GDP and Activity Archives - Page 4 of 13

October 15, 2022October 18, 2022

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.

September 20, 2022September 21, 2022

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.

July 2, 2022April 17, 2024

Global recession warning

Copper broke primary support at $9,000 per metric ton, signaling a bear market. Known as “Dr Copper” because of its prescient ability to predict the direction of the global economy, copper’s sharp fall warns of a global recession dead ahead.

Copper (S1)

The Dow Jones Industrial Metals Index broke support at 175, confirming the above bear signal. A Trend Index peak at zero warns of strong selling pressure across base metals.

DJ Industrial Metals Index (BIM)

Iron ore retreated below $125 per metric ton, warning of another test of $90. Further sign of a slowing global economy.

Iron Ore (TR)

The Australian Dollar is another strong indicator of the commodity cycle. After breaking primary support at 70 US cents, follow-through below support at 68.5 confirms a bear market. A Trend Index peak at zero warns of selling pressure.

Australian Dollar (AUDUSD)

Brent crude remains high, however, propped up by shortages due to sanctions on Russian oil. Penetration of the secondary trendline (lime green) is likely, as signs of a slowing economy accumulate. Breach of support at $100 per barrel is less likely, but would confirm a global recession.

Brent Crude (CB)

Long-term interest rates are falling, with the 10-year Treasury yield reversing below 3.0%, as signs of a US contraction accumulate.

10-Year Treasury Yield

ISM new orders fell to their lowest level since May 2020, in the midst of the pandemic.

ISM New Orders

The Atlanta Fed’s GDPNow forecast for Q2 dropped sharply, to an annualized real GDP growth rate of -2.08%.

Atlanta Fed GDPNow

Conclusion

We would assign probability of a global recession this year as high as 70%.

June 25, 2022June 25, 2022

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.

June 4, 2022

The globalization trap

On March 8, 2000, President Bill Clinton made a persuasive pitch to Washington’s foreign policy elite, Congress and the international community, on the merits of China’s accession to the World Trade Organization:

“Membership in the WTO, of course, will not create a free society in China overnight or guarantee that China will play by global rules. But over time, I believe it will move China faster and further in the right direction……..We have a far greater chance of having a positive influence on China’s actions if we welcome China into the world community instead of shutting it out.”

That was little more than a decade after the Beijing government massacred thousands of students participating in pro-democracy demonstrations in Tiananmen Square, June 1989. Twenty years have passed since China’s 2002 accession to the World Trade Organization. Let’s review how that is working out.

Zero progress toward a free society

Xi Jinping reversed any progress, towards a more open society, made under Hu Jintao. Xi revoked the term limit on his leadership as General Secretary of the Chinese Communist Party; increased censorship and mass surveillance; imprisoned minorities; suppressed news of the COVID outbreak in early 2020, causing a global pandemic; he shredded the one-country-two-systems agreement with the UK and cracked down on the pro-democracy movement in Hong Kong; while threatening democratic Taiwan with invasion.

Malign influence on democratic institutions

Rather than opening up China to Western influence, an open Western society proved highly susceptible to Chinese influence operations. Efforts to suppress free speech include infiltration of universities through establishment of Confucius Institutes and research grants; the Belt-and-Road initiative to increase control over fledgling democracies in the Asia-Pacific and Africa; and growing control over appointments in UN bodies. North Korea, for example, has been appointed as the current Chair of the UN Conference on Nuclear Disarmament.

Growing geopolitical challenge

Trade with the West has empowered China’s development of a powerful nuclear ICBM force, including hypersonic weapons; seizure and militarization of disputed shoals in the South China Sea, flouting international conventions; and development of a blue-water navy to expand its influence far beyond its shores.

Negative economic impact on the US.

Ignore the flowery speeches about democracy and freedom from the former President, the primary purpose of China’s admission was to enrich US corporations. When President Clinton described China’s admission as a “win-win”, you can be sure that US multinationals understood this to mean increased profit margins and new markets. China was also meant to benefit economically, to the extent that workers’ standard of living would need to rise so that they could consume more mass-produced Western goods.

It didn’t work out as planned.

Corporate profit margins rose to new highs, post-2002, as employee compensation fell.

Corporate Profits as Percentage of Value Added

The price was destruction of millions of manufacturing jobs as US companies shifted factories to Asia, where labor costs were a fraction of those in the US. Initially the erosion started with low-skill, menial jobs but soon expanded to high technology sectors as China’s industrial base grew.

Manufacturing Jobs

Industrial production in the US stalled after the 2008 crash, losing an entire decade of growth.

Industrial Production

Current account deficits ballooned as Chinese exports flowed into the US, supported by massive capital outflows from China to maintain their currency peg against the US Dollar. Capital outflows prevented the Yuan from appreciating against the Dollar — which would have eroded China’s pricing advantage in international markets.

Current Account

The US slipped from being a net creditor in the 1980s to the world’s biggest debtor, with a negative net international investment position (NIIP) of more than $18 trillion.

Net International Investment Position

Federal debt climbed to a precarious 128% of GDP in 2021 as the government ran ever-larger deficits to support the economy and offset the massive current account hemorrhage.

Federal Debt/GDP

The traditional relationship between government deficits and unemployment started to break down in the late 1980s. Unemployment (RHS) is on an inverted scale below, so high unemployment is near the bottom and low figures are near the top of the chart. Before the late 1980s, deficits were relatively small , increasing to between 4% and 6% of GDP when unemployment spiked during a recession. But deficits were kept close to 3% of GDP in the Reagan-Bush (HW) era, even when employment had recovered (blue circle). The hoped-for boost to GDP failed to materialize but the experiment was nevertheless repeated, even more aggressively, by Trump in 2016-2020, cutting corporate taxes in the hope that this would boost growth. But GDP growth again remained low.

Fiscal Deficit/GDP & Unemployment (inverted scale)

The Fed started expanding its balance sheet after the 2008 global financial crisis, in order to support a massive fiscal deficit of 10% of GDP, and an even larger 15% deficit in 2020. The effect was self-reinforcing as QE discouraged foreign investors from purchasing Treasuries — out of fear that the Dollar was being debased — forcing the Fed to inject ever-larger amounts of QE to make up for the absence of foreign funding. Money supply (M2) spiked upwards as a percentage of GDP, adding to debasement fears.

M2/GDP

There was one win, however, from globalization that the Fed was quick to claim. Low inflation is mistakenly attributed to Fed skill in managing the economy rather than the real reason: erosion of the US industrial base which undermined wages growth, particularly in the manufacturing sector.

CPI & Average Hourly Earnings - Manufacturing

Conclusion

Admission of China to the World Trade Organization in 2002 was an unmitigated disaster, unleashing a massive deflationary shock that destabilized the global financial system. Despite being a developing economy, China become a major exporter of capital, as well as goods, upsetting the level playing field of international exchange rates. This helped to suppress the Yuan, giving Chinese manufacturers an advantage over Western competitors, and caused the loss of millions of manufacturing jobs in the West. The Western response was to run larger deficits, causing public debt to balloon to precarious levels, while central banks efforts to support growing fiscal debt destabilized the global financial system.

Central Bank Total Assets

The recent surge in inflation exposed central banks inability to protect their currencies, without causing a global recession, undermined by precarious public debt levels and bloated central bank balance sheets.

Sir James Goldsmith — interviewed here in 1994 by Charlie Rose — was on the money when he referred to breach of the social contract between capital and labor, that ensured political stability in the West, and the betrayal of trust between political leaders and their electorate.

The present course is unsustainable in the long run and we anticipate an era of de-globalization as nations on-shore critical supply chains. There is no other currency that can compete with the Dollar’s status as global reserve currency but the system is likely to evolve towards a multi-polar world, with several separate trading/currency systems backed by commodities such as Gold, Silver and Base Metals. Oil would be ideal, as energy is central to the global economy, but storage is cumbersome; so a fixed exchange rate between oil and gold/base metals is more likely.

May 14, 2022May 14, 2022

Current turmoil and its impact on Gold

Michael Every from Rabobank is bearish on Gold in his recent video:

“I can’t see the case for Gold while the Fed is hiking — you don’t get a correlation with the Fed hiking aggressively and Gold going up…..If you want to buy into the Gold argument you are buying into the end of the US system. You are implicitly backing a New World Order and Commodity-backed currencies.”

Several readers have written, asking if this changes our view on Gold.

The short answer is NO, for three reasons:

1. The Fed can only hike rates until something breaks

Michael qualifies his view: he is bearish on Gold while the Fed hikes interest rates.

The Fed is expected to tighten — but only until something breaks. Not stocks, which they are unlikely to support, but the bond market. Credit is the lifeblood of the economy. When it stops flowing, the Fed is forced to inject liquidity into financial markets to maintain the flow.

Bank credit still grows at a healthy rate.

Bank Credit & Fed Funds Rate

The ratio of Copper/Gold (orange below), however, is a good indication of the economic cycle. When the economy is growing — and long-term interest rates (blue) are increasing — industrial metals, like Copper, rise faster than Gold and the ratio rises. When the economy contracts, the ratio falls.

Copper/Gold going sideways at present warns that the global economy is stalling. It is highly unlikely that the Fed would continue to tighten if the economy starts to contract — which would be signaled by a falling Copper/Gold ratio.

Copper-Gold Ratio & 10-Year Treasury Yield

Consumer sentiment (blue, inverted scale below) also gives a recession warning, at levels normally associated with high unemployment (red).

Unemployment & Consumer Sentiment (inverted scale)

Investment grade corporate bond issuance (green below) is still within its normal range, albeit on the low side, but high yield (light blue) has slowed to near its March 2020 low, warning that we are close to an economic contraction.

Investment Grade & High Yield Corporate Bond Issuance

A fall of investment grade issuance below $50 billion (the Dec 2020 low) would be cause for concern.

2. A strong Dollar is destroying US industry

The US has been running twin deficits for several decades, supporting the US Dollar as global reserve currency and offering US Treasuries as the global reserve asset.

Foreign Debt & Current Account

This has allowed the Financial sector to grow to a point where it dominates the US economy.

Market Capitalization: Financial/Non-Financial Sector

Wall Street may be reluctant to relinquish their “exorbitant privilege” of cheap debt but it has come at a huge cost to the US economy.

In order to supply international financial markets with sufficient Dollars, the US has to run large trade deficits. But every foreign exchange transaction has to have a buyer and a seller, so the large outflow of Dollars on current account is balanced by an equal and opposite inflow on the capital account.

Trade Deficit

The resulting trade imbalance boosts the Dollar exchange rate to the point that US manufacturers find it difficult to compete against foreign manufacturers in export markets and against foreign imports in domestic markets.

The strong Dollar decimated the manufacturing sector which has shed almost 7 million jobs over the past four decades.

Manufacturing Jobs & Current Account

The inflow of surplus capital also encourages malinvestment in nonproductive areas — dressed up to look attractive through leverage and artificially low interest rates — as in the sub-prime crisis. The ratio of GDP (output) to private non-financial debt has declined by more than 50% since the 1960s.

GDP/Non-financial Debt

Cheap debt also enabled the federal government to run large deficits at low cost, spending more than they raised in taxes and softening the impact of the growing trade imbalance.

The largest portion of capital inflows was invested in Treasuries. As the Current account balance plunged, federal debt held by foreign investors ballooned to almost $8 trillion.

Foreign Held Federal Debt & Current Account Balance

3. US debt above 120% of GDP would destroy the bond market

Overall federal debt climbed to more than 120% of GDP, well above the sustainable level of 70% to 80% of GDP posited by Dr Cristina Checherita and Dr Philip Rother in their ECB study of highly indebted economies.

Earlier research by Carmen Reinhart and Ken Rogoff (This Time is Different, 2008) suggested that states where sovereign debt exceeds 100% of GDP almost inevitably default.

That doesn’t mean that the US is about to default but it does mean that the federal government is precariously close to the point of no return, where it can no longer service the interest on its debt and is forced to capitalize it, compounding the problem.

Federal Debt/GDP

The only viable alternative is inflation. If the borrower suppresses interest rates below the rate of inflation, then GDP is likely to grow faster than the debt. This is already evident on the chart above, where US debt-to-GDP fell in the past 12 months. Federal debt (yellow) increased, but nominal GDP (blue) grew faster because of inflation.

Federal Debt & GDP growth

Current turmoil

The global financial system — with a US Dollar reserve currency and US Treasuries as the global reserve asset –appears increasingly fragile as global geopolitical conflict escalates.

China & the Dollar

After China’s admission to the World Trade Organization (WTO), it rapidly accumulated foreign reserves — mostly US Dollars — as it built up its industrial base, reaching $4 trillion by 2014.

China: Foreign Reserves

China maintained a strict peg against the Dollar until 2014, only allowing it to gradually rise in response to US pressure. But in 2014, a surging Dollar — in response to falling CPI and a shrinking deficit — started to cause problems.

Trade Weighted Dollar

The peg to a strong Dollar started to hurt Chinese exports; so in 2014 the authorities allowed the yuan to weaken, easing capital controls. Capital outflows and a falling Yuan attracted speculators like Hayman Capital who shorted the currency, forcing the PBOC to step in to support the currency in 2017.

China: Yuan

In 2018, the Yuan again fell when Donald Trump imposed tariffs on China’s exports to the United States, setting off a trade war.

The third major fall, in 2022, is the result of China’s debt crisis. An over-leveraged economy threatens to contract — triggered by rising US interest rates, a strong Dollar, rising energy prices, and an ongoing pandemic — while regulators attempt to shore up the financial system.

The Belt-and-Road initiative

In 2013 the PBOC were unhappy with the Fed’s program of quantitative easing (QE) which could be seen as currency debasement at the expense of foreign creditors (China).

China’s response was the Belt-and-Road initiative (BRI). This loaned US Dollars to emerging market governments in exchange for lucrative construction contracts, secured against the underlying infrastructure assets. Africa was a prime target.

China: Foreign Reserves

The capital inflow was diverted from US Treasuries — funding the federal deficit — and into the BRI. By 2022, BRI loans — denominated in Dollars to maintain the Yuan’s trade advantage over the Dollar — amounted to close to $5 trillion.

Funding the federal deficit

China’s BRI left Treasury with a problem with funding the US deficit, So far, the gap has been filled by Fed QE and, to a lesser extent, commercial banks.

Externally Held US Treasuries - Major Holders

But QE is not a long-term solution. The twin deficits supporting the US Dollar status as global reserve currency are now broken. And US Treasuries are no longer attractive to foreign investors as the global reserve asset.

The US is faced with a difficult choice:

Allow the Fed to continue its easy monetary policy in the hope that inflation will bail Treasury of its serious debt problem, lowering federal debt to between 70% and 80% of GDP. The risk is that foreign investors will increasingly shun Treasuries, threatening its status as the global reserve asset and driving up long-term interest rates in the USA.
Encourage the Fed to adopt a hawkish stance, shrinking its balance sheet (QT) and raising interest rates. Lower inflation and a stronger Dollar would restore investor confidence in Treasuries. But the risk is that the US plunges into recession which would make the debt problem even worse. Tax revenues would fall during a recession, increasing the fiscal deficit.

It appears that the Fed are attempting to walk a fine line between the two options at present, talking tough but delaying action for as long as possible, but later this year, they will be forced to show their hand.

China

Rising US interest rates and the strong Dollar are a major problem for China. Not only is the strong Dollar undermining Chinese businesses who borrowed in USD at cheap rates, but the strong Dollar also threatens to collapse China’s $5 trillion Belt-and-Road initiative which is funded by USD-denominated loans. Despite official statistics, the country is in a heap of pain. The private sector has never fully-recovered from the initial COVID-19 pandemic and is now being dragged down by Xi Jinping’s zero-Covid policy lockdowns. Ports are in gridlock.

Chinese Ports

Falling natural gas consumption warns of an economic contraction, promising further disruption to commodity producers and supply chains around the world.

Chinese LNG Demand

Team USA

This may be an over-simplification but “team USA” — to use Michael Every’s expression — is primarily split into two camps:

Wall Street and the Federal Reserve, who want to maintain the US Dollar position as the global reserve currency; and
The Department of Defense (DOD) and the manufacturing sector, who recognize the damage done by the Dollar reserve currency, with erosion of the US industrial base and offshoring of critical supply chains.

Weaponizing the Dollar against Russia, by seizing their foreign reserves, was apparently a DOD initiative, with the Fed not even consulted. The outcome is likely to be long-term damage to the Dollar’s reserve currency status, with non-aligned states — including China and India — increasingly reluctant to hold reserve assets in Dollars.

There are no ready alternatives to the Dollar — as Michael Every points out — but other asset classes, including Gold and Commodities, are likely to play an increasingly larger role.

Conclusion

Credit markets are tightening and warn of a recession. The Fed is unlikely to continue its hawkish stance if credit markets dry up or employment falls.

It is not in the US interest to continue running large current account deficits to support the Dollar’s reserve status. The economy has suffered long-term damage from its “exorbitant privilege” with the US Dollar as reserve currency. Support for the Dollar’s reserve status, from Wall Street, faces growing opposition from the DOD and manufacturing sector.

The US faces a tough choice between debt and inflation. A hawkish Fed may lower inflation but is likely to cause a recession, making the debt situation even worse. A dovish Fed, on the other hand, with higher inflation, may alleviate the debt problem but is likely to undermine foreign investor confidence in the Dollar and Treasuries.

The situation is further exacerbated by current market turmoil. The strong Dollar threatens to damage China’s economy and its Belt-and-Road initiative, raising tensions with the US. Weaponization of the Dollar in sanctions against Russia also threatens to undermine the Dollar’s reserve currency status.

Rising interest rates and a strong Dollar are bearish for Gold, but there are a number of developments that suggest the opposite. We remain overweight on Gold.

Acknowledgements

Tom Mclellan for the Unemployment/Consumer Sentiment comparison
Frankoz for the BRI insight

April 29, 2022April 29, 2022

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.

March 28, 2022

Consumer sentiment warns of recession

University of Michigan’s consumer sentiment index fell to 62.8 for February. Levels below 70 are normally associated with recession.

University of Michigan: Consumer Sentiment Index

January 25, 2022March 8, 2023

Dr Lacy Hunt, Hoisington Investment Management | The debt trap

From Dr Lacy Hunt at Hoisington Investment 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.

December 1, 2021December 1, 2021

Services inflation

A friend asked a question: “Our advanced economies are 70 – 80 % Services based these days; so will this make CPI inflation difficult to sustain if wages growth is not sustained.”

The answer is YES. Inflation is unlikely to be sustained if wages growth declines.

BUT wages growth is accelerating, not declining, both in the services sector and in the broader economy.

Average Hourly Wages Growth: Total Private & Services Sector

Wages growth is also not likely to decline while we have record job openings; 5.4 million in the services sector alone.

Job Openings: Services Sector

Employers are having to offer higher wages and sign-on bonuses to attract workers — the result of record high savings levels fueled by government stimulus.

M2/GDP