Blog 2 Columns

In a 9th November blog post I wrote that the US TMS (True Money Supply) growth rate had fallen far enough to suggest that the next trend reversal in credit spreads from narrowing to widening would mark the start of a boom-to-bust transition rather than just an interruption to the boom. What’s the current situation?

Before answering the above question it’s worth reiterating that a trend reversal in credit spreads (from narrowing to widening) isn’t the only early warning that a boom-to-bust transition has begun for the US economy. As mentioned in previous blog posts (for example, HERE), another necessary signal is pronounced weakness in the Industrial Metals Index (GYX) relative to the gold price. In other words, prior to the end of a boom* there will be upward trend reversals in credit spread indicators such as the US High Yield Index Option-Adjusted Spread (HYIOAS) and a downward trend reversal in the GYX/gold ratio. As an aside, the most recent bust began in early-October of 2018 and ended in early-June of 2020.

The following daily chart shows the HYIOAS.

In early-July of this year the HYIOAS was at its lowest level in more than 10 years and not far from an all-time low. It spiked upward around the middle of July and then returned to near its low, where it remains (it ended last week at around 3.2%).

Note that a credit-spread reversal would be signalled by the HYIOAS making a higher short-term high AND moving back above 4%. The first of these criteria (the initial warning) would be triggered by a move above 3.5%.

The next chart shows the GYX/gold ratio. To generate a boom-to-bust warning the line on this chart would have to make a sustained break below its 200-day moving average.

Neither of the indicators that in the past have always warned prior to the start of a boom-to-bust transition for the US economy has triggered, although it would not take much additional weakness in GYX relative to gold for the GYX/gold ratio to generate a warning signal. This implies that the US economic boom that began during the second quarter of 2020 is intact. Furthermore, as things currently stand it looks like the start of a boom-to-bust transition is still at least a few months away.

*An economic boom is a period of generally rapid economic activity fuelled by monetary inflation. It does not necessarily involve sustainable economic progress. In fact, most of the apparent gains achieved during the boom tend to be relinquished during the subsequent bust.

[This blog post is a slightly modified excerpt from a TSI commentary published last week]

The US government just reported a 6.2% year-over-year increase in the CPI (refer to the following chart). This was the largest increase since 1990 and the second-largest increase since 1982. Furthermore, nobody in their right mind believes that the CPI overstates the pace of US$ depreciation. How can this be happening in parallel with a yield of about 1.5% on the US 10-year T-Note and a yield of about 1.9% on the US 30-year T-Bond?

There’s a two-part answer to the above question, the first part of which is that the bond market expects the CPI to average only 2.7% over the next ten years. We know this is the case because 2.7% is the annual CPI increase factored into the current price of the 10-year TIPS. In other words, the bond market is anticipating a substantial pullback in the “inflation” rate from its current level. However, even a 2.7% rate of increase in the CPI is inconsistent with a current 10-year T-Note yield of around 1.5%. Based on today’s inflation expectations, the 10-year T-Note currently should be yielding at least 3.5%.

The other part of the answer is that the financial markets expect the Fed to do whatever it takes to cap the yields on US government bonds at well below the rates that would be consistent with the official “inflation” rate.

Given its unlimited ability to purchase assets with money that it creates out of nothing, the Fed is capable of keeping government bond yields pegged at unrealistically low levels for a long time. However, doing so would have very bearish implications for the US$ and very bullish implications for most US$-denominated prices. In particular, Fed policy that involved capping US government bond yields at low levels in the face of obvious evidence of high “inflation” would be extremely bullish for the US$ gold price.

Official Fed policy that involves capping bond yields at low levels in the face of persistently high “inflation” is not likely to be introduced over the next six months, but I suspect that it will become a major driver of market prices during 2023-2024.

[This blog post is an excerpt from a commentary posted at speculative-investor.com about two weeks ago]

The US financial system currently has an abundance of ‘liquidity’. We know that this is the case because US credit spreads are close to multi-decade lows. The probability of a liquidity crisis or crunch with credit spreads near their narrowest levels in decades is not just low, it is zero. However, the money-supply growth trend warns that a boom-to-bust transition could begin as soon as the first half of 2022, potentially setting the stage for a major financial-market event/crisis during the second half of 2022.

The US money-supply growth trend is illustrated by the following chart. The chart shows that the year-over-year rate of growth in US True Money Supply (TMS) peaked at almost 40% early this year and has since collapsed to around 7%.

We thought that the TMS growth rate would level out during September, but instead it extended its steep decline. The reason is that the Fed, via its Reverse Repo (RRP) program, removed $330B from the financial system over the course of the month. To put it another way, for every dollar the Fed added via its QE program during September it removed almost three dollars via its Reverse Repo program.

If not for the Fed’s additions to its RRP program in September, the TMS growth rate would have ended the month at 8.7% (slightly above the end-August level) instead of 7.0%. Furthermore, if not for all the money removed by the Fed via RRP’s since the program was initiated in March of this year, the TMS growth rate would now be 14.5% as opposed to 7.0%.

As an aside, the Fed hasn’t removed a lot of money ($1.43 trillion at the time of writing) from the US financial system over the past seven months in an effort to tighten monetary conditions; it has done so to address a problem that can be aptly described as a surplus of dollars. There has been a huge quantity of dollars ‘sloshing around’ the financial system looking for a zero-risk, temporary home with a small positive yield. The Fed’s RRP program has provided such a home.

All of the money removed by the Fed via RRP’s will be returned to the US financial system at some point (probably next year). However, the US TMS growth rate has fallen far enough to suggest that the next trend reversal in credit spreads from narrowing to widening will mark the start of a boom-to-bust transition rather than just an interruption to the boom.

By the same token, until the credit-spreads trend reversal happens it will be reasonable to assume that the boom is intact and that there won’t be anything more bearish than moderate corrections in the senior equity and commodity indices.

[This blog post is a modified excerpt from a commentary published at TSI about two weeks ago. We've updated the charts and prices to reflect the current market situation.]

Today we’ll take a brief look at oil through three different lenses: The long-term price-action lens, the physical supply-demand lens and the macro-economic lens.

The following chart shows the significance of the US$76-$77 price level above which oil has moved over the past few weeks. This price level acted as support during large downward corrections in 2011-2012 and capped the 2016-2018 rally.

The move above major resistance is not a short-term buy signal, because the market is ‘overbought’ (which, by the way, doesn’t guarantee that the price will fall, but does mean that the risk of new buying is relatively high). However, it is a reward for those who added to their oil exposure when the commodity and the related equities were ‘oversold’ at various times over the past three months and is consistent with our view that the cyclical advance will extend into 2022.

With regard to likely future performance, of far greater importance than the break above long-term resistance is that the physical supply situation remains unusually ‘tight’. We know this is the case because strong backwardation (meaning: nearer-dated contracts are priced well above later-dated contracts) prevails in the oil futures market. This is evidenced by the downward slope on the following chart. Strong backwardation can only arise and be sustained in the oil market during a period when the demand for oil is high relative to the currently available supply.

The most recent data on the following chart is for the situation at 14th October 2021, but the futures curve continues to have a steep downward slope. For example, at the time of writing oil for delivery in December of this year is priced at $84.55, whereas oil for delivery in December-2022 is priced at $72.58 and oil for delivery in December-2023 is priced at only $66.56.

Note that the prices of oil futures are NOT forecasts of where the spot price will be in the future. Instead, the futures price relative to the spot price reflects the cost of storage. Since the cost of storage is always above zero, the futures price will always be higher than the spot price unless there is a current shortage of the physical commodity.

Chart source: https://www.erce.energy/graph/wti-futures-curve/

Our last chart shows that the oil price and the Inflation Expectations ETF (RINF) usually trend in the same direction. This positive correlation is part and parcel of a broader positive correlation between commodity prices (as represented by indices such as GNX) and inflation expectations.

Both oil and inflation expectations have resumed their cyclical upswings following corrections during the second and third quarters of this year.

At the moment, the price action, the supply-demand fundamentals and the macro-economic backdrop (as reflected by inflation expectations) are saying the same thing. They are all saying that we should expect the oil price to continue its upward trend.

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

The latest leading economic data indicate that the US recovery/expansion is intact and that US GDP will continue to grow at an above-average rate for at least two more quarters, albeit not as quickly as it grew during the first half of this year. Of particular relevance, the following monthly chart shows that the ISM Manufacturing New Orders Index (NOI), one of our favourite leading economic indicators, remains near the top of its 20-year range. The ISM NOI leads Industrial Production by 3-6 months.

Note that the GDP growth number for Q3-2021, the preliminary calculation of which will be reported late this month, could reveal substantial deceleration from the 6%-7% growth that was reported for the first two quarters of this year. In fact, it could be as low as 2%. However, the financial markets are aware of this and went at least part of the way towards discounting the slowdown over the past few months. More importantly, there’s a good chance that US economic activity will re-accelerate late this year and into the first quarter of next year. This will be partly due to inventory building but mainly due to millions of people re-entering the workforce (millions of people who were paid by the government NOT to produce are going to become productive due to the expiry, early last month, of the federal government’s $300/week unemployment subsidy).

The performances of leading and coincident economic indicators show that the US economy remains in the boom phase of the boom-bust cycle, meaning that the economic landscape remains bullish for industrial commodities relative to gold. Consequently, the major upward trend in the commodity/gold ratio (GNX/gold) evident on the following chart should extend into next year.

In conclusion and as stated in previous commentaries over the past few months, the probability of the US economy re-entering recession territory prior to mid-2022 is extremely low, although current money-supply trends warn that a boom-to-bust transition and an equity bear market could begin as soon as the first half of 2022. This would suggest the second half of 2022 for the start of the next US recession, but there’s no point trying to look that far ahead. Our favourite leading indicators should give us ample warning.

There are two things that always happen at or prior to the start of a boom-to-bust transition for the US economy. One is a clear-cut widening of credit spreads and the other is pronounced weakness in the Industrial Metals Index (GYX) relative to the gold price. These indicators have sometimes warned incorrectly that a bust was about to begin, but they have never failed to signal an actual boom-to-bust transition in a timely manner. Below are charts showing the current positions of these reliable boom-bust indicators.

The first chart shows the US High Yield Index Option-Adjusted Spread (HYIOAS), a good indicator of US credit spreads.

In early-July of this year the HYIOAS was at its lowest level in more than 10 years and not far from an all-time low. It spiked upward around the middle of July, but it has since returned to near its low. This means that credit spreads in the US remain close to their narrowest levels ever.

Note that a credit-spread reversal would be signalled by the HYIOAS making a higher short-term high AND moving back above 4%. The first of these criteria (the initial warning) would be triggered by a move above 3.5%.

The next chart shows the GYX/gold ratio. To generate a boom-to-bust warning the line on this chart would have to move below its 200-day moving average, but currently it is in a clear-cut upward trend and not far from its cycle high.

Clearly, neither of the indicators that in the past have always warned prior to the start of a boom-to-bust transition for the US economy is close to triggering. This means that the economic boom* that began during the second quarter of 2020 remains in full swing. Furthermore, as things currently stand it looks like the start of a boom-to-bust transition is at least six months away.

For long-side speculations and investments, during the boom phase of the cycle it’s important to emphasise assets and commodities that do well during booms. For example, industrial commodities (e.g., energy, base metals, lithium, rare-earths) generally should be favoured over gold during the boom phase, with the opposite applying during the bust phase. This may seem like a statement of the bleeding obvious, but a lot of market participants stay bullish on certain investments and bearish on others regardless of whether the economy is in the boom phase or the bust phase.

*An economic boom is a period of generally-rapid economic activity fuelled by monetary inflation. It does not necessarily involve sustainable economic progress. In fact, most of the apparent gains achieved during the boom tend to be relinquished during the subsequent bust.

Over the past four months, in parallel with spectacular gains in the prices of coal and natural gas prices there have been spectacular declines in the prices of lumber and iron-ore. The following charts show the 70% crash in the lumber price from its May-2021 peak and the 40% crash in the iron-ore price from its July-2021 peak.

A common argument against there being a general inflation problem is that the large rises in commodity prices are due to temporary market-specific supply issues, leading to large price declines as soon as the supply issues are resolved. The plunges in the prices of lumber and iron-ore can be cited to support this argument.

There is an element of truth to this line of thinking. However, the same argument could have been made throughout the 1970s, in that every large commodity-price rise during that decade could be put down to a market-specific supply issue.

As long as the inflation doesn’t become ‘hyper’, that is, as long as the value of money doesn’t collapse relative to everything, a large and rapid rise in the price of a commodity will result in additional supply and/or reduced demand, eventually leading to a large price decline. This sequence of events played out in full in the lumber and iron-ore markets over the past 12 months and by the time we get to the middle of next year it likely will have played out in full in the natural gas and coal markets.

The clue that the price action has monetary roots is in its frequency, that is, in the number of markets that are experiencing huge price run-ups. Each huge price run-up in isolation can be put down to market-specific supply constraints, but when the same thing happens in so many different markets at different times within a multi-year period then we can be sure that the root cause is linked to the monetary system itself.

In the current environment, the root cause is the combination of rapid monetary inflation courtesy of the central bank and a huge increase in government deficit-spending. Thanks to the Fed, the supply of US dollars is about 50% greater today than it was two years ago. Thanks to the government, the newly-created money did a lot more than elevate the prices of financial assets.

[This blog post is an excerpt from a TSI commentary]

Our view has always been that as an organisation with unlimited power to create money out of nothing and with no rigid constraints on what it can buy with the money it creates, the Fed would never ‘run out of bullets’. The opposing view put forward by many financial-market analysts and commentators was that the Fed eventually would be overwhelmed by a virtual tidal wave of debt defaults and other deflationary forces.

The idea that the Fed could get overwhelmed by deflationary forces should have been killed by last year’s events, because the Fed proved that there were no lengths to which it would not go to prop-up equity prices, prevent widespread debt default and ensure that the US dollar continued to lose purchasing power. However, apparently it wasn’t. The view that deflation is on the horizon is not as popular as it once was, but it remains very much alive. We therefore wonder how far down the path of money destruction the Fed will have to go before smart people stop seeing deflation as the biggest threat. Unfortunately, over the next few years we are going to find out.

The US economy is immersed in a crisis-monetisation cycle, as are many other economies. In the US, a crisis or a deflation scare or a recession or even just a steep stock market decline prompts the Fed to start monetising assets, with the speed and magnitude of the monetisation ramping up until equity and consumer prices resume their long-term upward trends. This has been going on for decades and explains why the US stock market’s valuation keeps making higher highs and higher lows.

The big change over the past 18 months is that the US federal government has become more involved in promoting the perpetual price inflation, partly because there is political capital to be gained by taking actions that boost wages and partly because, at a superficial level at least, there have been no negative economic consequences to date associated with the massive increase in the government’s debt. The government’s actions are ensuring that the new money affects goods and services prices in addition to asset prices.

The crisis-monetisation cycle doesn’t end in deflation. The merest whiff of deflation just encourages central bankers and politicians to do more to boost prices. In fact, the occasional deflation scare is necessary to keep the cycle going. The cycle only ends when most voters see “inflation” as the biggest threat to their personal economic prospects.