Fed hikes now, pain comes later

Fed Chairman Jerome Powell announced a 75 basis point increase in the Fed funds target rate at his post-FOMC press conference today:

“Today, the FOMC raised our policy interest rate by 75 basis points, and we continue to anticipate that ongoing increases will be appropriate. We are moving our policy stance purposefully to a level that will be sufficiently restrictive to return inflation to 2 percent. In addition, we are continuing the process of significantly reducing the size of our balance sheet. Restoring price stability will likely require maintaining a restrictive stance of policy for some time.”

The target range is now 3.75% to 4.0%.

Fed Funds Rate

Commenting on today’s announcement, Michael Contopoulos from Richard Bernstein says little has changed:

“Nothing really changed today, the Fed has been hawkish since Jackson Hole. It doesn’t matter how high rates go, what matters is that the Fed is going to be restrictive and they’re going to bring down long-term growth…..The end game is not cutting rates, at least any time soon, the end game is to slow growth and slow the economy.” (CNBC)

Chris Brightman from Research Affiliates, co-manager several PIMCO funds, offers a useful rule-of-thumb as to how far the Fed will need to hike. The unemployment rate has to rise by 1.0% for every 1.0% intended drop in core inflation.

Core inflation is close to 6.0% at present, if we take the average of core CPI (purple), growth in average hourly earnings (pink), and core PCE index (gray). To achieve the Fed’s 2.0% inflation target, using the above rule-of-thumb, would require a 4.0% increase in the unemployment rate.

Unemployment

That means an unemployment rate of 7.5% (red line below), making a recession almost certain.

Unemployment Rate

The recent 10-year/3-month Treasury yield inversion also warns of a recession in 2023.

Treasury 10-Year minus 3-Month Yield

Conclusion

We expect the Fed to hike the funds rate to between 5.0% and 6.0% — the futures market reflects a peak of 5.1% in May ’23 — then a pause to assess the impact on the labor market. Employment tends to lag monetary policy by 6 to 12 months, so the results of recent rate hikes are only likely to show in 2023. The recent inversion of 10-year and 3-month Treasury yields also warns of a recession next year.

The unemployment rate will most likely need to rise to 7.5% to bring inflation back within the Fed’s target range. That would cause a deep recession, especially if the Fed holds rates high for an extended period as they have indicated.

Uncertainty still surrounds whether the Fed will be able to execute its stated plan. A sharp rise in unemployment or bond market collapse could cause an early Fed pivot as the Treasury yield curve and Fed fund futures still expect.

Treasury Yield Curve & Fed Funds Rate Futures

There’s always more than one cockroach

There is always more than one cockroach. ~ Doug Kass, 50 Laws Of Investing (#8)

Rising interest rates, soaring energy prices, and plunging exchange rates of major energy importers — Europe, Japan and China — are likely to expose widespread misuse of leverage in financial markets.

JPMorgan Chase CEO Jamie Dimon says investors should expect more blowups after a crash in U.K. government bonds last month nearly caused the collapse of hundreds of that country’s pension funds. The turmoil, triggered after the value of U.K. gilts nosedived in reaction to fiscal spending announcements, forced the country’s central bank into a series of interventions to prop up its markets. That averted disaster for pension funds using leverage to juice returns, which were said to be within hours of collapse. “I was surprised to see how much leverage there was in some of those pension plans,” Dimon told analysts Friday in a conference call to discuss third-quarter results. “My experience in life has been when you have things like what we’re going through today, there are going to be other surprises.” ~ CNBC

Contagion

Financial turmoil in one market soon spreads to others as market bullishness collapses.

Extreme Fear

Financial chaos in the UK is hitting the shores of Japan and roiling the $1 trillion global market for collateralized loan obligations. Norinchukin Bank, once known as the “CLO whale”, has stopped buying new deals in the US and Europe for the foreseeable future because of volatility sparked by UK pension funds…. (Bloomberg)

Misuse of debt

Speculators in a bull market, encouraged by the low cost of debt and the consequential rise in asset prices, borrow money in expectation of leveraging their gains. Companies, encouraged by the low cost of debt and rising stock prices, also borrow money to invest in projects with low returns or without proper consideration of downside risks should the economy go into recession. Companies may generate sufficient cash flow to service interest on their debt but insufficient to repay the capital. Their survival depends on rolling over their debt when it matures. Known as “zombies”, they are vulnerable to rising interest rates, shrinking liquidity and stricter credit standards during an economic down-turn.

Zombie Companies

The Great Repricing

“We’re seeing the beginning of the Great Repricing…and that repricing is going to have significant impacts on portfolios of many investors…But this is an inevitable consequence, in my view, of a return to more normal levels of interest rates…” ~ Mervyn King, former Governor of the Bank of England

Rising interest rates and tighter liquidity force speculators to sell off assets to repay debt. The sell-off causes a fall in asset prices, prompting further margin calls, fire sales and a downward spiral in asset prices. Also, zombie companies, devoid of support from creditors, go to the wall. Publicity surrounding bankruptcies and layoffs raises fears of further corporate failures and increases the difficulty for borderline companies to roll over debt, reinforcing the downward spiral.

The ratio of stock market capitalization to GDP — Warren Buffett’s favorite long-term indicator of market valuation — has fallen sharply to 211% (Q2) but is still well above the Dotcom bubble high of 189%. And a long way from the long-term average of 104% (dotted red line below).

Stock Market Capitalization to GDP

Government intervention

Attempts to support inflated asset prices, as in China’s real estate markets, prevent markets from clearing and merely compound the problem. They simply prolong the bubble, allowing further debt accumulation and increase the eventual damage to financial markets.

No soft landing

In the past few recessions the Fed has stepped in, injecting liquidity to end the deflationary spiral but this time is different. The recent rapid surge in inflation has tied the Fed’s hands. They cannot inject liquidity to slow the rate of descent without risking a bond market revolt as seen in the UK.

30-Year Gilts Yield

Portfolios with a 60/40 split between stocks and bonds are showing their worst year-to-date performance in the past 100 years as both asset classes suffer from shrinking liquidity.

60/40 Portfolio Performance

Conclusion

“The investor who says, ‘This time is different,’ when in fact it’s virtually a repeat of an earlier situation, has uttered among the four most costly words in the annals of investing.” ~ Sir John Templeton

We should not underestimate the ingenuity of governments and their central bankers in postponing the inevitable pain associated with sound economic management. Instead they kick the can down the road, compounding the initial problem until it assumes Godzilla-like proportions, making further avoidance/postponement almost inevitable. It takes the courage of a Paul Volcker to confront the problem head-on and restore the economy to a sound growth path.

The million-dollar question facing investors is whether Fed chair Jerome Powell can do another Volcker. But Volcker had the advantage of a federal debt to GDP ratio below 50% in 1980. Treasury could withstand far higher interest rates than at the present ratio of well over 100%. So Powell is unlikely to succeed in meeting financial markets head-on.

Federal Debt to GDP

We expect the Fed to pivot. Just not this year.

Acknowledgements

Bond market: No place to hide

Advance retail sales were flat in September, reflecting slowing growth, but remain well above their pre-pandemic trend. So far, Fed rate hikes have failed to make a dent in consumer spending.

Advance Retail Sales

Even adjusted for inflation, real retail sales are well above the pre-pandemic trend.

Advance Real Retail Sales

The culprit is M2 money supply. While M2 has stopped growing, there has been no real contraction to bring money supply in line with the long-term trend. A fall of that magnitude would have a devastating effect on inflated asset prices.

M2 excluding Time Deposits

Inflation is proving persistent, with CPI hardly budging in September. Hourly earnings growth is slowing but remains a long way above the Fed’s 2.0% inflation target.

CPI & Hourly Earnings Growth

Treasury yields have broken their forty year down-trend, with the 10-year testing resistance at 4.0%. Stubborn inflation is expected to lift yields even higher.

10-Year Treasury Yield

Inflation is forcing the Fed to raise interest rates, ending the forty-year expansion in debt levels (relative to GDP). Cheap debt supports elevated asset prices, so a decline in debt levels would cause a similar decline in asset prices.

Non-Financial Debt/GDP

A decline of that magnitude is likely to involve more pain than the political establishment can bear, leaving yield curve control (YCC) as the only viable alternative. The Fed would act as buyer of last resort for federal debt, while suppressing long-term yields. The same playbook was used in the 1950s and ’60s to drive down the debt to GDP ratio, allowing rapid growth in GDP while inflation eroded the real value of public debt.

Federal Debt/GDP

Conclusion

We are fast approaching a turning point, where the Fed cannot hike rates further without collapsing the bond market. In the short-term, while asset prices fall, cash is king. But in the long-term investors should beware of financial securities because inflation is expected to eat your lunch. Our strategy is to invest in real assets, including gold, critical materials and defensive stocks.

Will a recession kill inflation?

There is plenty of evidence to suggest that recessions cause a sharp fall in the consumer price index. Alfonso Peccatiello recently analyzed US recessions over the past century and concluded that they caused an average drop in CPI of 6.8%.

MacroAlf: CPI & Recessions

A recession no doubt reduces inflation but it does not necessarily kill underlying inflationary pressures. It took massive pain inflicted by the Volcker Fed in the early ’80s to reverse the long-term up-trend in inflation. Average hourly earnings (gray) is a better gauge of underlying inflation as can be seen on the graph below.

CPI, Average Hourly Earnings & Recessions

Recessions cause a fall in earnings growth but do not interrupt the underlying trend unless the economy is administered a severe shock. In the early 1980s, it took four recessions in just over a decade, a Fed funds rate (gray below) peaking at 22% in December 1980, and unemployment (blue) spiking to 10.8%.

Fed Funds Rate & Unemployment

In the current scenario, we have had one recession, but cushioned by massive fiscal stimulus and Fed QE. Another recession would be unlikely to break the up-trend in underlying inflation unless there is a sharp rise in unemployment.

A study by Larry Summers and Olivier Blanchard maintains that unemployment will have to rise above 5% in order to tame inflation. The chart below suggests that unemployment may need to rise closer to 10% — as in 1982 and 2009 — in order to kill underlying inflationary pressures.

Unemployment(U3) & Average Hourly Earnings Growth

Conclusion

We are not suggesting that the Fed hike rates sufficiently for unemployment to reach 10%. That would cause widespread destruction of productive capacity in the economy and take years, even decades, to recover. Instead, we believe that the Fed should tolerate higher levels of inflation while Treasury focuses expenditure on building infrastructure and key supply chains, to create a more robust economy. Largely in line with Zoltan Pozsar’s four R’s:

(1) re-arm (to defend the world order);
(2) re-shore (to get around blockades);
(3) re-stock and invest (commodities); and
(4) re-wire the grid (to speed up energy transition).

An early Fed pause, before inflation is contained, would drive up long-term yields and weaken the Dollar. The former would cause a crash in stocks and bonds and the latter would increase demand for Gold and other inflation hedges.

A weaker Dollar would make US manufacturing more competitive in global markets and reduce the harm being caused to emerging markets. Unfortunately, one of the consequences would be higher prices for imported goods, including crude oil, and increased inflationary pressures.

The US Fed and Treasury are faced with an array of poor choices and in the end will have to settle for a strategy that minimizes long-term damage. In an economic war as at present, higher inflation will have to be tolerated until the war is won. An added benefit is that rapid growth in nominal GDP, through high inflation, would reduce the government’s precarious debt burden.

Federal Debt/GDP

Acknowledgements

Alfonso Peccatiello for his analysis of CPI and recessions.

Jay Powell is selling but the bond market isn’t buying

Fed Chairman Jerome Powell declared that the Fed’s commitment to taming inflation is “unconditional”:

June 23 (Reuters) – The Federal Reserve’s commitment to reining in 40-year-high inflation is “unconditional,” Powell told lawmakers on Thursday, even as he acknowledged that sharply higher interest rates may push up unemployment.

“We really need to restore price stability … because without that we’re not going to be able to have a sustained period of maximum employment where the benefits are spread very widely,” the Fed Chairman told the U.S. House of Representatives Financial Services Committee.

Under questioning by members of the House panel on Thursday, Powell said there was a risk the Fed’s actions could lead to a rise in unemployment. “We don’t have precision tools,” he said, “so there is a risk that unemployment would move up, from what is historically a low level though. A labor market with 4.1% or 4.3% unemployment is still a very strong labor market.”

He also dismissed cutting interest rates if unemployment were to rise while inflation remained high. “We can’t fail on this: we really have to get inflation down to 2%,” he said.

The Fed chief was also asked about the central bank’s balance sheet, which was built up to around $9 trillion during the pandemic in an effort to ease financial conditions and is now being pared. The Fed aims to get it “roughly in the range of $2.5 or $3 trillion smaller than it is now,” Powell said.

But the bond market isn’t buying it. Treasury yields from 2-year to 30-year are compressed in a narrow band above 3%, indicating a flat yield curve. Expectations are that the Fed can’t go much higher than 3.0% to 3.5%.

Treasury Yield Curve

The dot plot from the last FOMC meeting similarly projects a 3.4% fed funds rate by the end of 2022, 3.8% by 2023, and lower at 3.4% by the end of 2024.

FOMC Dot Plot

You cannot cure inflation with a Fed funds rate (FFR) of 3.5%.

CPI is growing at 8.6% YoY, while the FFR target maximum is 1.75%. Another 1.75% just won’t cut it. You have to hike rates above inflation. Positive real interest rates are the best antidote for inflation but the economy, in its current precarious state, could not withstand this.

Fed Funds Rate & CPI

Taming inflation in the 1980s

Paul Volcker killed inflation by hiking the fed funds rate to 20% in 1980, but we live in a different world.

In 1980, federal debt to GDP was less than 50% of GDP. Today it’s 118%.

Federal Debt/GDP

The Federal deficit was 2.5% of GDP. Now it’s 12%.

Federal Deficit/GDP

Private debt (excluding the financial sector) was 1.35 times GDP in 1980. Now it’s more than double.

Private Non-Financial Debt/GDP

Powell can’t hike rates like Volcker. If he tried, he would collapse the economy and the US Treasury would be forced to default on its debt. Collapse of the global reserve asset is about as close as you can get to financial Armageddon.

Pricking the bubble

Instead, the Fed plans to use QT to deflate the asset bubbles in stocks and housing, in the hope that a reverse wealth effect — as households feel poorer — will slow consumer spending and reduce inflation.

So far, the S&P 500 has dropped by 25% and the housing market is likely to follow. The 30-year mortgage rate has climbed to 5.81%, more than double the rate in August last year.

30-Year Fixed Mortgage Rate

Housing starts and permits are both declining.

Housing Starts & Permits

Powell talks of a $2.5 to $3.0 trillion reduction in the Fed’s balance sheet. That would increase the supply of Treasuries and MBS in financial markets by an equivalent amount which would be sucked out of the stock market, causing a fall in prices.

The two largest foreign investors in US Treasuries — Japan and China — have also both become net sellers to support their currencies against the rising Dollar. That will further increase the supply of Treasuries, causing an outflow from stocks.

Since 2009, stock market capitalization increased by $47.4 trillion, from $16.9T to $64.3T at the end of Q1. At the same time, the Fed’s balance sheet increased by $7.9 trillion, from $0.9T to $8.8T. Market cap increased by $6T for every $1T increase in the Fed’s balance sheet (QE). The multiplier effect is 6 times (47.4/7.9).

Stock Market Capitalization & Fed Total Assets

If the Fed were to shrink its balance sheet by $2.5 trillion and net foreign sales  of Treasuries amount to another $0.5 trillion, we could expect a similar multiplier effect to cause an $18 trillion fall in market capitalization ($3Tx6). Market cap would fall to $50T or 26.5% from its $68T peak in Q4 of 2021.

That’s just the start.

“Inflation is always and everywhere a monetary phenomenon”

Nobel prize-winner Milton Friedman argued that long-term increases or decreases in the general price level were caused by changes in the supply of money and not by shortages or surpluses of oil, commodities or labor.

The chart below shows the supply of money (M2) as a percentage of GDP. The economy thrived with M2 below 50% throughout the Dotcom boom of the late 1990s but has since grown bloated with liquidity as the Fed tried to revive the economy from the massive supply shock of China’s admission to the World Trade Organization in 2002 — the introduction of hundreds of millions of workers earning roughly 1/30th of Western-level wages.

Money Supply (M2)/GDP

The massive supply shock helped to contain prices over the next two decades, perpetuating the myth of the Great Moderation — that the Fed had finally tamed inflation. Fed hubris led them to pursue easier monetary policy with little fear of  inflationary consequences.

All illusions eventually come to an end, however, and the 2020 pandemic caused the Fed to purchase trillions of Dollars of securities to support massive government stimulus payments. The MMT experiment failed disastrously, causing a $5 trillion spike in M2 without an accompanying rise in GDP. M2 spiked up from an already bloated 70% of GDP to more than 90%, before GDP recovered slightly to reduce it to the current 89%.

Trade tensions with China, coupled with supply chain disruptions from the 2020 pandemic and a sharp rise in natural gas prices — as industry switched from coal to reduce CO2 emissions — triggered price increases. These were aggravated by Russia’s invasion of Ukraine and resulting sanctions, leading to oil shortages.

Normally, high prices are the cure for high prices. Consumers cut back purchases in response to high prices and demand falls to the point that it matches available supply. Prices then stabilize.

But consumers are sitting on a mountain of cash, as illustrated in the above M2 chart. They continued spending despite higher prices and demand didn’t fall. Investors who have access to cheap debt also, quite rationally, borrow to buy appreciating real assets. Unfortunately cheap leverage is seldom channeled into productive investment and instead fuels expanding asset bubbles in homes and equities.

The Fed is forced to intervene, employing demand destruction, through rate hikes and QT deflate asset bubbles, to reduce consumer spending.

An unwelcome side-effect of demand destruction is that it also destroys jobs. Unemployment rises and eventually the Fed is forced to relent.

Conclusion

Fed Chairman Jerome Powell says that the Fed’s commitment to reining in inflation is “unconditional” but the bond market is pricing in rate hikes peaking between 3.0% and 3.5%, way below the current rate of inflation. The economy is unlikely to be able to withstand more because of precarious levels of debt to GDP and a massive fiscal deficit.

Instead, the Fed plans to shrink their balance sheet by $2.3 to $3 trillion. QT is expected to deflate asset bubbles in stocks and housing and achieve a reverse wealth effect. Households are likely to curb spending as their net worth falls and they feel poorer.

Unfortunately, demand destruction from rate hikes and QT will also cause unemployment, inevitably leading to a recession. The Fed seems to think that the economy is resilient because unemployment is low and job openings outnumber unemployed workers by almost 2 to 1.

Job Openings & Unemployment (U3)

But elevated debt levels and rapidly rising credit spreads could precipitate a sharp deleveraging, with crumbling asset prices, rising layoffs and credit defaults.

High Yield Spreads

The Fed may also manage to lower prices through demand destruction but inflation is likely to rear its head again when they start easing. Surging inflation is likely to repeat until the Fed addresses the underlying issue: an excessive supply of money.

Milton Friedman was a scholar of the Great Depression of the 1930s which he attributed to mistakes by the Fed:

“The Fed was largely responsible for converting what might have been a garden-variety recession, although perhaps a fairly severe one, into a major catastrophe. Instead of using its powers to offset the depression, it presided over a decline in the quantity of money by one-third from 1929 to 1933 … Far from the depression being a failure of the free-enterprise system, it was a tragic failure of government.”

Ben Bernanke, another scholar of the Great Depression, acknowledged this during his tenure as Fed Chairman:

“Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton (Friedman) and Anna (Schwarz): Regarding the Great Depression, you’re right. We did it. We’re very sorry. But thanks to you, we won’t do it again.”

Instead the Fed made the opposite mistake. By almost doubling the quantity of money (M2) relative to GDP (output) they have created an entirely different kind of monster.

Money Supply (M2)/GDP

Slaying the beast of inflation is likely to prove just as difficult as ending the deflationary spiral of the 1930s.

Stocks: Winter is coming

GDP grew by a solid 10.64% for the 12 months ended March ’22 but that is in nominal terms.

GDP

GDP for the quarter slowed to 1.58%, while real GDP fell to -0.36%. Not only is growth slowing but inflation is taking a bigger bite.

GDP & Real GDP

The implicit price deflator climbed to 1.94% for the quarter — almost 8.0% when annualized.

GDP Implicit Price Deflator

Growth is expected to decline further as long-term interest rates rise.

10-Year Treasury Yield & Moody's Baa Corporate Bond Yield

Conventional monetary policy would be for the Fed to hike the funds rate (gray below) above CPI (red). But, with CPI at 8.56% for the 12 months to March and FFR at 0.20%, the Fed may be tempted to try unconventional methods to ease inflationary pressures.

Fed Funds Rate & CPI

That includes shrinking its $9 trillion balance sheet (QT).

During the pandemic, the Fed purchased almost $5 trillion of securities. The resulting shortage of Treasuries and mortgage-backed securities (MBS) caused long-terms yields to fall and a migration of investors to equities in search of yield.

The Fed is expected to commence QT in May at the rate of $95 billion per month — $60 billion in Treasuries and $35 billion in MBS — after a phase-in over the first three months. Long-term Treasury yields are likely to rise even faster, accompanied by a reverse flow from equities into bonds.

S&P 500 & Fed Total Assets

S&P 500 breach of support at 4200, signaling a bear market, would anticipate this.

Conclusion

Fed rate hikes combined with QT are expected to drive long-term interest rates higher and cause an outflow from equities into bonds.

A bear market (Winter) is coming.

Dr Lacey Hunt, Hoisington Asset Management | The debt trap

From Dr Lacey Hunt at Hoisington Asset Management on the declining velocity of money:

M2 Velocity

The Fed is able to increase money supply growth but the ongoing decline in velocity (V) means that the new liquidity is trapped in the financial markets rather than advancing the standard of living by moving into the real economy…..

GDP/Debt

Money and debt are created simultaneously. If the debt produces a sustaining income stream to repay principal and interest, then velocity will rise since GDP will eventually increase beyond the initial borrowing. If advancing debt produces increasingly smaller gains in GDP, then V falls. Debt financed private and governmental projects may temporarily boost GDP and velocity over short timespans, but if the projects do not generate new funds to meet longer term debt servicing obligations, then velocity falls as the historical statistics confirm.

The increase in M2 is not channeled into productive investment — that fuels GDP growth — but rather into unproductive investment in financial assets. The wealthy invest in real assets, as a hedge against inflation, but these are mainly speculative assets — such as gold, precious metals, jewellery, artworks and other collectibles, high-end real estate, or cryptocurrencies — which seldom produce much in the way of real income, with the speculator relying on asset price inflation and low interest rates to make a profit. Many so-called “growth stocks” — with negative earnings — fall in the same category. Debt used to fund stock buybacks also falls in this category as their purpose is financial engineering, with no increase in real earnings.

In 2008 and 2009 Carmen Reinhart and Ken Rogoff (R&R) published research that indicated from an extensive quantitative analysis of highly indebted economies that their economic growth was significantly diminished once they become highly over-indebted.

…..Cristina Checherita and Philip Rother, in research for the European Central Bank (ECB) published in 2014, investigated the average effect of government debt on per capita GDP growth in twelve Euro Area countries over a period of about four decades beginning in 1970. Dr. Checherita, now head of the fiscal affairs division of the ECB and Dr. Rother, chief economist of the European Economic Community, found that a government debt to GDP ratio above the turning point of 90-100% has a “deleterious” impact on long-term growth. In addition, they find that there is a non-linear impact of debt on growth beyond this turning point. A non-linear relationship means that as the government debt rises to higher and higher levels, the adverse growth consequences accelerate……Moreover, confidence intervals for the debt turning point suggest that the negative growth rate effect of high debt may start from levels of around 70-80% of GDP.

…..Unfortunately, early-stage economic expansions do not fare well when inflation and interest rates are not declining at this stage of the business cycle, which is not the normal historical role, or the path indicated by economic theory. As this year has once again confirmed, in early expansion inflationary episodes, prices rise faster than real wages, thereby stunting consumer
spending. The faster inflation also thwarts the needed continuing cyclical decline in money and bond yields, which are necessary to gain economic momentum.

…..The U.S. economy has clearly experienced an unprecedented set of supply side disruptions, which serve to shift the upward sloping aggregate supply curve inward. In a graph, with aggregate prices on the vertical axis and real GDP on the horizontal axis, this causes the aggregate supply and demand curves to intersect at a higher price level and lower level of real GDP. This
drop in real GDP, often referred to as a supply side recession, increases what is known as the deflationary gap, which means that the level of real GDP falls further from the level of potential GDP. This deflationary gap in turn leads to demand destruction setting in motion a process that will eventually reverse the rise in inflation.

Currently, however, the decline in money growth and velocity indicate that the inflation induced supply side shocks will eventually be reversed. In this environment, Treasury bond yields could temporarily be pushed higher in response to inflation. These sporadic moves will not be maintained. The trend in longer yields remains downward.

Negative real yields

A negative real yield points to the fact that investors or entrepreneurs cannot earn a real return sufficient to cover risks. Accordingly, the funds for physical investment will fall and productivity gains will erode which undermines growth. Attempting to counter this fact, central banks expand liquidity but the inability of firms to profitably invest causes the velocity of money to fall but the additional liquidity boosts financial assets. Financial investment, however, does not raise the standard of living. While the timing is uncertain, real forward financial asset returns must eventually move into alignment with the already present negative long-term real Treasury interest rates. This implied reduction in future investment will impair economic growth.

….research has documented that extremely high levels of governmental indebtedness suppress real per capita GDP. In the distant past, debt financed government spending may have been preceded by stronger sustained economic performance, but that is no longer the case. When governments accelerate debt over a certain level to improve faltering economic conditions, it actually slows economic activity. While governmental action may be required for political reasons, governments would be better off to admit that traditional tools would only serve to compound existing problems.

Carmen Reinhart, Vincent Reinhart and Kenneth Rogoff (which will be referred to as RR&R), in the Summer 2012 issue of the Journal of Economic Perspectives linked extreme sustained over indebtedness with the level of interest rates…… “Contrary to popular perception, we find that in 11 of the 16 debt overhang cases, real interest rates were either lower or about the same as during the lower debt/GDP years. Those waiting for financial markets to send the warning signal through higher (real) interest rates that governmental policy will be detrimental to economic performance may be waiting a long time.”

Growth Obstacles

In 2022, several headwinds will weigh on the U.S. economy. These include negative real interest rates combined with a massive debt overhang, poor domestic and global demographics, and a foreign sector that will drain growth from the domestic economy. The EM and AD (Advanced) economies will both serve to be a restraint on U.S. growth this year and perhaps significantly longer. The negative real interest rates signal that capital is being destroyed and with it the incentive to plough funds into physical investment.

Demographics continue to stagnate in the United States and throughout the world……..Poor demographics retard economic growth by lowering household, business and state and local investment. This keeps intact the observable trend in numerous countries – extreme over-indebtedness reduces economic growth which, in turn, worsens demographics, which reinforces the weakness emanating from the debt overhang. William Stull, Professor of Economics at Temple University, makes the case that for nations’, “demographics is destiny” (a phrase coined by Ben Wattenberg and Richard M. Scammon), highlighting the importance of its critical secular growth in determining economic fortune.

Although fourth quarter numbers are not yet available, the global debt to GDP average for 2020-21 is almost certainly the highest on record for any two-year period. Transitory growth spurts, like the one Q4 2021, are unlikely to be sustained. The sporadic but weakening growth trend evident before the pandemic hit in 2019 will return, reinforcing the debt trap.

Inflation

The University of Michigan indicates consumer sentiment in the fourth quarter was worse than during the height of the 2020 pandemic and at the levels of the beginning of the very deep 2008-09 recession. Consumers cut back significantly on their buying plans as expectations for increases in future income slumped. To fund the sharply higher cost of necessities, households have been forced to reduce the personal saving rate in November to 6.9%, or 0.4% less than in December 2019. Needing to tap credit card lines undoubtedly contributed to the erosion in consumer confidence measures. Without the sizable cut in personal saving, real consumer expenditures were barely positive in the fourth quarter. With money growth likely to slow even more sharply in response to tapering by the FOMC, the velocity of money in a major downward trend, coupled with increased global over-indebtedness, poor demographics and other headwinds at work, the faster observed inflation of last year should unwind noticeably in 2022.