Carmen Reinhart: Financial repression
“These crises are really a form of domestic default that governments employ in countries where financial repression is a major form of taxation. Under financial repression, banks are vehicles that allow governments to squeeze more indirect tax revenue from citizens by monopolizing the entire savings and payments system, not simply currency. Governments force local residents to save in banks by giving them few, if any, other options. They then stuff debt into the banks via reserve requirements and other devices. This allows the government to finance a part of its debt at a very low interest rate; financial repression thus constitutes a form of taxation. Citizens put money into banks because there are few other safe places for their savings. Governments, in turn, pass regulations and restrictions to force the banks to relend the money to fund public debt….”
~ Carmen M. Reinhart, This Time Is Different: Eight Centuries of Financial Folly
The bond market revolt
The rise in Treasury yields accelerated over the past week, with 10-year Treasuries closing at 1.54% on Thursday and 10-year TIPS at -0.60.
A sharp fall in daily new COVID-19 cases has fueled optimism about a rapid re-opening of the US economy.
As well as fears of higher inflation.
What the sell-off means
Investors are selling Treasuries at a faster rate than the Fed (and banks) are buying, out of fear of accelerating capital losses. Fixed coupons have been badly affected, with iShares 20Year+ Treasury Bond ETF (TLT) showing a loss of 13% over the past 6 months. But even inflation-protected bonds have lost value in anticipation of higher real interest rates, with PIMCO’s 15 Year+ TIPS Bond ETF (LTPZ) falling more than 6%.
The Fed response
The Fed is likely to respond by weighting purchases towards longer maturities. The 10-year Treasury yield has already started to anticipate this, falling to 1.39% by Friday’s close.
Source: CNBC
The result is a 16 bps fall in the real 10-year yield, to -0.76% on Friday (1.39-2.15).
Conclusion
Fed purchases are expected to suppress long-term Treasury yields over the next few months, with inflation breakeven rates continuing their upward trend, while real yields remain negative.
S&P 500 fueled by the Fed
The S&P 500 continues, unwavering, in a strong up-trend.
But compare the growth in the S&P 500 index relative to growth in the money supply (M2). In relative terms, the S&P 500 appreciated only 29%, or 2.6% p.a., over the past decade. Most of the stellar performance over the past 10 years can be attributed to the Fed’s expansionary monetary policy.
Dollar Index
The Dollar Index continues to test support at 90. A Trend Index peak below zero warns of strong selling pressure. Breach of support is likely and would signal another primary decline.
The Chinese Yuan, however, has halted in its appreciation against the Dollar. Trend Index peak below the 7-week MA warns of secondary selling pressure. Breach of support at 15.4 US cents would warn of a correction.
Conclusion
The S&P 500 is likely to continue rising for as long as the Fed expands the money supply. The Dollar, however, is expected to weaken for the same reason.
USA: Sales up, daily COVID-19 cases down but jobs still scarce
Daily new COVID-19 cases in the US are clearly falling as the vaccine roll-out takes effect.
But daily deaths are still rising and may take another few weeks to level off.
January payroll figures show the economic recovery has stalled, with total jobs contracting by 6.08% compared to January 2020.
Hours worked are down 4.4% compared to last year.
Average hourly earnings jumped 5.44% for production and non-supervisory workers but these are distorted by strong job losses in the lowest pay grades.
Retail sales (excluding food) have also been artificially boosted by government stimulus which added roughly 20% to disposable income.
Light vehicle sales are similarly boosted.
While housing starts are climbing in response to record low mortgage rates.
Total unemployment claims (state and federal) declined to a still high 17.8 million for the week ended January 16th.
The proposed Biden stimulus will support households and businesses but employment is likely to remain weak until the COVID-19 outbreak is clearly under control.
Conclusion
Economic activity is expected to remain weak in the first half of 2021. A key determinant will be the length of time it takes to bring the COVID-19 outbreak under control. Subsequent recovery is likely to need strong fiscal support, with federal debt expected to grow faster than GDP in 2021. This will require continued Treasury purchases by the Fed and commercial banks, with interest rates remaining low throughout 2021.
The Debt Trap (video)
Can the Fed keep a lid on inflation?
Jeremy Siegel, Wharton finance professor, says the Fed has poured a tremendous amount of money into the economy in response to the pandemic, which will eventually cause higher inflation. David Rosenberg of Rosenberg Research argues that velocity of money is declining and the US economy has a large output gap so inflation is unlikely to materialize.
Click to playBoth are right, just in different time frames.
Putting the cart before the horse
The velocity of money is simply the ratio of GDP to the money supply. Fluctuations in the velocity of money have more to do with fluctuations in GDP than in the money supply. If GDP recovers, so will the velocity of money. Equating velocity of money with inflation is putting the cart before the horse. Contractions in GDP coincide with low/negative inflation while rapid expansions in GDP are normally accompanied, after a lag, by rising inflation.
Money supply and interest rates
Inflation is likely to rise when consumption grows at a faster rate than output. Prices rise when supply is scarce — when we consume more than we produce. Interest rates play a key role in this.
Low interest rates mean cheap credit, making it easy for people to borrow and consume more than they earn. Low rates also boost the stock market, raising corporate earnings because of lower interest costs, but most importantly, raising earnings multiples as the cost of capital falls. Speculators also take advantage of low interest rates to leverage their investments, driving up prices.
In the housing market, prices rise as cheap mortgage finance attracts buyers, pushing up demand and facilitating greater leverage.
Wealth effect
Higher stock and house prices create a wealth effect. Consumers are more ready to borrow and spend when they feel wealthier.
High interest rates, on the other hand, have the exact opposite effect. Credit is expensive and consumption falls. Speculation fades as stock earnings multiples fall and housing buyers are scarce.
Money supply is only a factor in inflation to the extent that it affects interest rates. There is also a lag between lower interest rates and rising consumption. It takes time for consumers and investors to rebuild confidence after an economic contraction.
The role of the Fed
Fed Chairman, William McChesney Martin, described the role of the Federal Reserve as:
“…..to take away the punch bowl just as the party gets going.”
In other words, to raise interest rates just as the economic recovery starts to build up steam — to avoid a build up of inflationary pressures.
The Fed’s mandate is to maintain stable prices but there are times, like the present, when their hands are tied.
Federal government debt is currently above 120% of GDP.
GDP is likely to rise as the economy recovers but so is federal debt as the government injects more stimulus and embarks on an infrastructure program to lift the economy.
With federal debt at record levels of GDP, raising interest rates could blow the federal deficit wide open as the cost of servicing Treasury debt threatens to overtake tax revenues.
Conclusion
Inflation is likely to remain low until GDP recovers. But the need to maintain low interest rates — to support Treasury markets and keep a lid on the federal deficit — will then hamper the Fed’s ability to contain a buildup of inflationary pressure.
Luke Gromen: Bitcoin alarm
“We do not think BTC is a bubble; we think BTC is the last remaining functioning fire alarm that has not been disabled by policymakers, and it is issuing an increasingly shrill alarm about the USD and fiat currencies more broadly. We have little doubt that policymakers will attempt to disable BTC as a functioning fire alarm as well, but its traits make that far more difficult to do to BTC than they have thus far done with gold.”
~ Luke Gromen, Treerings.com
Danielle DiMartino Booth On The Future Of The Federal Reserve
Jim Bianco forecasts higher inflation in 2021
Jim Bianco from Bianco Research:
“The problem the stock market has in 2021 is by most standard metrics (P/E, Market Cap/GDP, etc.) it’s overvalued. Now a lot of people expect it to stay that way for another year. If we don’t get inflation, that can actually happen and you could actually have the market stay at these elevated levels. But if you do get rising interest rates on inflation……that will frip earnings, make mortgage rates go up and lift interest rates. That has historically not been good for risk assets….”
The problem if we don’t get inflation will be far worse. MMT theorists will take this as validation and we are likely to see more calls for far higher stimulus checks. Why not $200,000 stimulus checks someone on Twitter asked. The bubble will keep expanding without any visible effect …..until it bursts.