short exposures and derivative hedges were reduced. I’ll assume the leveraged speculating community leaned in on the long side. The Fed has had months to withdraw liquidity (QT) during a period of risk and speculative leverage embracement. QT will become a liquidity issue during the next period of “risk off” deleveraging.
I certainly don’t sense that markets are prepared for a return of the 2022 dynamic – only worse. But when deleveraging takes hold, the questions from last year will reemerge: Where is the Fed put? How quickly would the Fed shift to QE – and at what size? And the more inflationary pressures persist, the more difficult these questions will be for the Fed. At this point, any serious de-risking/deleveraging episode comes with major risks. The day markets begin to question the Fed and global central bank liquidity backstop, there is a serious problem.
A scenario doesn’t seem that far-fetched to me. Confidence in China’s recovery wanes. The new BOJ governor faces a disorderly yen devaluation and fragile bond market. Already destabilized global markets – especially the vulnerable European periphery and EM – get hit by geopolitical developments. Escalation in the Ukraine war – nuclear blackmail. The U.S. responds to Chinese war support with sanctions – China reciprocates. Things become heated. Global markets turn dicey, with pressure on the Fed to intervene with bond market-stabilizing QE. With one eye on shaky markets and the other on sticky inflation, how will the Powell Fed respond? Will it suffice? Years of unsound “money” coming home to roost.
Original Post 25 February 2023
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Categories: Doug Noland