Puzzle Financial Advice

Background:   https://www.puzzlefinancialadvice.com/why-higher-inflation-ahead-july2020

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March/2021 Inflation and bond yields are 2 major things to focus on in 2021 if you wish to understand many of the major movements in Western asset prices for the next 5 years - and there is a good chance that rising US interest rates will trigger the coming major US share market crash during 2021.

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What you should be looking for in this coming period is as follows:-

• For the first time since 1930, central banks are substantially taking their eyes of inflation-targeting.

• Getting unemployment levels down to lower levels and targeting wage price inflation are (for at least the short-term) where central banks like the US Fed and RBA are focusing.

• The US Fed and the RBA have failed to hit their lower CPI target levels for more than 10 years - so they are giving up targeting CPI inflation for the near term at least.

• This could well result in inflation getting away from central banks (i.e. inflation rising significantly higher over the next 5-10 years)

  • And if inflation did rise to 5% or 10%pa over the next 5 or 10 years, who would be the winners?   Well western governments like that in USA and Australia, will be winners, because since they are implementing financial repression  (at least keeping cash rates artificially low - and below the inflation rate), higher inflation probably will be helping these governments deflate away their mountain of government debt, at least in real terms.

  • But this of course, will come with many other costs - including to savers and conservative investors.  i.e. one major class of losers out of these government policies, will be people who invest in cash and short-term term-deposits on a long-term basis.

• Now rising inflation is going to cause bond yields to rise

  • Yes, central banks may through QE, seek to suppress bond yields further out the yield curve - but that implies (effectively) QE which might cause more asset price inflation effects - and it has already caused a number of asset price bubbles. I think it more likely, that we will move more to a Modern Monetary Theory (MMT) style monetary policy, where central banks directly  fund government deficits to help keep government spending manageable/"affordable". But such MMT policies will also continue to stoke more consumer price inflation - because unlike QE, such MMT policies will substantially boost aggregate demand (Gross National Expenditure), depending on precisely where that deficit spending is  focused (Russell Napier discusses that here .... https://www.puzzlefinancialadvice.com/single-post/2020/07/30/inflation-at-4-in-2021-russell-napier ) . So I think we will see more financial repression measures over time during this decade anyhow, to reduce the extent to which MMT-style money creation stokes aggregate demand.

  • So there will be a lot of pressure building for rising bond yields if consumer price inflation rises significantly in a sustainable fashion

  • And this is going to make it more and more difficult for central banks to control bond yields .... particularly those of longer duration.

    • And this would also cause one other problem for the USA. In recent decades, it has been foreign investors who have been substantially funding US government deficits (i.e. foreign investors have been buying bonds) - and these investors will increasingly flee out of US government bonds if the US government proceeds down this path.

      • And if foreign investors stop funding the US government deficits (as well as if foreign investors start selling more of their US government bond holdings - a trend which is already in progress), these things will also be adding to the pressure for rising US bond yields.

  • But, let us just say that central banks succeed for a while in keeping longer duration bond yields down to lower levels while consumer price inflation rises  significantly.

    • EWI would point out that at some point, bond yields will get out of the control of central banks. Central banks are not omnipotent. They cannot defy gravity forever. And then the impact on other asset prices will be felt, if it has not happened before hand.

• Rising bond yields increases the discount rate used to value a large proportion of assets in our economies (Net Present Value calculations).   And this will cause many asset prices to fall - or at the very least put downward pressure on those asset prices.

  • John Hussman discusses this issue here. https://twitter.com/hussmanjp/status/1373804472116391939

    • "Valuations are the first casualty of rising inflation. The benefit of inflation on nominal growth dominates only after valuations have been crushed. The Turkish CPI has doubled since 2013. Only after valuations hit 2009 levels a year ago has inflation been "good" for the BIST100"

    • See also the chart at that Tweet.

 

Rising consumer price inflation in USA is an important factor to monitor. Watch this space.

 

 

Further background.

Generally, interest rates rise with inflation.

• In the 1800s in the USA, deflation was as common as inflation (See Appendix C) - and central banks (to the extent that they existed) we not particularly interventionist. However since 1930, central banks such as the US Fed have become increasingly interventionist.  Since the early 1930s when central banks started target positive inflation rates, while central banks tried to ensure there was inflation (so that cash rates were an effective tool is managing the economy), central banks always tried to target (with cash rates) a particular low level of inflation (eg 2%pa), because they also did not want high inflation like in the 1970s.

• How this time is different - for the first time since 1930.

  • The Australian RBA recently (~17 March 2021) said that they were not going to start raising interest rates until there was a significant level of wage inflation, on the basis that sustainably higher CPI inflation rates cannot be delivered unless there is sustainably higher wage price inflation. This was seen to also include targeting lower unemployment  levels.

  • The US Federal Reserve (US Fed) is also doing something similar.

  • This is a really big deal, and it creates the risk that that CPI rates might start rising quite sharply at some point over the years ahead - and this could have major ramifications for bond yields - and that is a big deal, because in this era where cash rates are being held at 0%pa by central banks, bond yields will be the key determinant in for the discount factor used to value many other asset prices (Net Present Value Calculations)

• Since about 2020, central banks have struggled to get inflation up to their target level - and there has been almost no wage inflation.

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Important relevant articles:

• Stanley Duckenmiller 12/May/21 worrying about serious inflation because he "cannot find 1 period in history where monetary and fiscal were this out of step with economic circumstances".

  • https://www.cnbc.com/video/2021/05/11/stanley-druckenmiller-fed-policy-criticism-us-economy.html

  • The US Fed is financing 60% of the US fiscal deficit. If the Fed was not buying so much Treasuries, the market would be totally rejecting this level of bond issuance to finance the massive fiscal deficit spending.

  • The problem is, if you end up getting inflation (and even if you don't), the debt will be so big that they will have to monetise the debt. This will have huge implications for the US$. This will probably mean that the US$ will lose reserve currency status within 15 years.

  • https://www.afr.com/chanticleer/why-inflation-has-this-wall-street-icon-so-worried-20210512-p57r5q  

  • https://www.afr.com/markets/debt-markets/us-inflation-shatters-interest-rate-complacency-20210513-p57rg7    

• "Larry Summers accuses Fed of ‘dangerous complacency’ over inflation"    AFR 19/May/2021

  • Mr Summers said monetary and fiscal policymakers had “underestimated the risks, very substantially, both to financial stability as well as to conventional inflation of protracted extremely low interest rates”.    The Fed has vowed to keep US interest rates on hold at close to zero until the recovery hits certain milestones, including full employment, while predicting that spikes in inflation will be transitory. The latest median forecast from the central bank’s officials shows rock-bottom rates remaining in place until at least 2024.   “Policy projections suggesting that rates may not be raised for ... close to three years are creating a dangerous complacency,” Mr Summers said, adding that the Fed could be forced into a knee-jerk tightening of monetary policy that would spook markets and even hurt the real economy. “When, as I think is quite likely, there is a strong need to adjust policy, those adjustments will come as a surprise.” That “jolt” would do “real damage to financial stability, and may do real damage to the economy”, Mr Summers warned. 

  • Mr Summers warned that the notion of an equal balance between inflationary and deflationary risks, and between financial bubbles and credit problems was “very far off of an accurate reading of the economy right now”.     “The primary risks today involve overheating, asset price inflation and subsequent financial excessive leverage and subsequent financial instability. Not a downturn in the economy, excessive unemployment and excessive sluggishness,” Mr Summers said.