[This blog post is an excerpt from a commentary posted at TSI last week]

The rebound from the H1-2020 plunge into recession probably will look like a ‘V’, at least initially. This is not because conditions will become positive as quickly as they became negative, but because conditions got so bad so quickly that charts of economic statistics such as industrial production and retail sales will appear to make a ‘V’ bottom in Q2-Q3 of this year. However, the ‘V’ won’t mark the start of a genuine recovery.

The following charts show what we mean by “got so bad so quickly”.

The first chart shows that within the space of three months the Small Business Optimism Index collapsed from a level that indicated a high level of optimism to one of the lowest levels in the 34-year history of the index. The only other decline of this magnitude occurred during the 2005-2008 period and took more than two years.

The second chart shows that Industrial Production has just registered its largest month-over-month decline in at least 101 years. By this measure, even the worst months of the Great Depression were not as bad as April-2020.

Source: dshort

Source: Hedgeye

There are thousands of people who have lost their businesses — in some cases, businesses that they spent the bulk of their adult lives building — over the past two months as a result of the lockdowns. These people probably are feeling angry and/or devastated. However, we get the impression that the vast majority of people have accepted the lockdowns with equanimity. They haven’t taken to the streets to protest the economic destruction that has been wrought by their political overlords. Instead, they have shrugged off the most rapid decline in industrial production in history and a sudden rise in the unemployment rate from below 4% to above 20%. How is this possible?

It’s possible only because the government and the Fed have showered the people with money. The money that has been created out of nothing is acting like pain-suppressing medication. In effect, the government and the Fed have administered anaesthetic so that the patient felt no pain as vital organs were removed. Without this anaesthetic, the populace would not have remained docile as its basic rights were cancelled and its economic prospects were greatly diminished.

Money, however, is just the medium of exchange. It facilitates the division of labour*, but it does not constitute real wealth. For example, if every current dollar were instantly replaced by ten dollars, there wouldn’t be any additional wealth. The point is that the government and the Fed cannot make up for the decline in real wealth caused by the lockdowns by providing more money. All they can do is change the prices of the wealth that remains.

There will be a ‘V’ shaped recovery, but due to the destruction of real wealth stemming from the lockdowns the rising part of the V is bound to be much shorter than the declining part of the V. This will lead to a general realisation that life for the majority of people will be far more difficult in the future than it was over the preceding few years.

Returning to our medical analogy, eventually the anaesthetic will wear off and the patient will have to start dealing with the consequences of having lost a kidney, a spleen, a lung and half a liver.

*In the absence of money, a tomato farmer who needed some dental work would have to locate a dentist who needed a few crates of tomatoes.

[This blog post is a modified excerpt from a recent TSI commentary]

At around this time last month we noted that the Fed had pushed the year-over-year rate of growth in US True Money Supply (TMS)*, also known as the US monetary inflation rate, to a multi-year high of 11.3%, and that based on what the Fed subsequently had done the monetary inflation rate could reach 15%-20% by the middle of this year. With the monthly monetary data for April having been published last week, we now know that the aforementioned range has been reached already. As illustrated below, as at the end of April the US monetary inflation rate was close to 20%. Next month’s rate should be even higher.

This is banana-republic-style money creation, although it isn’t unprecedented for the US. The above chart shows that a near-20% monetary inflation rate also was attained in January-2002. Back then it was the bursting of the stock market bubble followed by the 9/11 attacks that caused the Fed to panic and flood the financial system with new money.

In a way, the shock to the financial markets resulting from the attacks by terrorists in September-2001 is similar to the shock to the financial markets resulting from the COVID-19 lockdowns. That’s despite the huge differences in the economic ramifications (the damage inflicted on the overall economy by the 9/11 attacks was minor and short-term, whereas the damage inflicted on the overall economy by the virus-related lockdowns of 2020 will prove to be major on both a short-term basis and a long-term basis).

The similar reactions of the financial markets (most notably the stock market) to the events of 2001 and 2020 firstly can be put down to the fact that both situations involved a sudden increase in uncertainty. Investors and speculators knew that the world had changed for the worse, but were ‘in the dark’ regarding many of the details. Secondly, in both cases there was an immediate and aggressive attempt by policy-makers to ‘reflate’.

Some of the results of this year’s monetary inflation moonshot should be similar to the results of the 2001 episode. In particular, this year’s explosion in the supply of US dollars should lead to a weaker US$ on the foreign exchange market (the Dollar Index commenced a multi-year bearish trend in January-2002 and probably will do the same within the next few months), a higher gold price, higher commodity prices and — eventually — higher equity prices.

The most important difference is that over the years ahead the economy will stay weak and, as a result, the unemployment rate will stay high. This is because flooding the economy with new dollars not only does nothing to make up for the destruction of real wealth caused by the lockdowns, it gets in the way of wealth creation by falsifying price signals and keeping ‘zombie companies’ alive.

*TMS is the sum of currency in circulation, demand deposits and savings deposits. It does not include bank reserves, time deposits or money market funds.

According to my Gold True Fundamentals Model (GTFM), the gold market’s “true fundamentals” most recently shifted from bearish to bullish in December of last year. As indicated on the following weekly chart by the blue line being above 50, at the end of last week they were still bullish. This means that the fundamental backdrop is still applying upward pressure to the gold price.

As previously explained, I use the term “true fundamentals” to distinguish the fundamentals that actually matter from the largely irrelevant issues that many gold-market analysts and commentators focus on.

According to many pontificators on the gold market, gold’s fundamentals include the volume of metal flowing into the inventories of gold ETFs, China’s gold imports, the amount of “registered” gold at the Comex, India’s monsoon and wedding seasons, jewellery demand, the amount of gold being bought/sold by various central banks, changes in mine production and scrap supply, and wild guesses regarding JP Morgan’s exposure to gold. These things are distractions at best. For example, a gold investor/trader could have ignored everything that has been written over the past 20 years about the amount of gold in Comex warehouses and been none the worse for it.

On an intermediate-term (3-12 month) basis, there is a strong tendency for the US$ gold price to trend in the opposite direction to confidence in the US financial system and economy. That’s why most of the seven inputs to my GTFM are measures of confidence. Two examples are credit spreads and the relative strength of the banking sector. The model is useful, in that over the past two decades all intermediate-term upward trends in the gold price occurred while the GTFM was bullish most of the time and all intermediate-term downward trends in the gold price occurred while the GTFM was bearish most of the time.

However, upward corrections can occur in the face of bearish fundamentals and downward corrections can occur in the face of bullish fundamentals. For example, there was a sizable downward correction in the gold market in March of this year in the face of bullish fundamentals. Such corrections often are signalled by sentiment indicators.

Right now, the fundamentals are supportive while sentiment is warning of short-term downside risk.

As long as the fundamentals remains supportive, any short-term decline in the gold price should be ‘corrective’, that is, it should be within the context of a multi-year upward trend.

In a blog post on 31st March I argued that MMT (Modern Monetary Theory) had been surreptitiously put into practice in the US. However, according to a quote from Lacy Hunt (Hoisington Investment Management) included by John Mauldin in a recent letter, what the Fed and the US government are doing doesn’t qualify as MMT.

According to Lacy Hunt: “For the Fed to engage in true MMT, a major regulatory change to the Federal Reserve Acts would be necessary: The Fed’s liabilities would need to be made legal tender. Having the Treasury sell securities directly to the Fed could do this; the Treasury’s deposits would be credited and then the Treasury would write checks against these deposits. In this case, the Fed would, in essence, write checks to pay the obligations of the Treasury. If this change is enacted, rising inflation would ensue and the entire international monetary system would be severely destabilized and the US banking system would be irrelevant.”

One problem with Lacy Hunt’s argument is that some of the Fed’s liabilities are already legal tender and have been for a very long time. I’m referring to the $1.9 trillion of “Currency in circulation” (physical notes and coins). This currency sits on the liability side of the Fed’s balance sheet. Also, the money that the US Treasury spends comes from the Treasury General Account, which also sits on the liability side of the Fed’s balance sheet.

Admittedly, the Fed currently does not buy Treasury debt directly. Instead, it acts through Primary Dealers (PDs). The PDs buy the debt from the government and the Fed buys the debt from the PDs. When this happens, new money is credited by the Fed to the commercial bank accounts of PDs and thus becomes a liability of the private banking system. At the same time, the private banks are ‘made whole’ by having new reserves added to their accounts at the Fed.

In other words, rather than money going directly from the Fed to the Treasury General Account (TGA), under the current way of doing things the money gets to the same place indirectly via PDs. This enables the commercial banking system to get its cut, but from both the government’s perspective and the money supply perspective there is no difference between the Fed directly buying government debt and the Fed using intermediaries (PDs) to do the buying.

Now, the Fed’s QE programs of 2008-2014 generated a lot less “price inflation” than many people feared. This was largely because the new money was injected into the financial markets (bonds and stocks) and only gradually trickled into the ‘real economy’. To some extent what happened over the past couple of months is similar, but with two significant differences.

One significant difference between the Fed’s recent actions and the QE of 2008-2014 is that for some of its new money and credit creation the Fed is bypassing the PDs. No regulatory change was needed for this to happen. Instead, as I explained in my earlier post, the Fed created Special Purpose Vehicles (SPVs) that do the actual monetising of assets and the lending of new money into existence. In effect, new money is now being created by the Fed and sent directly to various non-bank entities, including municipalities, private businesses and bondholders.

The second significant difference is the crux of the issue and why the US now has MMT in all but name.

You see, the essence of MMT isn’t the mechanical process via which money gets to the government. The essence is the concept that the government is only limited in its money and debt creation by “inflation”. The idea is that until “inflation” becomes a problem, the government can create as much new money and debt as it wants as part of an effort to achieve full employment. A related idea is that government spending does not have to be financed by taxation.

Is there really any doubt that the US government no longer feels constrained in its creation of debt, the bulk of which is being purchased indirectly using new money created by the Fed? After all, in the space of less than two months the US federal government has blown-out its expected annual deficit from around $1T to around $4T and is talking about massive additional spending/borrowing increases to support the economy. Clearly, no senior politician from either of the main parties is giving any serious thought to how this debt will be repaid or the future implications of the deficit blow-out.

The bottom line is that the US doesn’t have MMT in law, but it does have MMT in fact.