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In Part one of this series, Our Currency The World’s Problem, we discuss the vital role the U.S. dollar plays in the global economy. With an understanding of the dollar’s role as the world’s reserve currency, it’s time to discuss how the Federal Reserve’s monetary policy machinations influence the dollar and, therefore, the global economy and financial markets.

Given the Fed’s recent extreme monetary policy actions, which haven’t been seen in over 40 years, it is more important now than ever to appreciate the potential global consequences of the Fed’s stern fight against inflation.

Triffin’s Paradox

In Part 1, we highlight the following two lines, which help describe Triffin’s paradox.

“To supply the world with dollars, the United States must consistently run a trade deficit. Running persistent deficits, the United States would become a debtor nation.”

“Simply the growing divergence between debt and the ability to pay for it, GDP, is unsustainable.”

Increasingly borrowing without the means to pay it off is unsustainable. The terms zombie company or Ponzi Scheme come to mind when considering such a system. That said, because the printer of the currency and taxer of its citizens is in charge, we can only ask how long the status quo can continue.

The answer is partially up to the Fed. The Fed can use QE and low-interest rates to delay the inevitable. As we now see, the problem is that those tools are detrimental when there is high inflation. Fighting inflation requires higher interest rates and QT, both of which are problematic for high debt levels.

Financial Tremors

The Bank of England is bailing out U.K. pension funds. The Bank of Japan uses excessive monetary policy to protect its currency and cap interest rates…

…click on the above link to read the rest…

How Durable Is The Potemkin Economy?

November 17, 2021

How Durable Is The Potemkin Economy?

“Increased borrowing must be matched by increased ability to repay. Otherwise, we aren’t expanding the economy – we’re merely puffing it up.” – Henry Alexander of Morgan Guaranty Trust

The original Potemkin Village dates to the late 1700s. At that time, Russian Governor Grigory Aleksandrovich Potemkin constructed facades to hide the poor condition of his town from Empress Catherine II.

Since then, Potemkin Village represents a false construct, physical or narrative, created to hide the actual situation.

As the pandemic ravaged the economy, the Federal Reserve, White House, and Congress went to work and built a Potemkin economy around the ailing economy.

As a result, the curb appeal of today’s economic recovery is beautiful. However, when our clients’ wealth is at stake, we understand looks can be deceiving. As such, we prefer to open the front door and explore the real economy. In the long run, it is sustainable economic growth that supports asset prices. In the short run, however, investors may continue to be mesmerized by the Potemkin economy. At some point, any differences between the Potemkin economy and the actual economy will become problematic for investors.

Selling A Narrative

Narratives of a booming economic recovery can only mislead the public and investors for so long. Toss in robust economic data, and the façade seems awfully real.

Consider the following:

Nominal GDP is now 4.5% above the high-water mark set pre-pandemic. Historically, economic recoveries do not get more “V-shaped!”

Potemkin economy, How Durable Is The Potemkin Economy?

Retail Sales are running about 12% above its trend of the last ten years. The premium represents nearly five years of growth at the prior trend.

CPI and Core CPI (excluding food and energy) are nearly triple their respective growth rates of the last five years.

…click on the above link to read the rest of the article…

History Warns The Fed Will Raise Interest Rates More, Not Less

November 3, 2021

History Warns The Fed Will Raise Interest Rates More, Not Less

History Warns The Fed Will Raise Interest Rates More, Not Less

“Currently, the December 2019 Fed Funds futures contract implies that the Fed will reduce the Fed Funds rate by nearly 75 basis points (0.75%) by the end of the year. While 75 basis points may seem aggressive, if the Fed does embark on a rate-cutting policy and history proves reliable, we should prepare ourselves for much more.”- Investors Are Grossly Underestimating the Fed

Our advice to plan for the unexpected was prescient. When we wrote the article in July 2019, Fed Funds were between 2.25% and 2.50%. The Fed Funds futures contracts were implying the Fed would reduce rates by .75% in the forthcoming months.

By April 2020, Fed Funds were trading near zero, 1.50% below where the market thought they would be in mid-2019. The article quantifies the Fed always raises or cuts rates much more than expected.

Today, the market is pricing in steady increases, starting in 2002, for the Fed Funds rate. Despite high inflation and low unemployment, the Fed refuses to even think about thinking about raising rates.

Given the Fed’s posture, it may appear traders are overestimating how much the Fed will raise rates. However, we caution once again; traders always underestimate the Fed.

Evidence

Whether higher Fed Funds seems logical is irrelevant. As investors, we need to strategize in case history proves clairvoyant. Given the Fed is starting to normalize monetary policy, it’s worth revisiting the article from 2019.

We recommend reading the article’s first section linked above for more background on Fed Funds and their futures contracts.

The graph below shows how much the Fed Funds futures market consistently over or underestimates what the Fed does. The green areas and dotted lines quantify how much the market underestimates how much the Fed ultimately reduces rates…

…click on the above link to read the rest of the article…

What is the Federal Reserve Hiding From Us?

October 28, 2021

What is the Federal Reserve Hiding From Us?

“The most inappropriate monetary policy that I’ve seen maybe in my lifetime.”- Paul Tudor Jones on the Federal Reserve via CNBC

The Federal Reserve has three mandates per their Congressional charter. They are to effectively promote maximum employment, stable prices, and moderate long-term interest rates. The Fed has met the first goal, employment is largely maximized. As far as the other two, the Fed is running monetary policy consistent with destabilizing prices and doing it with interest rates that are well below moderate.

Why are they employing the “most inappropriate monetary policy” that famed investor Paul Tudor Jones has seen in his lifetime? Maybe the better question is, is such an aggressive policy, which purposely goes against their mandate, hiding something?

Fed Mandate Scorecard

To provide context to the questions, let’s review the three Fed mandates and compare their current standing to the past.

Federal Reserve, What is the Federal Reserve Hiding From Us?

Maximum Employment

The unemployment rate is slightly above the average of the five years leading to the pandemic but over 1% below the longer-term average. The two alternative employment measures, which factor in job openings and those willingly quitting jobs, show the adjusted unemployment rate is well below the 20-year average.

Traditional measures of employment are essentially fully recovered from the pandemic. Alternative measures, such as those above, tell us the labor market is healthier than almost any time in the last 20 years.

Stable Prices

Inflation measured by CPI and the Fed’s preferred method, PCE, runs two to three times the rate of the last five and twenty years. Five-year market-implied inflation expectations are up to 2.90%, about twice that of the previous ten years. Consumer inflation expectations, measured by the University of Michigan, are nearing 5%, also twice that of the last ten years.

…click on the above link to read the rest of the article…

Two Pins Threatening Multiple Asset Bubbles

June 2, 2021

Two Pins Threatening Multiple Asset Bubbles

“Powell Says Fed Policies “Absolutely” Don’t Add To Inequality” -Bloomberg May 2020

The headline above is but one of countless times Fed Chairman Powell and his colleagues confidently said their policies do not result in wealth or income inequality. Their political stature and use of complex economic lingo give weight to their opinions in the media. Nevertheless, a deep examination of the Fed’s practices and their consequences leaves us to think otherwise.

In our opinion, the Fed’s contribution to wealth inequality is significant and grossly misunderstood. We have written articles explaining why QE and low interest rates generally benefit the wealthy and harm the poor. This article backs up those prior arguments with quantitative muscle.

Timely for investors, we also draw some lines between wealth inequality and financial stability and their relationship to monetary policy. We think it is becoming increasingly possible wealth inequality, and in particular, the outsized effect inflation has on the poor, could be the needle to pop many asset bubbles. The other possible needle is the Fed’s wanting for financial stability.

**Due to the importance of monetary policy from economic, societal, and market perspectives we are breaking this article into two. We will share part two next week.

Background

More inflation and financial stability (rising asset prices) are two of the three core tenets backing monetary policy. A strong labor market is the third objective. We focus on inflation in this article and financial stability in part II.

In our article Two Percent for the One Percent, we explain why inflation is detrimental to the poor, while rising asset prices (financial stability) primarily benefit the wealthy. The following paragraphs from the article explain:

…click on the above link to read the rest of the article…

What Interest Rate Triggers The Next Crisis?

March 17, 2021

What Interest Rate Triggers The Next Crisis?

The Ten-year U.S. Treasury note yields 1.61%.
10-year high-quality corporate bonds yield 2.09%.
The rate on a 30-year mortgage is 3.05%.

Despite recent increases, interest rates are hovering near historic lows. We do not use the word “historic” lightly. By “historic,” we refer to the lowest levels since the nation’s birth in 1776.

The graph below, courtesy of the Visual Capitalist, highlights our point.

Despite 300-year lows in interest rates, investors are becoming anxious because they are rising. Recent history shows they should worry. A review of the past 40 years reveals sudden spikes in interest rates and financial problems go hand in hand.

The question for all investors is how big a spike before the proverbial hits the fan again?

Debt-Driven Economy

Over the past 40 years, debt has increasingly driven economic growth.

That statement on its own tells us nothing about the health of the economy. To better quantify the benefits or consequences of debt, we need to understand how it was used.

When debt is used productively, the interest and principal are covered with higher profits and sustained economic activity. Even better, income beyond the cost of the debt makes the nation more prosperous.

Conversely, unproductive debt may provide a one-time spark of economic activity, but it yields little to no residual income to service it going forward. Ultimately it creates an economic headwind as servicing the debt in the future replaces productive investment and or consumption.

The graph below shows the steadily rising ratio of total outstanding debt to GDP. If debt, in aggregate, were productive, the ratio would be declining regardless of the amount of debt.

…click on the above link to read the rest of the article…

Plus ça change: A French Lesson in Monetary Debauchery

December 30, 2020

Plus ça change: A French Lesson in Monetary Debauchery

Fiscal policy shifted into turbo-charged, warp speed, overdrive early into the COVID related recession. To facilitate the borrowing binge, the Federal Reserve took unprecedented monetary actions. In 2020, the fiscal deficit (November 2019- October 2020) rose $3.1 trillion and was matched one for one with a $3.2 trillion increase in the Fed’s balance sheet.

The Fed is indirectly funding the government, but are they printing money? Technically they are not. However, they are inching closer through various funding programs in coordination with the Treasury Department.

Will the Fed ever print money? In our opinion, it is becoming increasingly likely as the requirements to service the interest and principal on existing debt, plus new debt, far exceeds what the economy is producing.

Given the increasingly dire mismatch between debt and economic activity, we think it is helpful to retell a tale we wrote about in 2015. This article is more than a history lesson. It effectively illustrates the road on which the U.S. and many other nations currently travel.

This story is not a forecast but a simple reminder of what has repeatedly happened in the past.

As you read, notice the lines French politicians use to persuade the opposition to justify money printing. Note the similarities to the rationales used by central bankers, MMT’ers, and neo-Keynesian economists today. Then, as now, monetary policy is promoted as a cure for economic ills. As we are now constantly reminded, massive monetary actions have manageable consequences, and failure is blamed on not acting boldly enough.

Our gratitude to the late Andrew D. White, on whose work we relied heavily. The exquisite account of France circa the 1780-the 1790s was well documented in his paper entitled “Fiat Money Inflation in France” published in-1896. Any unattributed quotes were taken from his paper.

…click on the above link to read the rest of the article…

When It Becomes Serious You Have To Lie: Update On The Repo Fiasco

December 11, 2019

When It Becomes Serious You Have To Lie: Update On The Repo Fiasco

Occasionally, problems reveal themselves gradually. A water stain on the ceiling is potentially evidence of a much larger problem. Painting over the stain will temporarily relieve the unsightly condition, but in time, the water stain will return. This is analogous to a situation occurring within the banking system. Almost three months after water stains first appeared in the overnight funding markets, the Fed has stepped in on a daily basis to “re-paint the ceiling” and the problem has appeared to vanish. Yet, every day the stain reappears and the Fed’s work begins anew. One is left to wonder why the leak hasn’t been fixed.

In mid-September, evidence of issues in the U.S. banking system began to appear. The problem occurred in the overnight funding markets which serve as one of the most important components of a well-functioning financial and economic system. It is also a market that few investors follow and even fewer understand. At that time, interest rates in the normally boring repo market suddenly spiked higher with intra-day rates surpassing a whopping 8%. The difference between the 8% repo rate recorded on September 16, 2019 and Treasuries was an eight standard deviation event. Statistically, such an event should occur once every three billion years.

For a refresher on the details of those events, we suggest reading our article from September 25, 2019, entitled Who Could Have Known: What The Repo Fiasco Entails.

At the time, it was surprising that the sudden change in overnight repo borrowing rates caught the Fed completely off guard and that they lacked a reasonable explanation for the disruption. Since then, our surprise has turned to concern and suspicion.

We harbor doubts about the cause of the problem based on two excuses the Fed and banks use to explain the situation. Neither are compelling or convincing.

…click on the above link to read the rest of the article…

Black Monday – Can It Happen Again?

September 12, 2019

Black Monday – Can It Happen Again?

The 1987 stock market crash, better known as Black Monday, was a statistical anomaly, often referred to as a Black Swan event. Unlike other market declines, investors seem to be under the false premise that the stock market in 1987 provided no warning of the impending crash. The unique characteristics of Black Monday, the magnitude and instantaneous nature of the drop, has relegated the event to the “could never happen again” compartment of investors’ memories.

On Black Monday, October 19, 1987, the Dow Jones Industrial Average (DJIA) fell 22.6% in the greatest one-day loss ever recorded on Wall Street. Despite varying perceptions, there were clear fundamental and technical warnings preceding the crash that were detected by a few investors. For the rest, the market euphoria raging at the time blinded them to what in hindsight seemed obvious.

Stock markets, like in 1987, are in a state of complacency, donning a ‘what could go wrong’ brashness and extrapolating good times as far as the eye can see. Even those that detect economic headwinds and excessive valuations appear emboldened by the thought that the Fed will not allow anything bad to happen.

While we respect the bullish price action, we also appreciate that investors are not properly assessing fundamental factors that overwhelmingly argue the market is overvalued. There is no doubt that prices and valuations will revert to more normal levels. Will it occur via a long period of market malaise, a single large drawdown like 1987, or something more akin to the crashes of 2001 and 2008? When will it occur? We do not have the answers, nor does anyone else; however, we know that those who study prior market drawdowns are better prepared and better equipped to limit their risk and avoid a devastating loss.

…click on the above link to read the rest of the article…

In The Fed We Trust – Part 1

May 15, 2019

In The Fed We Trust – Part 1

This article is the first part of a two-part article. Due to its length and importance, we split it to help readers’ better digest the information. The purpose of the article is to define money and currency and discuss their differences and risks. It is with this knowledge that we can better appreciate the path that massive deficits and monetary tomfoolery are putting us on and what we can do to protect ourselves.

How often do you think about what the dollar bills in your wallet or the pixel dollar signs in your bank account are? The correct definitions of currency and money are crucial to our understanding of an economy, investing and just as importantly, the social fabric of a nation. It’s time we tackle the differences between currency and money and within that conversation break the news to you that deficits do matter, TRUST me.

At a basic level, currency can be anything that is broadly accepted as a medium of exchange that comes in standardized units. In current times, fiat currency is the currency of choice worldwide. Fiat currency is paper notes, coins, and digital 0s and 1s that are governed and regulated by central banks and/or governments. Note, we did not use the word guaranteed to describe the role of the central bank or government. The value and worth of a fiat currency rest solely on the TRUST of the receiver of the currency that it will retain its value and the TRUST that others will accept it in the future in exchange for goods and services.

…click on the above link to read the rest of the article…

UNLOCKED: The Curious Case of Rising Fuel Prices and Shrinking Inflation

May 1, 2019

UNLOCKED: The Curious Case of Rising Fuel Prices and Shrinking Inflation

On Friday, April 26, 2019, the market was stunned with a much stronger than expected 3.2% rate of first-quarter economic growth. Wall Street expectations were clearly off the mark, ranging from 1.3-2.3%. The media took this as a sign the economy is roaring. To wit, a headline from the Washington Post started “US Economy Feels Like the 1990s.”

Upon first seeing the GDP report, we immediately looked with suspicion at the surprisingly low GDP price deflator. The GDP price deflator is an inflation measure used to normalize GDP so that prior periods are comparable to each other without the effects of inflation.

The Bureau of Economic Analysis (BEA) reports nominal and real GDP. Real GDP is the closely followed number that is reported by the media and quoted by the Fed and politicians. Since the GDP price deflator is subtracted from the nominal GDP number, the larger the deflator, the smaller the difference between real and nominal GDP.

The BEA reported that the first quarter GDP price deflator was 0.9%, well below expectations of 1.7%. Had the deflator met expectations, the real GDP number would have been about 2.4%, still high but closer to the upper range of economists’ expectations.

Fueling the Deflator

Like Wall Street, we were expecting a deflator that was in line or possibly higher than its recent average. The average deflator over the last two years is 2.05%, and it is running slightly higher at 2.125% over the last four quarters. Our expectation for an average or above average deflator in Q1 2019 were in large part driven by oil prices which rose by 32% over the entire first quarter. Due to the price move and the contribution of crude oil effects on inflation, oil prices should have had an unusually high impact on inflation measures in the first quarter of 2019.

…click on the above link to read the rest of the article…

The Fed’s Body Count

April 10, 2019

The Fed’s Body Count

“The problem with the war (Vietnam), as it often is, are the metrics. It is a situation where if you can’t count what’s important, you make what you can count important. So, in this particular case what you could count was dead enemy bodies.” – James Willbanks, Army Advisor, General of the Army George C. Marshall Chair of Military History for the Command and General Staff College
“If body count is the measure of success, then there’s a tendency to count every enemy body as a soldier. There’s a tendency to want to pile up dead bodies and perhaps to use less discriminate firepower than you otherwise might in order to achieve the result that you’re charged with trying to obtain.” – Lieutenant Colonel Robert Gard, Army and military assistant to Secretary of Defense Robert McNamara

Verbal Jenga

In recent press conferences, speeches, and testimony to Congress, Federal Reserve (Fed) Chairman Jerome Powell emphasized the Fed’s plan to be “patient” regarding further adjustments to interest rates. He also implied it is likely the Fed’s balance sheet reductions (QT) will be halted by the end of the year.

The support for this sudden shift in policy is obtuse considering his continuing glowing reports about the U.S. economy. For example, the labor market is “strong with the unemployment rate near historic lows and with strong wage gains. Inflation remains near our 2% goal. We continue to expect the American economy will grow at a solid pace in 2019…” The caveats, according to Powell, are that “growth has slowed in some major foreign economies” and “there is elevated uncertainty around several unresolved government policy issues including Brexit, ongoing trade negotiations and the effect from the partial government shutdown.”

…click on the above link to read the rest of the article…

The Fed’s Mandate To Pick Your Pocket – The Real Price Of Inflation

October 31, 2018

The Fed’s Mandate To Pick Your Pocket – The Real Price Of Inflation

“Inflation is everywhere and always a monetary phenomenon.” – Milton Friedman

This oft-cited quote from the renowned American economist Milton Friedman suggests something important about inflation. What he implies is that inflation is a function of money, but what exactly does that mean?

To better appreciate this thought, let’s use a simple example of three people stranded on a deserted island. One person has two bottles of water, and she is willing to sell one of the bottles to the highest bidder. Of the two desperate bidders, one finds a lonely one-dollar bill in his pocket and is the highest bidder. But just before the transaction is completed, the other person finds a twenty-dollar bill buried in his backpack. Suddenly, the bottle of water that was about to sell for one-dollar now sells for twenty dollars. Nothing about the bottle of water changed. What changed was the money available among the people on the island.

As we discussed in What Turkey Can Teach Us About Gold, most people think inflation is caused by rising prices, but rising prices are only a symptom of inflation. As the deserted island example illustrates, inflation is caused by too much money sloshing around the economy in relation to goods and services. What we experience is goods and services going up in price, but inflation is actually the value of our money going down.

Historical Price Levels

The chart below is a graph of price levels in the United States since 1774. In anticipation of a reader questioning the comparison of the prices and types of goods and services available in 1774 with 2018, the data behind this chart compares the basics of life. People ate food, needed housing, and required transportation in 1774 just as they do today. While not perfect, this chart offers a reasonable comparison of the relative cost of living from one period to the next.

…click on the above link to read the rest of the article…

Peak Hubris

February 7, 2018

Peak Hubris

In the past month, two well-known and highly respected money managers have made confident assertions about the markets. Their comments would lead one to believe that the future path of the market in the coming months is known. Sadly, many investors put blind faith in the words of high-profile, accomplished professionals and do little homework of their own. While we certainly respect the background, knowledge, and success of these and many other professionals, we take exception with their latest bit of advice.

Before the election In November 2016, were there investment professionals that claimed a Donald Trump victory would drive equity prices significantly higher? Although we are certain there were a (very) few, they certainly were not publicly discussing it, and the broad consensus was overwhelmingly negative. In March of 2009, which professional investors were pounding the table claiming that the next decade would produce some of the greatest market returns in history? Again, while some may have thought valuations were fair at the time, few if any were raging bulls.

The two instances are not unique. More often than not, investor expectations fail to accurately anticipate the future reality. This is not solely about amateur individual investors, as it equally applies to the best and brightest. Despite the urge to heed the sage advice of the “pros”, we must always remain objective, especially when everyone seems so certain about what will happen next.

The Known Future

The current message from Wall Street analysts, media gurus and most investors is that stock prices will undoubtedly go up for the foreseeable future. Unbridled optimism about corporate earnings offer one point of fundamental justification for such views, but in large part these forecasts are predominantly based on the simple extrapolation of prior price trends.

…click on the above link to read the rest of the article…

Consumption Exhaustion

September 6, 2017

Consumption Exhaustion

When people use the word catalyst to describe an event that may prick the stock market bubble, they usually discuss something singular, unexpected and potentially shocking. The term “black swan” is frequently invoked to describe such an event. In reality, while such an incident may turn the market around and be the “catalyst” in investors minds, the true catalysts are the major economic and valuation issues that we have discussed in numerous articles.

Most recently, in 22 Troublesome Facts, 720Global outlined factors that are most concerning to us as investors. As a supplement, we elaborate on a few of those topics and build a compelling case for what may be a catalyst for market and economic problems in the months ahead.

Debt Burden

Debt serves as a regulator of economic growth and is the focus of ill-advised fiscal and monetary policy. It is no coincidence that no matter what economic topic we explore, debt is usually a central theme. Illustrated in the chart below is the actual trajectory of total U.S. debt outstanding (black) through March 2017 and a calculated parabolic curve (red). The parabolic curve uses 1951 as a starting point and a quarterly 1.82% compounding factor to create the best statistical fit to the actual debt curve. If we start with the $434 billion of debt outstanding on December 1951 and grow it by 1.82% each quarterthereafter, the result is the gray line. If debt outstanding continues to follow this parabolic curve, it will exceed $60 trillion by the first quarter of 2020, or nine quarters from now.

Data Courtesy: Federal Reserve

Many economists point to the stability of debt service costs as a reason to ignore the parabolic debt chart. Despite rising debt loads, falling interest rates have served as a ballast allowing more debt accumulation at little incremental cost. While that may have worked in the past, near zero interest rates makes it nearly impossible to continue enjoying the benefits of falling interest rates going forward.

…click on the above link to read the rest of the article…

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