[This post is a slightly-modified excerpt from a TSI commentary published about two weeks ago.]

The way that most new money was created over the past 10 years was different to how it was created during earlier cycles. During earlier cycles almost all new money was loaned into existence by commercial banks, but in the final few months of 2008 the Fed stopped relying on the commercial banks and began its own money-creation program (QE).

The difference is important because most of the money created by commercial banks is injected into the ‘real economy’ (the first receivers of the new money are businesses and the general public), whereas all of the money created by the Fed is injected into the financial markets (the first receivers of the new money are bond traders). The Fed’s new money eventually will find its way to Main Street (as opposed to Wall Street), but the rate of monetary inflation experienced by the ‘real economy’ during the years following the Global Financial Crisis was a lot lower than suggested by the change in the US True Money Supply (TMS). Consequently, there may have been a lot less mal-investment during the current cycle than during the years leading up to the 2007-2009 crisis.

Don’t get us wrong — there has been a huge amount of ill-conceived and misdirected investment due to the Fed’s money-pumping and associated suppression of interest rates. Due to these bad investments, corporate balance sheets are now much weaker, on average, than otherwise would be the case. In particular, the corporate world collectively has gone heavily into debt and in a lot of cases the debt has not been used productively. For example, it has been used to buy back shares or fund high-priced acquisitions. This will have very negative consequences for the stock market within the next few years, but wasting money on share buy-backs and over-paying for assets does not cause the business cycle.

The ‘boom’ phase of the business cycle happens when artificially-low interest rates prompt investment, on an economy-wide scale, in new production facilities and construction projects that would not have seemed viable in the absence of the distorted interest-rate signal. The ‘bust’ phase of the business cycle kicks off when it starts to become apparent that, due to rising construction/production costs and/or less consumer demand than forecast, the aforementioned investments either cannot be completed or will generate a lot less cash than originally expected. Widespread liquidation ensues, and — as long as policy-makers don’t do too much to ‘help’ — resources eventually get reallocated in a way that meshes with sustainable consumer demand. The economy recovers.

The above is background information for the following charts. The first chart shows the year-over-year (YOY) rate of change in US True Money Supply (TMS), a.k.a. the US monetary inflation rate. The second chart shows the US monetary inflation rate without the Fed’s direct additions and deletions*.

Note that the second chart does not show what would have happened to the US monetary inflation rate in the absence of the Fed. Regardless of whether the Fed is creating new money or not, it exerts a strong influence on the commercial banks. What we have tried to do with the second chart is isolate the monetary inflation that causes the business cycle.

Prior to late-2008 the charts are very similar, but from late-2008 onwards there are some big divergences. The most obvious divergence was in 2009, when the rate of growth in TMS extended the rapid upward trend that began in 2008 while the rate of growth in “TMS minus Fed” collapsed to well below zero. Also worth mentioning is that the rate of growth in “TMS minus Fed” was in negative territory from August-2013 to June-2014, a period during which the rate of growth in TMS never dropped below 7%.

The swings in the “TMS minus Fed” growth rate explain some of the important swings in the US economy. For example, the rapid increase in “TMS minus Fed” during 2011-2012 almost certainly is linked to the mad rush to invest in the shale oil industry, and the 2013-2014 plunge in “TMS minus Fed” would be partly responsible for the collapse of the shale-oil investment boom during 2014-2015. Although it was focused on a single industry, this was a classic case of the mal-investment that results in a boom-bust cycle.

Over the past 18 months the TMS growth rate has extended its major downward trend, but the “TMS minus Fed” growth rate has rebounded. This rebound could delay the start of a recession.

*We assume that the amount of money added by the Fed equals the increase in the Fed’s holdings of securities minus the increase in Reverse Purchase Agreements.

After spending almost all of 2018 in bearish territory, gold’s true fundamentals* (as indicated by my Gold True Fundamentals Model – GTFM) have spent all of this year to date in bullish territory. Refer to the following chart comparison of the GTFM (the blue line) and the US$ gold price (the red line) for the details.

A market’s true fundamentals are akin to pressure. Due to sentiment and other influences a market can move counter to the fundamentals for a while, but if the fundamentals continue to act in a certain direction then the pressure will build up until the price eventually falls into line. Also, even if it isn’t sufficient to bring about a significant rally, the upward pressure stemming from a bullish fundamental backdrop will tend to create a price floor. That’s what happened with gold during March and April.

As was the case when I last addressed this topic at the TSI Blog, the most important GTFM input that is yet to turn bullish is the yield curve (as indicated by the 10year-2year and 10year-3month yield spreads). This input shifting from bearish to bullish requires a reversal in the yield curve from flattening (long-term rates falling relative to short-term rates) to steepening (long-term rates rising relative to short-term rates). If the reversal is driven primarily by falling short-term interest rates it indicates a boom-to-bust transition, such as occurred in 2000 and 2007, whereas if the reversal is driven primarily by rising long-term interest rates it points to increasing inflation expectations.

As illustrated below, at the end of last week there was no evidence of such a trend change in the 10year-3month yield spread.

To get a gold bull market there probably will have to be a sustained trend reversal in the yield curve. I think that will happen during the second half of this year, but it hasn’t happened yet. Also, when it does happen my guess is that it will be driven by rising long-term interest rates (indicating rising inflation expectations), not falling short-term interest rates. That’s an out-of-consensus view right now, because inflation expectations are low/falling and almost everyone has come to the conclusion that an aggressive Fed rate-cutting campaign will get underway in the near future.

Another GTFM input that could shift from bearish to bullish in the near future and thus add to the upward pressure on the gold price is the currency exchange rate input. At the moment, all it would take to bring about this shift is a weekly close in the Dollar Index about half a point below last week’s close.

My guess is that there will be some corrective activity in the gold market over the coming 1-2 weeks, but as long as the GTFM stays in bullish territory the fundamentals-related upward pressure should enable the gold price to make new multi-year highs within the next few months.

*I use the term “true fundamentals” to distinguish the actual fundamental drivers of the gold price from the drivers that are regularly cited by gold-market analysts and commentators. 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 volume of gold being transferred out of the Shanghai Futures Exchange inventory, 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 aren’t true fundamental price drivers. At best, they are distractions.

In 1961, Deng Xiao Ping uttered what is perhaps his most famous quotation: “I don’t care if it’s a white cat or a black cat. It’s a good cat so long as it catches mice.” This was interpreted to mean that being economically successful is more important than being loyal to any particular ideology.

Deng’s view that having a productive economy was more important than adhering rigidly to theories that were failing in practice brought him into conflict with Mao Tse Tung. It could be argued that Deng was more practical than Mao in that he was prepared to allow/encourage some elements of a market economy, although if the primary objective is holding onto political power then what’s practical is not necessarily what’s best for the country.

From a purely political perspective, Mao was practical. His policies generally had disastrous economic effects, but in addition to maintaining power he was able to stay popular with China’s peasant class (his political support base). He did this by creating the impression that there was always a revolution — of one form or another — to be fought. There were always enemies that had to be defeated, mountains that had to be climbed and sacrifices that had to be made in the present in order to set the stage for a brighter future.

The revolutionary feeling was sustained via a series of dramatic programs and policy shifts, chief among them being:

1. “The Hundred Flowers Campaign” of 1956-1957: Mao encouraged differing opinions on how China should be governed and even permitted public criticism of the Communist Party leadership.

2. “The Anti-Rightist Movement” of 1957-1959: Those who accepted Mao’s invitation to express anti-communist opinions under the “Hundred Flowers Campaign” were eliminated (purged, imprisoned, killed). Quite likely, the “Hundred Flowers Campaign” was just a ruse to identify anyone who could possibly be a threat to Mao.

3. “The Great Leap Forward” of 1958-1962: A 5-year plan focusing on the collectivisation of agriculture that caused widespread food shortages and resulted in the death of tens of millions of people (estimates of the famine-related death toll range from 20M to 45M). This disaster created the first serious rift between Mao and Deng, which eventually led to Deng being purged from the Communist party in the early days of the “Cultural Revolution”.

4. “The Cultural Revolution” of 1966 through to Mao’s death in 1976: Ostensibly a movement to topple the “ruling class”, spread power more evenly and stamp out counter-revolutionary activities, this was Mao’s most blatant attempt to keep China in a perpetual state of revolution. During the “Cultural Revolution”, anyone considered to have skills above those of the average person became a likely target for persecution. In addition, formal education all but ceased, countless works of art and historical buildings were destroyed, and Mao’s “Little Red Book” of quotations effectively became the bible. The result was social and economic chaos.

Fortunately for China, Deng was able to gain control of the Communist Party following Mao’s death. The reforms he implemented showed that even a modicum of economic freedom can go a long way towards improving living standards.

Interestingly, one of the most successful reforms of the Deng era was not the brainchild of Deng, but was, instead, developed by local farmers who were desperate to escape the poverty that collectivised agriculture had imposed upon them. In much the same way that America’s Pilgrims adopted private ownership of farmland in response to a communal system’s failure to produce sufficient food, the inhabitants of one small Chinese village decided, in 1978, to experiment with a new system under which individuals and families would have ownership of farmland. The experiment was a huge success, and was subsequently tried — also with great success — in some other villages. After learning of these experiments and the resultant large increases in agricultural productivity, Deng openly praised the participants and encouraged the nationwide adoption of the ‘new’ system. It is almost certain that the government’s reaction would have been very different if Mao had still been in power.

China’s political leaders between Deng Xiao Ping and Xi Jin Ping, the current leader, were really just place fillers. It’s clear that Xi is the most important leader of the Communist Party of China (CPC) since Deng.

Xi seems to be more like Mao than Deng, in that he places the supremacy of the Party above all other considerations and puts a strong emphasis on Communist ideology. He has made this clear in numerous speeches. For example:

At the October 2017 19th Party Congress, he said: “Government, military, society and schools, north, south, east and west, the Party is the leader of everything.”

And in March-2018, Xinhua (China’s official state-run press agency) quoted him as saying: “The Party exercises overall leadership over all areas of endeavor in every part of the country. A primary task of deepening reform of the Party and state institutions is to strengthen the CPC’s leadership in every sector.”

The phrase “capitalism with Chinese characteristics” is not used in China, at least not by any high-ranking members of the CPC. Only Western pundits believe that China is shifting towards capitalism. In China the political system is often referred to as “socialism with Chinese characteristics”. Here are two examples from a Xi speech given last year at the Central Commission for Discipline Inspection (CCDI) Plenary Session:

“[Party members should] understand the dialectical relationship between the grand vision of Communism and socialism with Chinese characteristics.”

“We cannot indulge ourselves in empty talk without working for the cause of socialism with Chinese characteristics and national rejuvenation. We can neither afford to lose the grand vision because realizing Communism is a long process.”

And here’s an excerpt from a Xinhua article that quotes Xi making the same point:

“The purpose of reviewing the Communist Manifesto is to understand and grasp the power of the truth of Marxism and write a new chapter of socialism with Chinese characteristics in the new era, Xi said. It’s necessary to “apply the scientific principles and the spirit of The Communist Manifesto to the overall planning of activities related to the great struggle, great project, great cause, and great dream,” he said. More efforts should be made to develop Marxism in the 21st century and in contemporary China, and write a new chapter of adapting Marxism to the Chinese context, Xi said.”

Like Mao, Xi is attempting to galvanise support behind himself and the Party (Xi is now defined as the “core” of the Party) by promoting the idea that China and the Chinese people are under threat. In this regard he is being helped by having a ready-made enemy in the form of a US government that clearly is trying to contain China both economically and militarily. Moreover, the “trade war” and the US government restrictions on US corporations doing business with Huawei make Xi look prescient, because he has warned for many years that this sort of thing could happen and therefore that it was dangerous for Chinese manufacturers to rely on imported technology.

Unfortunately for Xi, innovation, which he correctly perceives to be lacking in China, won’t happen at the command of government.

Also like Mao, Xi does not tolerate any dissension. All views must be consistent with the goal of having a population unified in its beliefs in “socialism with Chinese characteristics” and the primacy of the Party in all aspects of life. Hence the draconian treatment of millions of Muslims in Xinjiang Province, the severe policing of opinions expressed in social media and the setting-up of the world’s largest domestic surveillance network.

In a way, China has come full circle. However, Xi has far greater technological and economic resources at his disposal than Mao could have ever dreamed of.

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

Keynesian economic theory is useless if the aim is to understand how the world of human production and consumption works, but it is useful when attempting to figure out the policies that will be implemented in the future. The reason is that government and central bank policy-making is dominated by Keynesian ideas.

One of the most prominent Keynesian ideas is that changes in aggregate demand drive the economy. This leads to the belief that the government can keep the economy on a steady growth path by boosting its deficit-spending (thus adding to aggregate demand) during periods when economic activity is too slow and running surpluses (thus subtracting from aggregate demand) during periods when economic activity is too fast.

To further explain using an analogy, in the Keynesian world the economy is akin to a bathtub filled with an amorphous liquid called “aggregate demand”. When the liquid level gets too low it’s the job of the government and the central bank to top it up, and when the liquid level gets too high it’s the job of the government and the central bank to drain it off. Keynesian economics therefore has been called “bathtub economics”. The real-world economy is nothing like a bathtub, but that doesn’t seem to matter.

In any case, the point we now want to make is that in the US the traditional Keynesian guidelines are no longer being followed. Gone are the days of ramping-up government deficit-spending in response to economic weakness and running surpluses or at least reducing deficits when the economy is strong. These days the US federal government applies non-stop Keynesian-style stimulus and regularly exhorts the central bank to do the same. So, debt-financed tax cuts were implemented in 2017 when the economy seemed to be performing well, and now, with the unemployment rate at a generational low, the stock market near an all-time high and GDP growth chugging along at around 3%/year, the US government is planning a US$2 trillion infrastructure spending spree and the executive branch of the government is demanding that the Fed cut interest rates from levels that are already very low by historical standards.

In other words, although the ‘Keynesian bathtub’ appears to be almost over-flowing, the US government is pushing for more demand-boosting actions. The strategy is now full-on ‘stimulus’ all the time. That’s part of why it doesn’t make sense to be anything other than long-term bullish on “inflation” and long-term bearish on Treasury bonds.