Blog 2 Columns

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

Monetary inflation is the driver of the economic boom-bust cycle, with booms being set in motion by rapid monetary inflation and busts getting underway after the rate of new money creation drops below a critical level and/or it becomes impossible to complete projects due to resource shortages. The following chart shows that the US monetary inflation rate (the year-over-year growth rate of US True Money Supply) extended its decline in September-2022 and is now below 4%, down from a peak of almost 40% early last year.

Due to the economic damage done over multiple cycles by the manipulations of the central bank, the current US economic bust began at a higher rate of monetary inflation than previous busts. In addition, most things related to the current boom-to-bust transition have happened within a compressed timeframe.

In previous cycles over the past three decades, a decline in the monetary inflation rate to below 6% kicked off a sequence lasting 1-2 years encompassing an inversion of the yield curve, a substantial widening of credit spreads (the start of the credit-spreads widening trend combined with the start of an upward trend in the gold/commodity ratio marks the start of the bust phase) and a reversal of the yield curve from flattening/inverting to steepening — PRIOR to the start of an economic recession. This time around, however, all of the above except a steepening of the yield curve occurred within 7 months of a decline in the monetary inflation rate to below 8%.

There is yet to be a reversal in the yield curve from flattening/inverting to steepening, but that’s because this time around the Fed is continuing to tighten monetary conditions aggressively into the teeth of an economic recession. This is similar to what happened in 1973-1974.

To further explain the above comment, the monetary inflation rate (the blue line on the following monthly chart) drives the yield curve (the red line on the chart). Of particular relevance to this discussion, an inversion of the yield curve (the red line dropping below zero) is an EFFECT of a large decline in the monetary inflation rate, and in general a trend reversal in the yield curve from flattening/inverting to steepening requires an upward trend reversal in the monetary inflation rate.

With the downward trend in the US monetary inflation rate unlikely to end any sooner than the first quarter of next year, a trend reversal in the yield curve (to steepening) is probably still at least several months away. In the meantime, it’s reasonable to expect that the curve will move even further into inverted territory.

As mentioned in the 3rd October Weekly Update, if the Fed sticks with its current balance-sheet reduction plan for only a few more months then by February of next year the year-over-year rate of US money supply growth probably will turn negative, that is, the US will be experiencing monetary deflation. If this happens then the prices of most assets will go much lower than they are today.

As also previously mentioned, economic and stock market weakness eventually will put irresistible pressure on the Fed to commence a new monetary easing campaign, but there is nothing to be gained by trying to guess when that will be. This is because the initial attempts to ‘stimulate’ almost certainly won’t be sufficient to ignite a new boom, and because the stock market usually doesn’t bottom until well after the monetary inflation trend has reversed upward. At the moment we are a long way from such a reversal.

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

The root of Europe’s energy crisis is under-investment or outright dis-investment in nuclear energy and natural gas production/storage/transportation combined with over-reliance on intermittent and relatively inefficient forms of renewable energy. Russia’s invasion of Ukraine and the anti-Russia sanctions exacerbated the problem, but the problem was evident prior to this year. A policy course correction therefore would be appropriate (to put it mildly), but it won’t happen anytime soon.

When private companies go in the wrong direction they lose money and either change direction or go broke, but after it becomes clear that a government has gone in the wrong direction the typical response is to go faster in that direction. This is because doing otherwise would require an uncomfortable public admission that mistakes have been made or a practically impossible public admission that the political ideology underpinning the chosen direction is wrong. In the case of the shift towards increasing reliance on renewable energy, the latter (a public admission that the underlying political ideology is wrong) would be required, which is why we shouldn’t expect it. Instead, we should expect acceleration along the wrong path.

Signs of acceleration along the wrong path are not hard to find. Examples include the recent increase from 32% to 45% in the official European target for the renewable energy share of total energy, requiring a doubling of the renewable energy share within the next eight years, and the government of Victoria, Australia, recently announcing a goal to become 95% dependent on renewables by 2035.

It is not possible to achieve the renewable energy targets being set by governments, but nevertheless it’s reasonable to expect that great efforts will be made to achieve them. Here are some of the likely effects of these efforts:

1) There will be major shortages within the next few years of the minerals used in renewable energy systems, leading to vastly higher prices for these minerals and increased mining activity.

2) On a global basis there will be extensive environmental damage, and for at least the next ten years there will be increased carbon emissions, due to the additional mining and manufacturing activity associated with building the renewable energy systems.

3) There will be periodic major shortages of natural gas, oil, oil-based products (diesel and gasoline) and coal due to under-investment in the production of these commodities, leading to the existing producers of these commodities becoming far more valuable.

4) The cost of energy as a percentage of GDP will be much higher this decade than in the preceding decade, leading to a lower standard of living for the average person.

5) There will be a large rise in the price of uranium, because the expansion of nuclear energy will become politically attractive (meaning: a vote winner) in the face of periodic energy shortages and extremely high energy prices.

As investors/speculators, we can’t do anything about the adverse social and environmental consequences of the accelerating trend towards ‘renewables’. However, we can attempt to profit from points 1), 3) and 5).

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

It would be difficult for our opinion of Powell and Co. to be any lower, and yet we still manage to overestimate them.

Having correctly anticipated that the Fed had paved the way for a major inflation problem — a problem that would become evident in commodity, goods and services prices rather than just asset prices — during the first half of 2020, we were surprised that the Fed continued to stimulate after such a problem became blatantly obvious in 2021. And over the past few months we have been surprised that the Fed remained on an aggressive monetary tightening path after it became clear that the equity bubble had burst, the US economy had entered or was about to enter recession territory, commodity prices had set intermediate-term peaks and forward-looking indicators of the CPI were in downward trends.

With regard to forward-looking CPI indicators, one of the most useful is the difference between the 10-year T-Note yield and the 10-year TIPS yield, a.k.a. the 10-year Breakeven Rate, which is a measure of the future annual percentage growth of the CPI factored into the bond market. The following chart shows that over the past two weeks this indicator made an 18-month low.

Chart source: https://research.stlouisfed.org/

Another forward-looking CPI indicator is the ISM Manufacturing Prices Paid Index, an index based on a survey of purchasing managers at US manufacturing companies. As illustrated below, this index has plunged over the past six months to its lowest level in more than two years.

Chart source: https://tradingeconomics.com/

A popular view at the moment is that inflation will prove to be sticky. Well, if the Fed continues along its current path then many people are going to be surprised at just how non-sticky inflation proves to be. We think that if the Fed stays with its current balance-sheet reduction plan until early next year, then by this time next year the year-over-year growth rate of the headline CPI will be less than 2%. It could even be negative.

One of the reasons that the Fed may continue along its current path for a few more months is that policymakers are focusing on the headline CPI growth numbers, and these numbers will remain at very high levels for at least a few more months due to the large price rises that occurred during the first half of this year. Putting it another way, there won’t be a substantial decline in the CPI’s year-over-year growth rate until the large gains that occurred during the first half of this year start dropping out of the calculation. Until then, it’s possible that the Fed will be under political pressure to persist with its “inflation fighting”, and Powell has demonstrated that he is very susceptible to political pressure.

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

Last year US President Biden was telling oil companies that they should be producing less. Then, during the first few months of this year he berated oil companies for not rapidly increasing their production in response to higher prices. Who knows what he will be telling oil companies to do next year or even next week? In this political environment, why would high-profile, publicly-listed oil companies make large investments in long-term oil production growth?

The answer is that they wouldn’t. Even if the next US president understands the need to increase fossil fuel production for at least another 10-15 years and is prepared to stand up to the crowd of misguided environmentalists who seem to believe that renewable energy systems can be created out of nothing, the person that gets the job four years later could have no such understanding and/or no backbone. Therefore, even if the political landscape were to become temporarily supportive, it would be too risky to invest in anything other than small projects with rapid paybacks.

Consequently, we probably have reached “Peak Oil”. This is not the Peak Oil that became a popular story during 2004-2008, because there is no doubt that oil production could be increased with the appropriate investment. It is Peak Oil caused by Regime Uncertainty. As defined HERE, Regime Uncertainty is a pervasive lack of confidence among investors in their ability to foresee the extent to which future government actions will alter their private-property rights.

Due to Regime Uncertainty, we expect that two things will happen over the next few years. The first is that the oil price will make a sustained move above this year’s high (US$130/barrel), because demand will grow (following the 2022-2023 recession) and the oil industry will not respond with large-scale investments in new production. The second is that there will be substantial growth in the amount of wealth returned by oil producers to their shareholders via dividends and share buybacks.

As is the case with NG [natural gas] stocks, short-term weakness in the commodity market combined with downward pressure exerted by the general equity bear market could create excellent opportunities to increase exposure to the oil sector within the next few months.

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

The financial markets were shocked — shocked, we tell ya! — by the US CPI for August. We know they were shocked because on the day of the CPI release the US stock market gave back almost all of the gain achieved during the preceding strong 4-day rebound and there was a big up-move in the Dollar Index. Before we take a look at the CPI report that caused the mini panic, it’s worth repeating the following comments from the 15th August Weekly Update:

“Over the past few weeks the financial markets have celebrated the signs of declining “inflation”, the thinking being that the evidence of an inflation reversal will lead to a Fed pivot in the short-term. This line of thinking is wrong in two critical ways.

The first way it is wrong is that the Fed’s leadership appears to have its eyes firmly fixed on the rear-view mirror. Although there is now a CPI downtick in the rear-view mirror, base effects (the CPI increases that will remain in the year-over-year calculations for months to come) ensure that the headline CPI growth numbers will remain elevated for at least the remainder of this year. For example, even though inflation most likely has peaked on an intermediate-term basis, the numbers that will stay in and drop out of the year-over-year calculations each month mean that there is almost no chance of the year-over-year CPI growth rate dropping below 6% sooner than the first quarter of next year. In fact, the year-over-year CPI growth rate reported for each of the next three months probably will still have an ‘8 handle’.

Therefore, for months to come the Fed is going to be seeing annual CPI growth rates near multi-decade highs, which will encourage it to continue tightening.

The second way it is wrong is that even after the Fed’s leadership starts to feel confident that inflation is heading towards a level that it deems acceptable, there won’t be an immediate policy reversal.”

The evidence continues to accumulate that inflation is now in a downward trend, but due to the price increases that have already occurred it is reasonable to expect that the year-over-year CPI growth numbers will be near multi-decade highs for at least a few more months. Nobody should expect anything else. Certainly, nobody should have been shocked by the 8.3% year-over-year CPI growth number reported for August.

The 8.3% growth rate reported for August followed 8.5% in July and 9.1% in June. This is probably the start of a downward trend that won’t bottom until Q2-Q3 of next year. More significantly, we point out that the percentage change in the CPI over the past two months was approximately zero — the result of a large decline in the gasoline price offset by price gains elsewhere (e.g. in rent and food).

However, the monthly chart displayed below shows that the numbers remain very high relative to everything over the past twenty years prior to the past few months. This is the issue, given the tendency of the Fed’s leadership to fixate on the rear-view mirror.

It’s worth mentioning that there continues to be a wide gap between the current CPI growth rate and the expected future CPI growth rate.

The following daily chart shows that the 10-Year Breakeven Rate, a measure of what the bond market expects the CPI to be in years to come, peaked on 21st April this year at 3.02%, made a short-term bottom at 2.29% on 6th July and currently is much closer to a 12-month low than a 12-month high. There’s a good chance that the expected CPI will drop to 2.0% or lower during the stock market’s next large multi-month decline.

The problem for the stock market bulls who take every hint of declining “inflation” as a reason to anticipate a shift from monetary tightening to monetary easing is that such a shift won’t happen within the next six months unless there is a lot more economic and stock market weakness. We think that the aforementioned monetary shift will happen during the first quarter of next year, but that’s only because we are expecting a lot more weakness in the stock market and the economy.

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

In most countries/regions around the world, monetary inflation rates peaked at extraordinary heights in early 2021 and have since crashed. Furthermore, the declines are set to continue over the next several months as central bankers attempt to make up for their mistake of being far too ‘easy’ during 2020-2021 by being far too ‘tight’ during 2022-2023, thus revealing a fondness for irony given that part of the official justification for central banks is to smooth-out the business cycle. Here are monthly money-supply charts showing where we are and where we’ve been.

G2 True Money Supply (TMS), a concoction of ours that combines the money supplies of the US and the euro-zone, is the primary driver of the global boom-bust cycle. The following chart shows that in July-2022 the year-over-year G2 TMS growth rate dropped below the boom-bust threshold. With both the Fed and the ECB intent on contracting their balance sheets over the months ahead, it’s a virtual certainty that the line on this chart will continue to move downward. This will worsen the global recession that is already underway.

At a little over 10%, Australia’s monetary inflation rate remains high. However, it has come down a lot from its level of 18 months ago and looks set to drop to 5% or lower over the next several months as the Reserve Bank of Australia ‘tightens the screws’. This is bearish for Australia’s real estate market, where valuations generally remain extremely high.

Over the past 18 months Canada’s monetary inflation rate has collapsed from an all-time high to near a multi-decade low. This has very bearish implications for Canada’s real estate market.

The UK’s monetary inflation rate also has collapsed from an all-time high to near a multi-decade low.

Japan has been a monetary inflation enigma for a long time, in that despite the appearance of aggressive Bank of Japan (BOJ) money pumping the year-over-year growth rate of Japan’s M2 money supply spent the bulk of the past 25 years in the 0%-4% range. In response to the COVID crisis the M2 growth rate surged to almost 10% in 2020-2021, but it has since fallen back to its low/narrow multi-decade range.

With regard to money-supply growth, China has been the ‘odd man out’ over the past three years. In China the monetary response to the COVID crisis was relatively minor and by January of this year the year-over-year growth rate of M1 money supply had dropped below zero. It has since rebounded to around 7%.

The following chart shows that China’s monetary inflation rate has been making lower highs and lower lows (trending downward, that is) since 2010. It probably isn’t a fluke that this downward trend coincides with Xi Jinping’s leadership, because Xi does not like financial speculation.

China’s relatively slow rate of monetary inflation over the past few years is a long-term plus for that country’s economy, but it is being counteracted by many negatives including the severe damage that has been wrought by the “Dynamic Zero COVID” policy.

Once central banks have created a bubble the best they can do is step aside and let the markets sort out the mess. Stepping aside would involve not creating any more money and not destroying any existing money. The worst they can do is take money out of the economy, because that causes additional price distortions and because simply ending the pumping-in of new money would be sufficient on its own to burst the bubble. Currently, central banks are doing the worst they can do in an effort to address price rises resulting from supply constraints, as if reducing the availability of money and credit will promote the investment needed to bring about additional supply. These actions will have dire consequences.

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

We have referred to the 6% level for the year-over-year US True Money Supply (TMS) growth rate (the US monetary inflation rate) as the boom-bust threshold, because transitions from economic boom to economic bust generally don’t begin until after the TMS growth rate has made a sustained move below this level. It was different this time, however, because according to other indicators the US economy entered the bust phase of the monetary-inflation-driven boom-bust cycle during the first quarter of this year with the TMS growth rate still above 6%. Why was it different this time and what’s the current situation?

We outlined the most likely reasons why it was different this time in previous commentaries, most recently in the 27th July Interim Update. Here’s the relevant excerpt from our 27th July commentary:

“We think that the current bust began at a higher rate of monetary inflation than in the past for two main reasons. The first is that the Fed was still in monetary-loosening mode at the peak of the economic boom. This had never happened before and resulted in even greater wastage of real savings/resources than in previous booms. The second reason is that due to decades of increasing central bank manipulation of money and interest rates, the economy has become structurally weaker and therefore the collapse of a boom now requires less relative monetary tightening than in the past.”

The main new point we want to make today is that the US money-supply data for July-2022, which were published on Tuesday of this week, reveal that the monetary inflation rate has now confirmed the bust by moving well below the 6% boom-bust threshold. This is illustrated by the first of the two monthly charts displayed below. Furthermore, the second of the following charts shows that the year-over-year TMS growth rate minus the year-over-year percentage change in the Median CPI*, an indicator of the real (inflation-adjusted) change in the US monetary inflation rate, has plunged to near a multi-decade low.

As an aside, from the end of last year to the end of July this year the US True Money Supply increased by $580B. This figure comprises the change in currency in circulation, the change in commercial bank demand and savings deposits, and the change in the amount of money held by the US government in the Treasury General Account (TGA) at the Fed. It is very roughly equal to the increase in commercial bank credit plus the increase in Federal Reserve credit minus the increase in the Fed’s Reverse Repo program. Over the aforementioned period the Fed’s direct actions REDUCED the US money supply by about $210B, but the Fed’s actions were more than offset by the money-creating actions of the commercial banking industry.

With the Fed still on the tightening path, it’s unlikely that the lines on the above charts have bottomed. One implication is that the yield curve probably will become more inverted over the next few months. Another implication is that it would be difficult to be too bearish with regard to the US stock market’s 6-12 month prospects.

*A price index calculated by the Cleveland Fed

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

Over the past few weeks the financial markets have celebrated the signs of declining “inflation”, the thinking being that the evidence of an inflation reversal will lead to a Fed pivot in the short-term. This line of thinking is wrong in two critical ways.

The first way it is wrong is that the Fed’s leadership appears to have its eyes firmly fixed on the rear-view mirror. Although there is now a CPI downtick in the rear-view mirror, base effects (the CPI increases that will remain in the year-over-year calculations for months to come) ensure that the headline CPI growth numbers will remain elevated for at least the remainder of this year. For example, even though inflation most likely has peaked on an intermediate-term basis, the numbers that will stay in and drop out of the year-over-year calculations each month mean that there is almost no chance of the year-over-year CPI growth rate dropping below 6% sooner than the first quarter of next year. In fact, the year-over-year CPI growth rate reported for each of the next three months probably will still have an ‘8 handle’.

Therefore, for months to come the Fed is going to be seeing annual CPI growth rates near multi-decade highs, which will encourage it to continue tightening.

The second way it is wrong is that even after the Fed’s leadership starts to feel confident that inflation is heading towards a level that it deems acceptable, there won’t be an immediate policy reversal. Instead, the following sequence is likely:

1) The pace of rate hiking will slow

2) The rate hiking will stop

3) The balance sheet contraction (QT) will stop

4) Rate cutting will begin

5) Balance sheet expansion (QE) will begin

At the moment Step 5 is probably at least eight months into the future. In the 2007-2009 bear market and recession, the bear market didn’t end until about six months AFTER step 5.

This suggests to us that asset prices in general and the stock market in particular will face monetary headwinds until at least the first quarter of next year, and that monetary conditions will not be ripe for a new equity bull market any sooner than the second half of next year. In the meantime there will be rebounds to lower highs followed by declines to lower lows.