Expecting Inflation

By John Mauldin

The annual whirlwind is over. SIC was once again a mental overload. This year our virtual schedule spread it over almost two weeks, which was actually nice. The in-between days let the ideas settle a bit before the firehose opened again. Fifty powerful, thoughtful speakers are a lot to absorb.

As promised, I’ll continue sharing some SIC highlights with you in my next few letters. This week and next we will look at the inflation/deflation debate. This popped up repeatedly (sometimes by design, sometimes randomly) and often provoked vigorous disagreement.

Today we’ll consider the arguments for higher inflation in the near future. As you will see, they are serious and convincing. But there are equally serious and convincing points on the deflationary side as well. We’ll get to those next week.

Let me say at the outset that I am merely touching the surface of the arguments from the pro-inflation speakers at the conference. There were at least five hours of discussion on the topic, and you need to read at least the transcripts to get the full weight of the argument. What follows below is just a sample.

You can get the full SIC experience with a Virtual Pass that includes video of every session, slides, and transcripts of every session. There’s a lot more and you really need to share the experience. Get your pass here and save 50% by acting before May 31.

Now, let’s hear from some SIC inflation hawks

Inflationary Heartbeat

We’ll start with Peter Boockvar. Peter is the CIO at Bleakley Advisory Group and somehow also produces the Boock Report, in which he flash-analyzes the latest economic data in handy bite-size multiple emails per day. In other words, he has as good a finger on the economy’s pulse as anyone I know. And for the last year or so, he’s felt an inflationary heartbeat.

Peter began with an important distinction between goods inflation and services inflation. They have been behaving differently. Looking at services inflation (ex energy) with the Consumer Price Index, he showed it averaged around 2.8% in the 20-year period leading up to the pandemic.

Source: Peter Boockvar

These services are the non-tangible things you can’t put in your pocket but are nonetheless valuable: rent, healthcare, college tuition, insurance, entertainment, etc. Usually we expect their price to rise every year, our only question being how much. Peter’s data says the answer has been around 2.8% a year. Sometimes a bit more or less, but rarely flat and never negative. Take away the Great Recession and the average is much higher. (Of course, your mileage may vary depending where you live.)

“Goods,” on the other hand, are the material objects and substances we buy in stores, or have shipped to us: food, energy, cars, furniture, toys, lawn mowers, and so on. These prices have more variation than we usually see in services, and often even go down. The 20-year, pre-COVID net, looking at the CPI Core Goods component, was no change at all.

Source: Peter Boockvar

If you never expected to see 0% inflation, now you have. But that’s only in goods; inflation in services pulled the full CPI higher.

How do we explain this discrepancy? We discussed two key factors last week: China and globalization. Goods inflation turned into stability, and often deflation, right about the time China joined the World Trade Organization (2001) and began exporting low-priced goods. But it wasn’t just China; globalized goods production really took off at that point.

Reversal of this strong disinflationary influence is one reason Peter expects inflation. It’s not entirely virus-driven; globalization has been slowing for other reasons. But the pandemic stepped on the brakes even harder. In early 2020 when China basically shut down, we saw how vulnerable these ocean-spanning supply chains can be to events on the other side. Meanwhile, staying home renewed our demand for various physical stuff. If you can’t go to concerts anymore, maybe you buy better home electronics—or a bigger home, which means you (or your contractor) buy more construction material, tools, etc.

Now we see shipping rates and container traffic rising sharply. This isn’t coincidence. The global economy was optimized to deliver something else, and now has to suddenly satisfy new consumer preferences. That drives prices up. Throw in the fact that many transportation companies went bankrupt over the past few years, and the supply of transportation companies all along the supply chain was reduced and thus the prices paid to the survivors have increased.

If services inflation simply continues as it has, and goods inflation rises above the 0% level where it’s been for years, we should expect higher total inflation. But there’s reason to think services inflation will accelerate even more. Buying services really means you’re buying some kind of labor. In a restaurant the food itself costs something, as does the building. But a large part of the bill, maybe most of it, is wages/tips for the cooks, bartenders, and waitstaff. In a hair salon or physician’s office you pay mostly for professional time and skill. There is a close connection between services inflation and wage inflation.

Now look at what happened since last year. The pandemic and its associated restrictions hit the service sector like a neutron bomb. The US government acted, appropriately, to help the millions rendered suddenly jobless. But as often happens, their methods weren’t targeted well. This, combined with the new hazards and hassles of in-person work during a pandemic, reduced the labor supply.

With recovery now underway, employers need workers again and are often having to pay higher wages to get them. That means even more service inflation, on top of the prior 2.8%+ annual growth. Add in new goods inflation and Peter doesn’t see how we avoid a new inflationary cycle. The question is how long will it last?

What Peter and others talked about was what economists call “sticky prices.” Wages are sticky. It is hard to pull back a wage increase. It is not unreasonable to assume that the inflationary forces of rising wages caused by the pandemic and labor shortages will persist.

Demand-Driven Price Hikes

Jim Bianco thinks inflation is already here, and as usual illustrated his point with a series of fascinating charts, some of which I’ll share below. 

I think Jim mostly agrees with Peter Boockvar but the inflation he foresees is more demand-driven. 

A lot of people have a lot of spending money and he thinks it will push prices even higher.

Where did this cash come from? Check out this chart:

Source: Bianco Research

The blue line shows the percentage of personal income that comes from government transfer payments. This includes Social Security, disability benefits, unemployment insurance, and various other programs. It also includes the three pandemic “stimulus” payments send to most American adults. The months those were made pushed this percentage to the peaks you see on the right side. Notice the steep drop after the first stimulus package prior to the even higher peak of the start of the second stimulus wave. Ditto for the third.

These percentages rose not only because the stimulus payments were so huge, but also because wage income had dropped. But the cash stimuli made no such distinction. 

Everyone got their check, needed or not. 

So a lot of it went into savings.

Source: Bianco Research

Again, notice the steep drop-off and increase between the first, second, and third stimulus waves. 

Some of this excess found its way into financial assets, helping stock prices, Bitcoin, etc. 

But a lot of it was spent on other goods and services. 

Jim pointed to rising demand in a variety of sectors. 

It is outstripping producers’ ability to deliver, as he showed in this index of delivery times.

Source: Bianco Research

Having to wait for an item you would once have easily found in the store is itself a kind of inflation, even if the price is the same. 

You get less value than you would by taking it straight home. 

That’s happening right now and it doesn’t show up in CPI or PCE. 

But actual prices are rising too. Jim noted it in raw materials, and said finished goods prices should follow. 

He showed this chart of several price indexes tracked by regional Fed banks. 

The average (gray line) was last at this level in 1980. 

Those old enough may recall a little inflation was evident at the time (1980 saw 13.9% inflation).

Source: Bianco Research

Next, Jim showed this chart of the CRB Raw Industrial Spot Index, which includes copper but also several commodities which don’t have associated futures markets: steel scrap, tallow, burlap, print cloth, etc. 

These are quite important to some key industries and their prices are rising right now.

Source: Bianco Research

High-grade copper, hot-rolled coil steel, and lumber are all soaring.

Source: Bianco Research

Source: Bianco Research

To be fair, much of this price inflation was due to production closures during the pandemic. 

Lumber has backed off recently as more supply comes online and high prices deter some buyers. 

This is why the Fed thinks inflation will be “transitory.” 

And to some extent, they are correct. 

But not completely and certainly not in the other elements of inflation.

Source: Business Insider

Jim summed up his view this way. Note: When Jim says “un-anchoring” that is an economic term. Prices over time tend to be “anchored” to prior prices. When prices become generally unanchored, you get inflation.

One-third of everybody's income is now mailed to them from the government. Everybody is stuffed full of money. They're buying stuff like crazy. The supply chain cannot keep up. It is not a problem of COVID, semiconductors. Look, the head of Intel said that the semiconductor supply chain is going to be a problem for two years. There is a simple fix for the supply chain. Charge more money, that's called inflation. What they've done now isn't status, they've rationed the product, delivery times are at a 70-year high, but I think the next step is they're going to charge more money and we're going to get inflation…

But I have a feeling that we're going to find that once the base effect passes, those price increases are going to stick around, people are going to become comfortable raising prices, un-anchoring, and then we're going to have something we haven't seen in a long time and that's inflation. You pretty much have to be over the age of 50, probably over the age of 60 to remember inflation first-hand, it's been such a long period of time. But what I try to show with this is almost every measure says that inflation is coming back and it's coming back with a vengeance.

That’s pretty convincing, but there’s more.

From Energy to Wages

Last week I mentioned Louis Gave’s appearance on our China panel. His later solo presentation was, if possible, even more perceptive. While Louis expects inflation for some of the same reasons Peter and Jim mentioned, he went on to make an interesting connection with energy, housing, and wages. Briefly, it goes like this.

Most economic activity is simply transformed energy of one sort or another. 

Modern economies developed as we found more efficient energy sources, going from coal to oil to natural gas and nuclear. 

Now we want to transition from carbon to renewables like solar and wind. 

This may ultimately bring great benefits, but for now it has produced under-investment in fossil fuel production capacity.

US shale production plunged last year and hasn’t yet recovered.

Source: Gavekal

This may be a problem because inventories are low and fuel demand is rising as more people begin moving around again. We can import to make up lost domestic production, but that will add to the trade deficit and weaken the dollar (which is also inflationary). Meanwhile other countries will also be reopening, further increasing global oil demand. This will likely push energy prices significantly higher.

That alone is inflationary, but the follow-on effects may be more so. Rising energy prices will sustain higher housing prices, since construction requires fuel to manufacture and transport large quantities of heavy, bulky building materials.

As housing becomes less affordable, wages will have to rise. 

Prior recessions always saw wage growth slow, if not reverse. 

We are trying to emerge from a recession in which wage growth never fell, which is historically unprecedented.

Source: Gavekal

You can see in the chart how wages dropped in the 2000 recession and even more obviously in the 2008-2010 period. 

Note, this doesn’t include the millions who lost jobs and whose wage income fell to zero. 

In a typical recession, even those who keep their jobs see wages cut or at least don’t get raises. 

Not so this time. If you weren’t a laid-off service worker, you saw little effect on your pay.

So wages, generally speaking, haven’t dropped and are rising in some segments. 

You might expect employers to respond with more automation… but we also have a serious microchip shortage. 

It is reducing automotive production (which raises vehicle prices, further aggravating inflation). 

Replacing human workers with robots may not be a short-term solution.

Louis thinks this adds up to a 180-degree change in the economic winds, from deflation to inflation. 

As he put it in his wrap-up slide (read this slide two or three times)…

Source: Gavekal

That’s a compelling list… but this story has another side. Deflation may not be as dead as it looks. We’ll consider those arguments next week. I should also note there may be another way to look at this. On the last day of Bill White, former Chief Economist for the Bank of International Settlements (and now with other similarly prestigious groups), in his characteristic low-key manner he squared the circle of inflation and deflation. (Get your pass to hear more.)

Longtime readers know I have been in the disinflation/deflation camp for decades. Any brief perusal of long-term interest rates and inflation since 1980 demonstrates that was the right position. It was truly self-evident.

But looking at the current inflation data, as we have today, you have to be willing to recognize that all trends, no matter how seemingly inexorable, come to an end. Even the Federal Reserve this week, which has been adamantly protesting that any inflation was transitory and should be ignored, acknowledged in the just-released minutes of their April policy meeting:

"A number of participants suggested that if the economy continued to make rapid progress toward the Committee's goals, it might be appropriate at some point in upcoming meetings to begin discussing a plan for adjusting the pace of asset purchases." (H/T Peter Boockvar)

If I read that correctly, they are going to think about thinking about inflation at some point in the future. 

Well, I damn well hope so. 

Announcing a policy of zero interest rates for 30+ months no matter what is the height of insanity. 

They have no way of knowing the future. 

What if things change? 

Remember the days under Bernanke when they said they were “data dependent?”

The Fed’s current policy has painted policymakers in a corner which is fraught with financial repression, destroys the value of savings, hurts retirees, and exacerbates income and wealth disparity, not to mention it helps maintain froth in the mortgage and housing markets which need no help.

Far be it from me to criticize my economic betters, but they risk “losing the narrative” (read: confidence of the markets) and dramatically increasing volatility in all sorts of markets from the unintended consequences of not admitting they don’t know what the future will bring. Why not just stay “data-dependent” (itself a vague, ephemeral notion)? Allowing for the possibility of change if the data changes? (Read me on Twitter for more thoughts on this.)

I’ll Be Seeing You in NYC, Maine, and All the Old Familiar Places

It’s official. I booked a flight to New York City for mid-June. 

With the country opening up, as more and more of us get vaccinated, the desire to travel, see friends, and have experiences is on the rise. 

As my friend David Bahnsen said yesterday:

As for weekly economic progress with restaurants, hotels, and travel, restaurants being just 16% off of 2019 levels with some states still finally re-opening is incredibly encouraging to me. 

Hotel occupancy only down 12% from 2019 levels with such little business travel happening is tremendous (granted, the higher foot traffic appears to be at a much lower price point). 

But it is air travel that is clearly the biggest surprise for those who predicted the world would never be the same again.

Peter Boockvar sent me this wonderful short clip of Willie Nelson singing, “I’ll be seeing you in all the old familiar places,” with scenes of people returning to “normal” life. I really do look forward to seeing friends and people in all the old familiar places. I miss speaking in front of a crowd. I miss quiet (and sometimes not quite so quiet) dinners with friends. 

Even as we are forced to think about inflation, deflation, the markets and our portfolios, the pandemic has shown us that what we really miss, what is really important, is all the old familiar places and faces.

It’s time to hit the send button so let me wish you a great week. Here’s hoping to see you soon, not just in this letter every week, but in some familiar place!

Your still absorbing the information from the conference analyst,

John Mauldin
Co-Founder, Mauldin Economics

There are reasons to worry about US inflation

Both monetary and fiscal policy are, by historical standards, wildly expansionary

Martin Wolf 

     © James Ferguson

The jump in US annual consumer price inflation to 4.2 per cent reported last week was a shock. 

But was it a good reason to panic? 

Not obviously, since special factors can explain it. 

It was ever thus: when inflation starts to rise, special factors can always explain it. 

But in truth the big reasons for concern are not what is happening right now, but rather the political forces at work.

Naturally, economic forces shape those political choices. 

And these forces are currently rather confusing. 

The unexpectedly big jump in consumer prices followed on an unexpectedly weak employment report: last month, the US added just 266,000 jobs, while the unemployment rate edged up to 6.1 per cent. 

The obvious explanation is that this is a recovery from an unprecedented recession, driven not by tightening demand but by shutdown of supply.

Goldman Sachs notes that the proximate causes of that jump lie in travel and related services, where prices are rebounding from depressed levels, and in some goods, where a post-pandemic surge in demand has run into temporary shortages and bottlenecks.

Jason Furman of the Peterson Institute for International Economics notes, too, that employment was still 10m jobs below its pre-pandemic trend in April, even though the job openings rate was higher in February 2021 than in any month since 2001. 

Again, this suggests persistent post-pandemic disruption to labour supply. 

An unprecedented shock inevitably makes the data hard to interpret and performance hard to predict.

This uncertainty applies also to commodity prices. 

They have jumped upwards. 

But prices are not that high by historical standards and are well below past peaks.

Meanwhile, the “break-even rate” — the difference between the yield on conventional and inflation-indexed US Treasuries — has risen sharply, though still to only 2.5 per cent over 10 years. 

This indicates a rise in inflation expectations and concern over the risks of inflation. 

Bloomberg’s John Authers notes that forecasts by consumers and professional forecasters have also risen, with the former expecting close to 6 per cent inflation and the latter 3 per cent over the next year.

It would be fair to conclude that inflation expectations are moving up. 

But, at current levels, they will not concern the Federal Reserve all that much, since, as Jay Powell, Fed chair, said last August, “we will seek to achieve inflation that averages 2 per cent over time. 

Therefore, following periods when inflation has been running below 2 per cent, appropriate monetary policy will probably aim to achieve inflation moderately above 2 per cent for some time.” 

Because inflation has fallen short of the goal by a cumulative total of 5 percentage points since 2007, this could justify, say, 3 per cent inflation for five years, before a return to 2 per cent.

So should we keep calm, knowing that short-term performance reflects post-pandemic unpredictability, while rising inflation expectations are just what the Fed ordered? 

Yes, up to a point. 

The true concern is deeper and longer term.

First, both monetary and fiscal policy settings are, by historical standards, wildly expansionary, with near-zero interest rates, exceptional monetary growth and huge fiscal deficits, even though the IMF suggests that the US economy will be operating above potential this year.

Second, there is a large overhang of private savings waiting to be spent and surely a great desire to get back to normal life. 

Maybe, these will not be the “roaring 2020s”. But they might be far more economically dynamic than most suppose.

Third, while I understand why the Fed changed its monetary framework, I am unpersuaded it was a good idea. 

It means driving while looking into the rear-view mirror. 

It would surely be better to learn from past experience how the economy works than to try to compensate directly for historic failures. 

In particular, the new framework creates uncertainty over how the Fed intends to make up for the past shortfalls.

Fourth and most important, politics have changed. 

One would have to be at least 60 years old to have experienced high inflation and subsequent disinflation as an adult. 

The government and substantial swaths of the private sector have huge debt liabilities and borrowing plans. 

Joe Biden’s administration is determined to ensure that this recovery does not repeat the disappointment of the previous one. 

The stock market is more than generously priced by historical standards, with bubble phenomena everywhere. 

The doctrines of “modern monetary theory” are highly influential, as well. 

All this together has strengthened lobbies for cheap money and big fiscal deficits, and weakened ones for prudence.

Given all this, doubts about the Fed are reasonable. 

We know that it is politically easier to loosen than tighten monetary policy. 

Right now, the latter is going to be particularly unpopular. 

Yet if a central bank does not take away the punch bowl before the party gets going, it has to take it away from people who have become addicted to it. 

That is painful: it takes a Paul Volcker.

Milton Friedman said that “inflation is always and everywhere a monetary phenomenon”. 

This is wrong: inflation is always and everywhere a political phenomenon. 

The question is whether societies want low inflation. 

It is reasonable to doubt this today. 

It is also reasonable to doubt whether the disinflationary forces of the past three decades are now at work so strongly. 

It is hard to believe these emergency monetary policies should continue for years, as many at the Fed think. 

I doubt whether they should continue even now.

Superpower politics

The most dangerous place on Earth

America and China must work harder to avoid war over the future of Taiwan

The test of a first-rate intelligence, wrote F. Scott Fitzgerald, is the ability to hold two opposing ideas in mind at the same time and still retain the ability to function. 

For decades just such an exercise of high-calibre ambiguity has kept the peace between America and China over Taiwan, an island of 24m people, 100 miles (160km) off China’s coast. 

Leaders in Beijing say there is only one China, which they run, and that Taiwan is a rebellious part of it. 

America nods to the one China idea, but has spent 70 years ensuring there are two.

Today, however, this strategic ambiguity is breaking down. 

The United States is coming to fear that it may no longer be able to deter China from seizing Taiwan by force. 

Admiral Phil Davidson, who heads the Indo-Pacific Command, told Congress in March that he worried about China attacking Taiwan as soon as 2027.

War would be a catastrophe, and not only because of the bloodshed in Taiwan and the risk of escalation between two nuclear powers. 

One reason is economic. 

The island lies at the heart of the semiconductor industry. 

tsmc, the world’s most valuable chipmaker, etches 84% of the most advanced chips. 

Were production at tsmc to stop, so would the global electronics industry, at incalculable cost. 

The firm’s technology and know-how are perhaps a decade ahead of its rivals’, and it will take many years of work before either America or China can hope to catch up.

The bigger reason is that Taiwan is an arena for the rivalry between China and America. 

Although the United States is not treaty-bound to defend Taiwan, a Chinese assault would be a test of America’s military might and its diplomatic and political resolve. 

If the Seventh Fleet failed to turn up, China would overnight become the dominant power in Asia. 

America’s allies around the world would know that they could not count on it. 

Pax Americana would collapse.

To understand how to avoid conflict in the Taiwan Strait, start with the contradictions that have kept the peace during the past few decades. 

The government in Beijing insists it has a duty to bring about unification—even, as a last resort, by means of invasion. 

The Taiwanese, who used to agree that their island was part of China (albeit a non-Communist one), have taken to electing governments that stress its separateness, while stopping short of declaring independence. 

And America has protected Taiwan from Chinese aggression, even though it recognises the government in Beijing. 

These opposing ideas are bundled into what Fitzgerald’s diplomatic inheritors blithely call the “status quo”. 

In fact, it is a roiling, seething source of neurosis and doubt.

What has changed of late is America’s perception of a tipping-point in China’s cross-strait military build-up, 25 years in the making. 

The Chinese navy has launched 90 major ships and submarines in the past five years, four to five times as many as America has in the western Pacific. 

China builds over 100 advanced fighter planes each year; it has deployed space weapons and is bristling with precision missiles that can hit Taiwan, us Navy vessels and American bases in Japan, South Korea and Guam. 

In the war games that simulate a Chinese attack on Taiwan, America has started to lose.

Some American analysts conclude that military superiority will sooner or later tempt China into using force against Taiwan, not as a last resort but because it can. 

China has talked itself into believing that America wants to keep the Taiwan crisis boiling and may even want a war to contain China’s rise. 

It has trampled the idea that Hong Kong has a separate system of government, devaluing a similar offer designed to win over the people of Taiwan to peaceful unification. 

In the South China Sea it has been converting barren reefs into military bases.

Although China has clearly become more authoritarian and nationalistic, this analysis is too pessimistic—perhaps because hostility to China is becoming the default in America. 

Xi Jinping, China’s president, has not even begun to prepare his people for a war likely to inflict mass casualties and economic pain on all sides. 

In its 100th year the Communist Party is building its claim to power on prosperity, stability and China’s status in its region and growing role in the world. 

All that would be jeopardised by an attack whose result, whatever the us Navy says, comes with lots of uncertainty attached, not least over how to govern a rebellious Taiwan. 

Why would Mr Xi risk it all now, when China could wait until the odds are even better?

Yet that brings only some comfort. 

Nobody in America can really know what Mr Xi intends today, let alone what he or his successor may want in the future. 

China’s impatience is likely to grow. 

Mr Xi’s appetite for risk may sharpen, especially if he wants unification with Taiwan to crown his legacy.

If they are to ensure that war remains too much of a gamble for China, America and Taiwan need to think ahead. 

Work to re-establish an equilibrium across the Taiwan Strait will take years. 

Taiwan must start to devote fewer resources to big, expensive weapons systems that are vulnerable to Chinese missiles and more to tactics and technologies that would frustrate an invasion.

America requires weapons to deter China from launching an amphibious invasion; it must prepare its allies, including Japan and South Korea; and it needs to communicate to China that its battle plans are credible. 

This will be a tricky balance to strike. 

Deterrence usually strives to be crystal-clear about retaliation. 

The message here is more subtle. 

China must be discouraged from trying to change Taiwan’s status by force even as it is reassured that America will not support a dash for formal independence by Taiwan. 

The risk of a superpower arms race is high.

Be under no illusions how hard it is to sustain ambiguity. 

Hawks in Washington and Beijing will always be able to portray it as weakness. 

And yet, seemingly useful shows of support for Taiwan, such as American warships making port calls on the island, could be misread as a dangerous shift in intentions.

Most disputes are best put to rest. 

Those that can be resolved only in war can often be put off and, as China’s late leader Deng Xiaoping said, left to wiser generations. 

Nowhere presents such a test of statesmanship as the most dangerous place on Earth. 

Margin debt and leverage are flashing red, again

Much of the froth in US markets is being driven by unusual liquidity flows that may reverse soon

Gillian Tett

          © Daniel Pudles

When the Archegos fund imploded last month, it demonstrated yet again the perils of taking on excessive margin debt.

Although a then little known family office, Archegos amassed a reported $50bn of loans from banks such as Mizuho and Credit Suisse to purchase risky equities. 

When those bets turned sour, its losses surpassed $10bn, judging from recent results from the banks that made those loans.

That is a startling amount. 

Even more startling, though, is that Archegos is far from being the only fund to rack up large margin debt — the funds that an investor borrows from brokers to trade financial markets.

Data collected by the Financial Industry Regulatory Authority shows that total margin debt across Wall Street hit $822bn by the end of March — after Archegos had failed. 

That was almost double the $479bn level of this time last year and far more than the around $400bn peak that margin debt reached in 2007, just before the financial crisis.

To put these numbers in context, ABP Invest, a London-based fund, calculates that during the 2000 dotcom and 2007 credit booms, US margin debt topped out at roughly 3 per cent of gross domestic product. 

Now it is nearly 4 per cent.

As John Waldron, chief operating officer of Goldman Sachs told the Economics Club of New York this week: “That’s an extraordinary (level) of margin debt.” 

Quite so — particularly as Goldman was reportedly “very exposed” to Archegos, although it apparently managed to exit its positions and avoid major losses.

Is all this dangerous for markets? The answer depends on what you think will happen to asset prices. 

If you believe they will keep rising while the cost of borrowing remains so low, the answer is “No”. 

Indeed, many investors and investment banks appear confident that is the case.

The Federal Reserve forecasts that the US economy will notch up a heady 6.5 per cent growth rate this year. 

That should boost corporate earnings and support asset prices, especially as US companies plan to pass on any rise in producer prices to consumers rather than let their profits take the hit.

Nor is there any indication the Fed wants to raise borrowing costs. 

On Wednesday it argued the recent rise in inflation was “transitory” and there had to be “substantial further progress” in job creation before it shifted policy. 

Scott Minerd, head of Guggenheim investment group, is one financier who now believes “the first rate hike could be pushed back to 2025”. 

Perhaps more surprising is that markets are not pushing up borrowing costs either. 

Over the past two weeks, the yield on the US 10-year bond has stayed under 1.7 per cent, even though US consumer prices jumped 0.6 per cent in March from February, their quickest rise in almost a decade.

That seems like a big vote of market confidence in the Fed, if you view markets as an efficient weighing machine of investor views of macroeconomic trends. 

However, there is another reason why bond yields may have remained relatively unmoved. 

It may be due to an unusual change in the way liquidity flows around the US financial system.

Matt King at Citi, for example, recently told clients that one reason why bond yields have stayed low — and equity markets soared — is that the Fed has been quietly releasing funds into the market, via banks, from the so-called US Treasury General Account.

A year ago, the US Treasury put $1.6tn into what is essentially its checking account, held by the New York Fed, as a helpful JPMorgan primer explains. 

This big jump from the previous $400bn-odd level was to cope with Covid-19 shocks. 

Now the Fed is quietly running it down to pre-pandemic levels.

King thinks this injection of liquidity has “swamped fundamentals”, raising asset prices. 

But he also warns the dynamic will reverse later this year as the account balance falls to pre-pandemic levels, causing asset prices to fall.

If so, that might create more unease about the risk of high levels of margin debt. 

And that unease would only rise if, say, the Biden administration’s bold tax plans are implemented in a way that crimped corporate earnings and thus undercut equity prices.

After all, the Archegos episode was a repeat lesson in how nobody usually worries about excess leverage while asset prices are rising. 

It is only when they suddenly tumble, for idiosyncratic or system-wide reasons, that nasty surprises emerge.

As Thanos Papasavvas, founder of the ABP fund says: “Money is cheap, so elevated levels of gearing and margin should not be a surprise . . . [But this creates] great ingredients for some good old fashioned market fragility.”

Savvy financiers are of course keenly aware of this and the smartest prime brokers are undoubtedly already trimming back their margin lending. 

Goldman’s Waldron, for example, says the bank is “watching that carefully”.

For most of the rest of us, it is a useful reminder that fundamentals such as profits and low interest rates can explain some of today’s rise in asset prices. 

But they are only part of the tale. 

As was true in 2007, just before the financial crisis exploded, liquidity and leverage can matter just as much — even if they are harder to observe and thus often ignored.

Fed Begins to Taper QE- US Central Bank Removes $351 Billion in Liquidity via Reverse Repos

After pumping extreme amounts of liquidity into markets, the U.S. Federal Reserve seems to be tapering back monetary easing policy via reverse repos (RRP). 

Following this week’s published minutes report from the Fed’s April monetary policy meeting, it seemed as though members of the central bank were prepared to discuss rolling back large-scale Treasury and mortgage-backed securities (MBS) purchases. 

This week, during a three-day period, the U.S. central bank removed $351 billion in liquidity according to reports.

Last week, the Federal Reserve released the minutes’ transcript from the central bank’s April 27-28 policy meeting. 

The minutes’ transcript noted that a “number” of Fed board members have initiated the conversation about tapering back quantitative easing (QE) policy. 

Beyond initiating the conversation, the Fed said that it needed to see “substantial” progress in order to curb the massive Treasury note and MBS purchases. 

Reiterating this opinion, Fed Chair Jerome Powell told reporters it wasn’t the time to start the process of sunsetting QE purchases.

“No, it is not time yet. 

We have said we’ll let the public know when it is time to have that conversation, and we’ve said we’d do that well in advance of any actual decision to taper our asset purchases, and we will do so,” Powell stressed.

However, Powell’s commentary is contradictory to the actions the Fed participated in earlier this week. 

In fact, the Fed has begun tapering back QE without informing the general public in a loud fashion via mainstream media. 

After the myriad of press reports disclosing the statements from the recently published minutes transcript, the public has been led to believe the Fed is not even ready to talk about tapering back QE. 

That’s not the case according to data stemming from reverse repo (RRP) operations that saw $351 billion in liquidity removed from markets.

The financial columnist from Wolf Street, Wolf Richter explained that the Fed removed this liquidity as “the banking system creaks under [a] mountain of reserves.”

Essentially, RRP operations are the exact opposite of QE and the central bank removes M1 from the system by selling Treasuries back to the market. 

Richter’s editorial and a report published by the Wall Street Journal’s Michael Derby, are the only two reports that disclose the RRP operations.

Reverse Repos a Sign of ‘Unforeseen Consequences’

Meanwhile, a majority of mainstream media publications continue to lead the public to believe the Fed is not quite ready to have the tapering conversation. 

On May 20, 2021, the U.S. central bank started the sell-off of $351 billion in Treasuries via overnight RRP operations. 

The deal between the Fed was with 48 counterparties, and no MBS sales are mentioned in any of the published reports. 

The recently published minutes report did discuss RRP tools and the recent action suggests the Fed is unloading liability.

Richter’s report also details that the Fed will likely raise the rate the central bank pays on reserves during the next monetary policy meeting. 

The minutes’ transcript explains that pressure has pushed the central bank to adjust overnight rates, because RRPs have been “trading at negative rates.” 

Members of the System Open Market Account (SOMA), an organization managed by the Fed, noticed the negative rates while acquiring large-scale assets through operations in the open market.

“The SOMA manager noted that downward pressure on overnight rates in coming months could result in conditions that warrant consideration of a modest adjustment to administered rates and could ultimately lead to a greater share of Federal Reserve balance sheet expansion being channeled into ON RRP [overnight reverse repurchase agreement] and other Federal Reserve liabilities,” the Fed’s minutes transcript notes.

Wolf Street’s Richter stresses in his report that he’s never seen the banking system beg for the Fed to roll back QE. 

The financial reporter thinks that the Fed has figured out that it might go past the point of no return.

“This is the first time that I have seen Wall Street banks clamoring for the Fed to back off QE as the banking system is creaking and straining under the huge pile of reserves,” Richter’s report emphasizes. 

“And apparently, from the response disclosed in the minutes, the Fed is figuring out that you can push QE only so far before something big is going to go haywire with unforeseen consequences,” he added.

Charts For A Crazy World: Inflation And Other Screw-ups

It’s getting harder to tell which approaching crisis requires attention and which can be safely ignored. 

Sometimes it helps to see the data laid out visually.

Section One: If the supply of money still matters …

Inflation (as the government defines it) has tracked the per capita money supply pretty closely over the past century. If that relationship still holds, inflation is just beginning a long upward march:

money supply vs CPI crazy world inflation

Workers are apparently hard to find lately, forcing employers to pay up for qualified people. 

So add fatter paychecks to the many other portents of future inflation.  

wage growth crazy world inflation

Why, you might wonder, hasn’t the economy already gone off the inflationary rails after the past year’s money printing orgy? 

Because … plunging velocity. 

People are getting money but aren’t spending it. Is there any conceivable way for a chart like this to resolve non-chaotically? 

money supply vs velocity crazy world inflation

Section Two: We’re making lots of other mistakes

Seems like we’ve gotten so used to massive numbers that they’ve lost their impact. 

how much is a billion crazy world inflation

How badly did we screw up the pandemic response? 

Here’s an excerpt from one of Tom Woods’ posts on the past year’s (apparently unnecessary) lockdowns: 

“This graph shows the results for the states allegedly following The Science, and the so-called neanderthal states [that avoided lockdowns]. 

Well, how about that: It’s impossible to figure out which places ruined people’s lives over COVID and which didn’t.”

Midwest covid crazy world inflation

And as the global debate over who, in the latest Israel/Palestine conflict, is exercising their sacred “right to self-defense,” a time-lapse view of what certainly looks like genocide is illuminating. 

Let’s hope no major powers get pulled into this mess. 

Israel Palestine crazy world inflation

Section Three: Just buy silver and let the broader world sort itself out

At least your money will be stable.

silver price to money supply crazy world inflation


A Brexit Post-Mortem for the City

Almost five years after the Brexit referendum, and five months after Britain's exit from the European Union, the future of London as a global financial center seems secure. But although the City will remain Europe’s largest financial marketplace, its Golden Age as Europe’s financial capital is over.

Howard Davies

LONDON – Nearly five years after the Brexit referendum, and in the five months since Brexit itself, the debate about the future of the City, the financial center of London, has remained a dialogue of the deaf. 

Those who voted in June 2016 to leave the European Union believe, whatever the evidence to the contrary, that the impact will be minimal, and that the warnings of job losses and business relocation are exaggerated. 

Remain voters are programmed to think the opposite and, whatever the evidence to the contrary, forecast gloom and doom. 

What can we learn from what has actually happened?

The prevailing consensus among Israelis that Palestinian nationalism had been defeated – and thus that a political solution to the conflict was no longer necessary – lies in tatters. 

And even as the violence escalates, it has become clear to both sides that the era of glorious wars and victories is over.

We have to acknowledge, first, that COVID-19 has confused the picture mightily over the last 18 months. 

People have not found it easy to change location, even if they wanted to. 

More important, there are some temporary regulatory arrangements that blunt the impact of the United Kingdom’s departure from the single financial market. 

There is a Temporary Permissions Regime in London for some EU-based firms, and the European Commission has allowed euro-denominated instruments to be cleared in London until 2022, to avoid the disruption a sudden change on December 31, 2020, might have brought. 

So what we are seeing today may not reflect Brexit’s full longer-term impact.

Nonetheless, changes that have occurred so far permit us to start assessing the future of the City and the financial operations based there. 

One move that generated headlines was the abrupt shift of trading in European equities from London to Amsterdam at the start of the year. 

An average of €9.2 billion ($11.2 billion) in shares was traded daily on the Amsterdam exchange in January, four times the volume in December 2020, while London’s daily average dropped sharply, to €8.6 billion. 

The switch can be traced to regulation: the European Commission has not granted “equivalence” to UK trading venues, and is in no rush to do so.

That was a crucial early goal by the Remain team in this match, you might think. 

But the Leave team hit back quickly. 

Very few job moves resulted from this switch, they say: most of the traders remain in London. 

And they point out that London continues to lead Europe as a center for raising new capital. 

In the first quarter of this year, €8.3 billion was raised through London IPOs, compared to €5.4 billion in Frankfurt, €5.6 billion in Amsterdam, and just €0.1 billion in Paris.

The Remain team advances again: Equities are not the only, or even the most important, instrument. 

The UK share of euro-denominated interest-rate swaps fell from 40% to 10% from July 2020 to January 2021, while the EU share rose from 10% to 25%. 

New York was the beneficiary of some of the business lost to London, as many forecasted. 

And they point to the move of banking assets worth perhaps €1 trillion out of the UK, mainly to Frankfurt.

But both sides acknowledge that from an economic point of view, the city in which trades are booked is less significant than the city in which traders pay their taxes. 

Soon after the Brexit vote, consultants Oliver Wyman estimated that 75,000 jobs would quickly be relocated to other EU centers. 

Others produced even higher estimates. 

Have those pessimistic forecasts been borne out?

The Leave team can claim another goal. 

A detailed survey from consultancy New Financial last month identified 7,400 positions that had been moved from London to a eurozone financial center – just 10% of the estimates in 2016. 

The biggest beneficiaries have been Dublin, Paris, Luxembourg, Frankfurt, and Amsterdam, in that order.

But the study can be interpreted in another way. Two years ago, the same authors identified 269 firms that had relocated some activity. 

Now they find that 440 have done so, and they regard that as an underestimate of the number that will eventually do so. 

They expect the relocated jobs number to rise further.

Moreover, there are signs that the property market may be reacting. 

Over the last two years, property prices have risen 20% in Paris, almost 40% in Amsterdam, but just 6% in London.

But it will not be one-way traffic. Just as firms based in the UK no longer have unfettered access to the EU’s markets, so most EU-located firms will need authorization to conduct business with London-based clients. 

So perhaps 300-500, mainly smaller, European firms will need to set up in London. 

The net result will be an outflow of jobs from London, but not on anything like the scale widely expected in 2016.

That is because firms have found ways to work around the regulatory obstacles. 

They have also found that moving staff is costly and difficult. 

London retains many attractions: schools, cultural life, and many long-established expatriate social networks. 

It will take time for any putative rival in the EU to develop a plausible matching offer.

It seems likely, therefore, that London will remain Europe’s largest financial marketplace, by a considerable distance. 

It will remain plugged into a global network: transactions with European clients are perhaps a quarter of its business. 

But it will no longer be the continent’s de facto financial center.

For the EU, London will shift from being its principal onshore financial center, to an important offshore center. 

Other cities will pick up business, though the signs are that a multipolar system will develop, with no single winner. 

There will still be a profitable role for London, but the Golden Age of the City as Europe’s financial capital will recede, as Golden Ages tend to do.

Howard Davies, the first chairman of the United Kingdom’s Financial Services Authority (1997-2003), is Chairman of NatWest Group. He was Director of the London School of Economics (2003-11) and served as Deputy Governor of the Bank of England and Director-General of the Confederation of British Industry.