When will the next US recession begin?

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

Our view for the past 11-12 months has been that last year’s US recession ended in June plus/minus one month, making it the shortest recession in US history. The latest leading economic data indicate that the recovery is intact and that the strong GDP growth reported for the first quarter of this year will continue.

Of particular relevance, the following monthly chart shows that the ISM 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.

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. Therefore, the small amount of relative strength demonstrated by gold over the past two months is probably part of a countertrend move that will run its course within the next three months.

A year ago our view was that there would be a strong rebound in economic activity fueled by monetary stimulus, fiscal stimulus and the release of pent-up demand after COVID-related restrictions were removed, but that the rebound would be short-lived. Specifically, we were looking for the US economy to recover rapidly during the second half of 2020, level off during the first half of 2021 and return to recession territory by the first half of 2022. This view was revised in response to leading indicators and by October of last year we were expecting the period of strong growth to extend through the first half of 2021.

Based again on leading indicators, we now expect the period of above-average GDP growth to continue throughout 2021, albeit with a slower growth rate during the second half than during the first half. Furthermore, the probability of the US economy re-entering recession territory as soon as the first half of 2022 is now extremely low. To get a recession within the next 12 months there will have to be another shock of similar magnitude to the virus-related lockdowns of 2020.

As far as what happens beyond the first half of next year, it’s largely pointless trying to look that far ahead. One thing we can say is that the current position of the yield curve suggests that the next US recession will not begin earlier than 2023. To further explain this comment we will make use of the following chart of the US 10yr-2yr yield spread, a good proxy for the US yield curve.

A major yield-curve trend reversal from flattening (indicated by a falling line on the chart) to steepening (indicated by a rising line on the chart) generally occurs during the 6-month period prior to the start of a recession. After that, what tends to happen is:

a) The yield curve steepens throughout the recession and for 1-2 years after the recession is over.

b) The yield curve peaks and a long (3-year +) period of curve flattening gets underway.

c) The curve eventually gets as flat as it is going to get and reverses direction, warning that a recession will begin within the ensuing 6 months.

Currently, there is a lot of scope for curve steepening prior to peak ‘steepness’. To be more specific, right now the 10-year T-Note yield is about 1.5% above the 2-year T-Note yield, but previous periods of curve steepening didn’t end until the 10-year T-Note yield was at least 2.5% above the 2-year T-Note yield. Moreover, history tells us that there will be a multi-year period of curve flattening between the peak in yield-curve steepness and the start of a recession.

We expect that the current economic cycle will be compressed, but it still could take years for the yield curve to return to the position where it is warning of recession.

Due to unprecedented manipulation of interest rates it could be different this time, meaning that the end of the current boom could coincide with a yield curve that contrasts with the typical pre-recession picture. However, regardless of what happens to the yield curve near the end of the current boom there will be timely warnings of a boom-to-bust transition in the real-time data, including an upward reversal in credit spreads. At the moment, such warnings are conspicuous by their absence.

[Below is an excerpt from a commentary published at TSI last week. It is our latest monthly review of the short and intermediate term prospects of the US economy. Just to be clear, a boom is defined as a period during which monetary inflation and the suppression of interest rates create the FALSE impression of a strong/healthy economy.]

We think that last year’s US recession ended in June plus/minus one month, making it the shortest recession in US history. The latest data indicate that the recovery is well and truly intact.

Of particular relevance, the following monthly chart shows that the ISM New Orders Index (NOI), one of our favourite leading economic indicators, remains near the top of its 20-year range following a pullback in January-2021 and a rise in February-2021.

The ISM NOI leads Industrial Production (IP), so it isn’t surprising that the year-over-year percentage change in IP has experienced a rapid rebound from its Q2-2020 trough (refer to the following monthly chart for the details). More importantly, based on the latest NOI number, other leading indicators and the inevitability of additional stimulus from both the Fed and the government, IP’s rebound is set to continue. The IP number for March-2021 will (not might) indicate year-over-year growth.

The performances of leading and coincident economic indicators show that we are well into the boom phase of the boom-bust cycle, meaning that the economic landscape remains bullish for industrial commodities and bearish for gold. Therefore, it’s reasonable to expect the continuation of the rising trend in the GYX/gold ratio (industrial metals relative to gold) clearly evident on the following chart. Be aware, though, that on a short-term basis this trend appears to be over-extended.

The economic strength that was predicted eight months ago by leading indicators and is starting to become apparent in coincident indicators is largely artificial. This means that it will evaporate soon after the Fed is forced by blatant evidence of an inflation problem to end the monetary stimulus.

Our thinking at this time is that the period of strong economic growth will be followed by a period of what is often called “stagflation”, that is, a period when “inflation” accelerates in parallel with slow or no economic growth, because the Fed is not going to stop creating new money at a fast pace and the US government is not going to stop spending at a fast pace anytime soon. If so, then during the post-boom period commodities could continue to do well but gold should outperform almost everything.

However, we’ve learned from bitter experience that during the boom it’s best NOT to look ahead to the inevitable economic denouement. Instead, the focus should be on “making hay while the sun shines”. Near the end of the boom there will be timely warnings in the real-time data, but at the moment such warnings are conspicuous by their absence. This means that the boom should continue for at least another three months and could continue for much longer than that.

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

Gold mining is — to use technical jargon — a crappy business. It doesn’t have to be, it just works out that way due to irresistible incentives associated with the post-1970 monetary system. We explained why in TSI commentaries and some articles at the TSI Blog (for example, HERE) during 2014-2015.

The explanation revolves around the boom-bust cycle caused by the monetary machinations of the banking establishment (the central bank and the commercial banks). For the economy as a whole, malinvestment occurs during the boom phase of the cycle and the bust phase is when the proverbial chickens come home to roost (the investing mistakes are recognised and a general liquidation occurs). For the gold mining industry, however, the malinvestment occurs during the economy’s bust phase, because the boom for gold mining coincides with the bust for the broad economy.

To further explain, rapid monetary inflation distorts relative price signals and in doing so incentivises investments that for a while (usually at least a few years) create the impression that the economy is powering ahead. Eventually, however, many of these investments are revealed for what they are (ill-conceived), with the revelation stemming from rising costs, declining profits or the absence of profit, resource shortages within the economic sectors that ‘boomed’ the most, and rising short-term interest rates due to a scramble for financing to complete projects and/or deal with cash flow problems.

After it starts to become clear that many of the boom-time investments were based on unrealistic expectations, a general drive to become more liquid gets underway. Many people sell whatever they can in an effort to pay expenses and service debts, thus kicking off an economic bust (recession or depression).

For the average person, becoming more ‘liquid’ usually involves obtaining more cash. However, corporations and high-net-worth individuals often prefer other forms of ‘liquidity’, including Treasury Bills and gold. That, in essence, is why the demand for gold tends to rise during the bust phase of the economy-wide boom-bust cycle.

The rising demand for gold pushes up gold’s price relative to the prices of most other assets and commodities, which elevates the general interest in gold mining. Eventually there will be a flood of money towards the gold mining industry that boosts valuations and that the managers of gold mining companies will use for something. That something will be project developments or acquisitions.

Regardless of how high market valuations move or how costly new mine developments become, gold-mining company managers will never say: “We don’t want your money because there currently are no acquisitions or new projects that make economic sense.” Instead, they will take the money and put it to work, based on the assumption that current price trends can be extrapolated into the distant future. The result invariably will be an artificial boom in the gold mining industry characterised by a cluster of high-cost investments that eventually get revealed as ill-conceived. Massive write-offs and an industry-wide retrenchment will ensue as surely as night follows day, thus obliterating the wealth created by the industry during the boom.

Gold itself is not made less valuable by the monetary-inflation-caused inefficiencies and widespread wastage that periodically beset the gold-mining industry. That’s why the gold mining sector, as represented on the following weekly chart by the Barrons Gold Mining Index prior to 1995 and the HUI thereafter, has been in a downward trend relative to gold bullion since 1968. That’s right — gold mining stocks, as a group, have been trending downwards relative to gold for more than 50 years!

The trend illustrated by the above chart is a function of the current monetary system and won’t end before the current system is replaced. The trend could end within the next ten years, but it didn’t end in 2020 and almost certainly won’t end in 2021 or 2022. An implication is that if you want to make a long-term investment in gold, then buy gold. Gold mining stocks are for trading.

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

The 4-8 year period beginning in February of this year potentially will contain three or more official recessions and come to be referred to as the Depression of the 2020s. If so, unlike the Depression of the 1930s the Depression of the 2020s will be inflationary.

The Depression of the 1930s was deflationary in every sense of the word, but the primary cause of the deflation was the performance of the money supply. We don’t have the data to calculate True Money Supply (TMS) during the 1930s, but we have the following chart showing what happened to the M1 and M2 monetary aggregates from 1920 to 1953. The chart shows that there was a substantial contraction in the US money supply during 1929-1933 and that the money supply was no higher in 1938 than it had been at the start of the decade.

Clearly, the money-supply situation today could not be more different from the money-supply situation during the early-1930s*.

One reason for the difference is that during the 1930s the Fed was restricted by the Gold Standard. The Gold Standard was diluted in 1933, but throughout the 1930s the US$ was tethered to gold.

The final official link between the US$ and gold was removed in 1971. This made it possible for the Fed to do a lot more, but as far as we can tell the Fed actually didn’t do a lot more in the 1990s than it did in the 1960s. It has been just the past 20 years, and especially the past 12 years, that the Fed has transmogrified from an institution that meddles with overnight interest rates and bank reserves to a central planning agency that attempts to micro-manage the financial markets and the economy. After history’s greatest-ever mission creep, it now seems that there is nothing associated with the financial markets and the economy that is outside the Fed’s purview.

In parallel with the expansion of the Fed’s powers and mission there emerged the idea that for a healthy economy the currency must lose purchasing power at the rate of around 2% per year. This idea has come to dominate the thinking of central bankers, but it has never been justified using logic and sound economic premises. Instead, when asked why the currency must depreciate by 2% per year, a central banker will say something along the lines of: “If the inflation rate drops well below 2% then it becomes more difficult for us to implement monetary policy.”

As an aside, because of the way the Fed measures “inflation”, for the Fed to achieve its 2% “inflation” target the average American’s cost of living probably has to increase by at least 5% per year.

Due to the central-banking world’s unshakeable belief that money must continually lose purchasing power and the current authority of the central bank to do whatever it takes to achieve its far-reaching goals, the greater the perceived threat of deflation the more monetary inflation there will be. We saw an example of this during 2001-2002 and again during 2008-2009, but 2020 has been the best example yet. The quantity of US dollars created since the start of this year is greater than the entire US money supply in 2002.

It actually would be positive if deflation were the high-probability outcome that many analysts/commentators claim it is, because deflation is relatively easy to prepare for and because 1-2 years of severe deflation would set the stage for strong long-term growth. However, one of today’s dominant driving forces is the avoidance of short-term pain regardless of long-term cost, so there will be nothing but inflation until inflation is perceived to be the source of the greatest short-term pain. This doesn’t mean that a depression will be sidestepped or even postponed. What it means is that the next depression — which may have already begun — will be the inflationary kind.

*US True Money Supply (TMS) has expanded by 35% over the past 12 months.

Many things have happened in 2020 that have never happened before, so in some respects it certainly is different this time. The most important of these differences, four of which are discussed below, revolve around the policy responses to the COVID-19 pandemic.

In the context of human history and in terms of the amount of death that it has caused, the COVID-19 pandemic is not particularly unusual. On average, there have been about two major pandemics every hundred years going back several centuries. Over the past hundred or so years, for example, there was the “Spanish Flu” in 1918 and the “Asian Flu” in 1958. Almost everyone has heard about the Spanish Flu and its horrific death toll, but the Asian Flu is less well known. Suffice to say that the death toll per million of global population resulting from the Asian Flu was about four times the current death toll per million of global population resulting from COVID-19.

The big difference this time is not the disease itself but the reaction to the disease. In particular, never before have large sections of the economy been shuttered by the government in an effort to limit the spread of the disease. Now, however, it has become accepted practice that as soon as the number of COVID-19 cases in an area moves beyond an unspecified low level, the orders go out for many businesses to close and for the public to stay home.

If locking down large sections of the economy is the optimal response to a pandemic, why wasn’t it tried before? Why did it take until 2020 to figure this out?

The answer is associated with the fact that COVID-19 is the first major pandemic to strike under the monetary system that came into being in the early-1970s. Under this system there is no limit, except perhaps an arbitrary level of increase in an arbitrary indicator of “inflation”, to the amount of money that can be created out of nothing. Previously there were limits to money creation imposed by some form of gold standard.

If there were rigid limits to the supply of money, the sort of economic lockdown implemented by many governments this year would cause immediate and extreme hardship to the majority of people. Therefore, it wouldn’t be an option. It is an option today because the ability to create an unlimited amount of money out of nothing presents the opportunity for the government to alleviate, or even to completely eliminate, any short-term pain for the majority of people. It should be obvious that this is an exchange of short-term pain for greater pain in the long-term, but hardly anyone is thinking about the long-term. In fact, the short-term fix that involves showering the populace with money is being advocated as if it didn’t have huge long-term costs.

Another difference between the current pandemic and earlier pandemics is the availability of information. For the first time ever during a major pandemic, almost everyone has up-to-the-minute data regarding the number of cases, hospitalisations and deaths. The widespread fixation on the cases/deaths data has fostered the general belief that getting the numbers down takes precedence over everything, long-term consequences be damned.

The third difference is linked to the first difference, that is, to the ability to create an unlimited amount of money out of nothing. This ability has existed for almost half a century, but 2020 is the first time it has been used by the government to provide money directly to the public. Prior to this year it was used exclusively by the central bank to manipulate interest rates and prop-up prices in financial markets. A consequence WILL be much more traditional “inflation” next year than has occurred at any time over the past decade.

The fourth and final difference that I’ll mention today is also linked to the money-creation power. It is that in 2020 some developed-world governments, most notably the US government, have stopped pretending to be concerned about their own indebtedness. Previously they made noises about prudently managing deficits and debts, as if the debt eventually would have to be repaid. However, this year they have tacitly acknowledged the reality that there has never been any intention to pay off the debt, and, therefore, that the debt can expand ad infinitum.

2020 certainly has been a watershed year.

[This blog post is an excerpt from a TSI commentary published on 19th July]

Sometimes, financial market relationships that have applied for a very long time stop working. This usually happens because the monetary system undergoes a major change or because the economy is altered in a permanent way by government and/or central bank intervention. It also can happen due to a major technological change that, for example, permanently reduces the demand for a commodity.

As a result of increasing central bank manipulation of money and interest rates, for the past 12 years gold has been getting more expensive relative to commodities that are consumed*. This is because the manipulation has been a) making it more difficult to earn a satisfactory return on investment and b) reducing the appeal of saving in terms of the official money. As central banks reduce the returns available from investing in productive enterprises and punish anyone who chooses to save cash, the demand for a store of value that central banks can’t depreciate naturally rises.

A knock-on effect is that some gold/commodity ratios appear to have been permanently elevated to higher ranges. There still will be periods when gold falls in value relative to these commodities, but the former ceilings no longer apply. In fact, in some cases it may be appropriate to view the former ceilings as the new floors. The two long-term monthly charts displayed below are cases in point.

The first chart shows the gold/platinum ratio. From the early-1970s through to 2015, gold was always near a long-term peak relative to platinum whenever the ratio moved up to 1. However, in 2015 the ratio broke above 1 and continued to trend upward.

A few years ago we speculated that gold/platinum’s former ceiling near 1 had become the new floor, that is, that the gold price would never again make a sustained move below the platinum price. The probability that this is so has since increased, although it’s likely that gold/platinum made an important high in March-2020 and is in the early stages of a 1-2 year decline.

The second chart shows the gold/oil ratio. From 1970 through to the start of 2020, gold was always near a long-term peak relative to oil whenever the ratio moved up to 30. However, during March-April of this year the gold/oil ratio reached a multiple of its previous long-term peak.

As is the situation with the gold/platinum ratio, it’s likely that the gold/oil ratio is in the process of establishing a higher long-term range that involves the former ceiling (30) being the new floor. As is also the situation with the gold/platinum ratio, it’s a good bet that the gold/oil ratio made an important high in April-2020 and is in the early stages of a 1-2 year decline.

It could be a similar story for the gold/silver ratio, although to a lesser degree. It’s likely that the gold/silver ratio has been permanently elevated, but not to the extent where the former ceiling (80-100) is the new floor. Our guess is gold/silver’s new floor is 50-60.

*That’s right, central banks are inadvertently manipulating the gold price upward, not deliberately manipulating it downward.

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

The year-over-year rate of growth in US True Money Supply (TMS), a.k.a. the US monetary inflation rate, has continued its journey “to da moon.” Based on the monthly monetary data for May-2020, it is now at 27% and still rising rapidly. The following chart shows that the money-supply growth surge engineered by “Mississippi Jay” Powell* now dwarfs the earlier efforts of “Easy Al” Greenspan and “Helicopter Ben” Bernanke.

Anyone who thinks that this year’s monetary inflation moon-shot won’t lead to much higher prices for many things is kidding themselves. It has already fuelled the fastest 40% rise in the S&P500 Index in history, but unlike the other money-supply growth surges of the past 20 years the current episode also should lead to substantial gains in what most people think of as “inflation”. Not so much this year, because in the short-term there are counter-balancing forces such as an increasing desire to hold cash, but during 2021-2022.

Apart from its larger scale, there are three reasons that the money-supply growth surge engineered by “Mississippi Jay” should lead to much higher “price inflation”** than the money-supply growth surges engineered by his predecessors. The first is that although the Fed is still buying US government debt via Primary Dealers as opposed to directly from the government, it is crystal clear that the Fed is monetising the US government’s deficit. That’s why the Federal government is no longer even pretending to be concerned about the level of its spending and indebtedness. In effect, MMT (Modern Monetary Theory) is now being implemented in the US.

MMT is based on the ridiculous idea that there should be no upper limit on government spending/borrowing, facilitated via the creation of new money, as long as the CPI’s growth rate is below a certain level. It completely ignores all effects of monetary inflation apart from the most superficial. It also ignores the reality that government spending tends to be counterproductive because it is driven by political considerations and not market forces.

The good thing about MMT is that it should short-circuit the boom-bust cycle, in effect almost skipping the boom and going directly to an inflationary bust. This is because it lays bare the crudeness of the central bank’s monetary machinations. No longer is the central bank (incorrectly) perceived as finely tuning interest rates to keep the economy on an even keel. Under MMT it is seen to be pumping out whatever amount of new money the government demands.

The boom associated with this year’s monetary inflation moon-shot began in April and probably will end within the next six months. Actually, it might have ended already.

The second reason to think that this year’s money-supply growth surge will be followed by substantial “price inflation” is that the lockdowns of the past few months have damaged supply chains. This, combined with the shift away from globalisation, will lead to reduced supply and/or less efficient production of goods.

The third reason is supply constraints on important commodities. Firstly, this year’s lockdowns caused the mining industry to delay expansion plans and cancel new developments. Secondly, in labour-intensive mining countries such as South Africa, the requirement to implement social distancing following the return to work has made and will continue to make the mines less efficient. Thirdly, many small-scale commodity producers that together account for a significant portion of total supply have been put out of business by the lockdowns. Fourthly, the “El Nino” weather event of 2020-2021 and the Grand Solar Minimum that should start becoming influential in 2021-2022 probably will result in extreme weather volatility, which potentially will disrupt the supply of important agricultural commodities during 2021-2022. Lastly, due to the virus-related lockdowns and associated economic pressures there is heightened risk of war in the Middle East, implying heightened risk of an oil supply shock.

In summary, the latest flood of new money created by central banks will be more widely perceived to be “inflationary” than the other ‘money floods’ of the past 20 years. In addition, the latest money flood has occurred near the start of a multi-year period during which the production of many commodities and manufactured goods will be hampered. A likely result is substantial “price inflation” during 2021-2022.

*“Mississippi Jay” is the nickname we’ve given to current Fed Chair Jerome (Jay) Powell. The name links Powell with John Law, the roguish Scotsman (is there any other kind?) who, while residing in France in the early-1700s, engineered the Mississippi Bubble via a scheme that involved creating an extraordinary amount of new currency.

**We don’t like the term “price inflation”, because there is no such thing as an economy-wide average price level and because at any given time some prices will be rising while others are falling. However, we use the term because it is generally understood to mean a rising cost of living for most people.

In a TSI commentary last November I wrote about adjustments I was making to my stock selection process. These adjustments weren’t due to issues with any individual stock(s) or the performance of any individual stock-market sector. In particular, the poor performance of the average junior gold-mining stock during 2019′s gold rally wasn’t the primary driver of my decision to make some changes, although it was the proverbial “last straw”. The primary basis for my adjustment was evidence that the investing landscape had changed in a permanent, or at least a semi-permanent, way.

Long-term changes in the investing landscape happen from time to time, that is, the future is not always a simple extrapolation of the past. This occurs not because of a change in human nature (human nature never changes), but because of a change in the monetary system. For example, the investment strategy that involved shifting from equities to bonds when the stock market’s average dividend yield dropped below the average yield on investment-grade bonds worked without fail for generations prior to the mid-1950s, but from the mid-1950s onward it didn’t work. The reason this ‘fail safe’ approach to asset allocation stopped working was the increasing propensity/ability of central banks to inflate the money supply.

As part of their attempts to encourage more borrowing and consumption, over the past few years the major central banks manipulated interest rates down to unprecedented levels. Ten years ago very few people thought that negative nominal interest rates were possible, but in 2019 we reached the point where 1) a substantial portion of the developed-world’s government debt was trading with a negative yield to maturity, 2) some corporate bonds had negative yields to maturity, and 3) banks in some European countries were offering mortgages with negative interest rates.

Due to the draconian efforts of central banks to promote more spending and borrowing, it’s possible that the public is now effectively ‘tapped out’. This would explain why the quantity of margin debt collapsed over the past 18 months relative to the size of the US stock market, something that NEVER happened before with the S&P500 in a long-term bullish trend and regularly making new all-time highs. Also, it would explain why the average small-cap stock (as represented by the Russell2000) is trading at a 16-year low relative to the average large-cap stock (as represented by the S&P500).

Linked to the relatively poor performance of the average small-cap stock is the increasing popularity of passive investing via indexes and ETFs. Over the past several years there has been a general decline in the amount of active, value-oriented stock selection and a general rise in the use of ETFs. This has caused the stocks that are significant components of popular ETFs to outperform the stocks that are not subject to meaningful ETF-related demand, regardless of relative value. There is no reason to expect this trend to end anytime soon. On the contrary, the general shift away from individual stock selection and towards the use of ETFs appears to be accelerating.

At this stage I’m not making dramatic changes to my stock selection approach. I will continue to follow speculative small-cap stocks, but my selection process will be more risk averse and I will reduce the potential tracking error during intermediate-term rallies in mining stocks by putting more emphasis on ETFs and mutual funds. Also, when making future speculative mining-stock selections I will pay greater heed to the attractiveness of the assets to large mining companies. The reason is that regardless of the public’s willingness to speculate, large mining companies will always be under pressure to replace their depleted reserves and add new reserves. The easiest way for large companies to do this is to buy small companies that have discovered mineral deposits of sufficient size and quality.

In summary, as a result of unprecedented manipulation of money and interest rates it’s possible that some of the investing/speculating strategies that worked reliably in the past will not work for the foreseeable future. I think it makes sense to adapt accordingly.

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

Over the past four months the Fed has added about $400B to its balance sheet. To put this into perspective, since early September the Fed has expanded its balance sheet at an annualised rate of around 30%. According to the Fed, the purpose of this dramatic monetary expansion was to address a temporary liquidity issue in the “repo” market. The question is: If the Fed is dealing with only a temporary shortage of liquidity in the market for short-term money, why did it introduce a program in mid-October to supplement the temporary injections of “repo” money with $60B/month of permanent money?

The answer is that the Fed is dealing with something more than a temporary shortage of liquidity in the market for short-term money. The fact that the Fed sees the need to remove $60B/month of Treasury supply from the market in addition to the Treasury supply that is being removed on a temporary basis via “repo” operations implies that the overall demand for Treasury debt is falling short of Treasury supply at the Fed’s targeted interest rates. Looking from a different angle, it is clear that at current interest rates the global financial system wants more dollars and less Treasury debt. The Fed is accommodating this desire by increasing the supply of dollars to the market and reducing the supply of government debt that must be absorbed by the market.

The key phrase in the above paragraph is “at current interest rates”. If the supply of and the demand for money and credit were permitted to balance naturally then interest rates would now be much higher. However, the Fed doesn’t want supply and demand to strike a natural balance; the Fed has decided that it wants the price of credit at a certain level and that it will use its power to create and destroy money to override natural market forces. In this regard the current situation is unusual only in degree, because the Fed has been attempting to override market forces for more than 100 years.

The US Federal government is not about to slow the pace at which it emits new debt. On the contrary, the rate of growth in government debt supply looks set to rise. Therefore, one of two things will have to happen if interest rates are to stay near current low levels: The Fed will have to keep absorbing Treasury supply at a rapid pace or the market’s desire to hold Treasury debt will have to increase substantially. The latter could occur in response to a sizable decline in the US stock market or a crisis outside the US.

Within a week of its mid-October announcement we wrote that the Fed’s promise to inject $60B/month of new ‘permanent’ money was a potential game-changer, in that it could extend the current cycle (prolong the equity bull market) and lead to more “price inflation” than earlier programs. We continue to think that a cycle extension could be on the cards, but if so the recession warnings that were generated by leading indicators during the second half of last year must disappear within the next couple of months.

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

Once an equity bear market is well underway it runs its course, regardless of the Fed’s actions. For example, the Fed started cutting interest rates in January of 2001, but the bear market that began in March of 2000 continued until October-2002. For another example, the Fed started cutting interest rates in September-2007, but a bear market commenced in October-2007 and continued until March-2009 despite numerous Fed actions designed to halt the price decline. On this basis it can be argued that the Fed’s introduction of a new asset monetisation program roughly one week ago won’t prevent the stock market from rolling over into a major bearish trend. However, there is a good reason to think that it could be different this time (dangerous words, we know) and that the Fed’s new money-pumping scheme will prove to be game-changer.

The reason to think that it could be different this time is that in one respect it definitely is different. We are referring to the fact that although the Fed started cutting interest rates in the early parts of the last two cyclical bear markets (2000-2002 and 2007-2009), it didn’t begin to directly add new money to the financial markets until the S&P500 Index had been trending downward with conviction for about 12 months.

To further explain, when the Fed’s targeted interest rates follow market interest rates downward, which is what tends to happen during at least the first half of an economic downturn, the official rate cuts do not add any liquidity to the financial system. It’s only after the Fed begins to pump new money into the financial markets that its actions have the potential to support asset prices.

During the last two bear markets, by the time the Fed started to pump money it was too late to avoid a massive price decline. This time around, however, the Fed has introduced a fairly aggressive money-pumping program while the S&P500 is very close to its all-time high and seemingly still in a bullish trend.

The Fed has emphasised that the new asset monetisation program should not be called “QE” because it does not constitute a shift in monetary policy. Technically this is correct, but in a way it’s worse than a shift towards easier monetary policy. The Fed’s new program is actually a thinly-disguised attempt to help the Primary Dealers absorb an increasing supply of US Treasury debt. To put it another way, the Fed is now monetising assets for the purpose of financing the US federal government, albeit in a surreptitious manner.

This relates to a point we made in a recent blog post. The point is that when the central bank is perceived to be financing the government, as opposed to implementing monetary policy to achieve economic (non-political) objectives such as “price stability”, there is a heightened risk that a large decline in monetary confidence will be set in motion. One effect of this would be an increase in what most people think of as “inflation”.

Summing up, it’s possible that the Fed’s new asset monetisation program will extend the current cycle (prolong the equity bull market) and lead to more “price inflation” than earlier programs.

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

We regularly look at what’s happening with monetary inflation around the world, but today we’ll focus exclusively on the US monetary inflation rate. This is because of the recent evidence that the unusually-low level of this long-term monetary indicator is starting to have a significant short-term effect.

The following chart shows that the year-over-year rate of change in US True Money Supply (TMS), a.k.a. the US monetary inflation rate, made a new 12-year low in August-2019. Furthermore, the latest TMS growth figure for the US is very close to the 20-year low registered in September-2006.

Within three months of the TMS growth trough in September-2006 the first obvious crack appeared in the US mortgage debt/securitisation bubble. The crack was a trading update issued by HSBC on 5th December 2006 that noted the increasing “challenges” being faced by the Mortgage Services operations of HSBC Finance Corporation. This initial sign of weakness was followed by the appearance of a much larger crack on 7th February 2007. That’s when HSBC issued another trading update that included a profit warning due to substantially increased loan impairment charges. Within days of this February-2007 HSBC update, the shares of sub-prime lending specialists such as New Century Financial and NovaStar Financial went into freefall. This marked the beginning of the Global Financial Crisis, although the US stock market didn’t top out until October of 2007 and industrial commodities such as oil and copper didn’t top out until mid-2008.

The above-mentioned events could be relevant to the current situation, in that the recent chaos in the US short-term funding market could be the initial ‘crack’ in today’s global debt edifice. While the low rate of US monetary inflation was not the proximate catalyst for the recent chaos, there is little doubt that it played a part. Temporary issues such as a corporate tax deadline and a large addition by the US Treasury to its account at the Fed would not have had such a dramatic effect if the money supply had been growing at a ‘normal’ pace.

Generally, when the money supply is growing very slowly within a debt-based monetary system, a relatively small increase in the demand for cash can create the impression that there is a major cash shortage.

Now, if there’s one thing we can be sure of it’s that the next crisis will look nothing like the last crisis. The financial markets work that way because after a crisis occurs ‘everyone’, including all policy-makers, will be on guard against a repeat performance, making a repeat performance extremely improbable. Therefore, we can be confident that even if the recent temporary seizure of the US short-term funding market was a figurative shot across the bow, within the next couple of years there will NOT be a major liquidity event that looks like the 2007-2008 crisis. However, some sort of crisis, encompassing an economic recession, is probable within this 2-year period.

The nature of the next crisis will be determined by how the Fed reacts to signs of economic weakness and short-term funding issues such as the one that arose a few weeks ago. In particular, quick action by the Fed to boost the money supply would greatly reduce the probability of a deflation scare and greatly increase the risk that the next crisis will involve relatively high levels of what most people call “inflation”.

As an aside, there’s a big difference between the Fed cutting its targeted short-term interest rates and the Fed directly boosting the money supply. For example, in reaction to signs of stress in the financial system the Fed commenced a rate-cutting program in September of 2007, but it didn’t begin to directly pump money into the system until September of 2008. In effect, during the last crisis the Fed did nothing to address liquidity issues until almost two years after the appearance of the initial ‘crack’. As a consequence, the monetary inflation rate remained low and monetary conditions remained ‘tight’ until October of 2008 — 12 months after the start of an equity bear market and 10 months after the start of an economic recession.

Early indications are that the Fed will be very quick to inject new money this time around, partly because 2007-2008 is still fresh in the memory. These early indications include the rapidity of the Fed’s response to the effective seizure of the “repo” market last month and the fact that last Friday the Fed introduced a $60B/month asset monetisation program. This program is QE in everything except name. In other words, the Fed already has resumed Quantitative Easing even though GDP is growing at about 2%/year, the unemployment rate is at a generational low and the stock market is near an all-time high.

In summary, while it is too early to have a clear view of how the next major crisis will unfold, something along the lines of 2007-2008 can be ruled out. Also, there are tentative signs that the next crisis will coincide with or follow a period of relatively high “inflation”.

The events of the past 10 years have fostered the belief that central banks can create a virtually unlimited amount of money without significant adverse consequences for the purchasing power of money. Since the law of supply and demand applies to money similarly to how it applies to every other economic good, this belief is wrong. However, the ‘failure’ of QE programs to bring about high levels of what most people think of as inflation has generated a false sense of security.

The difference between money and every other economic good is that money is on one side of almost every economic transaction. Consequently, there is no single number that can accurately represent the price (purchasing power) of money, meaning that even the most honest and rigorous attempt to calculate the “general price level” will fail. This doesn’t imply that changes in the supply of money have no effect on money purchasing power, but it does imply that the effects of changes in the money supply can’t be explained or understood via a simple equation.

Further to the above, the Quantity Theory of Money (QTM) is not a valid theory. Ludwig von Mises thoroughly debunked this theory a hundred years ago and I summarised its basic flaws in a blog post two years ago. Unfortunately, QTM’s obvious inability to explain how the world works has strengthened the belief that an increase in the supply of money has no significant adverse effect on the price of money.

The relationship between an increase in the money supply and its economic effects is complicated by the fact that the effects will differ depending on how and where the new money is added. Of particular relevance, the economic effects of a money-supply increase driven by commercial banks making loans to their customers will be very different from the economic effects of a money-supply increase driven by central banks monetising assets. In the former case the first receivers of the new money will be within the general public, for example, house buyers/sellers and the owners of businesses, whereas in the latter case the first receivers of the new money will be bond speculators (Primary Dealers in the US). Putting it another way, “Main Street” is the first receiver of the new money in the former case and “Wall Street” is the first receiver of the new money in the latter case. This alone goes a long way towards explaining why the QE programs of Q4-2008 onward had a much greater effect on financial asset prices than on the prices that get added together to form the Consumer Price Index (CPI).

Clearly, the QE programs implemented over the past 11 years had huge inflationary effects, just not the effects that many people expected.

A proper analysis of the effects of the QE programs has not been done by central bankers and the most influential economists. As a result, there is now the false sense of security mentioned above. It is now generally believed that substantially increasing the money supply does not lead to problematic “inflation”, which, in turn, lends credibility to monetary quackery such as MMT (Modern Monetary Theory).

Due to the combination of the false belief that large increases in the supply of money have only a minor effect on the purchasing power of money and the equally false belief that the economy would benefit from a bit more “price inflation”, it’s a good bet that central banks and governments will devise ways to inject a lot more money into the economy in reaction to future economic weakness. As is always so, the effects of this money creation will be determined by how and where the new money is added. If the money is added via another QE program then the main effects of the money-pumping again will be seen in the financial markets, at least initially, but if the central bank begins to monetise government debt directly* then the “inflationary” effects in the real economy could be dramatic.

The difference between the direct and the indirect central-bank monetising of government debt is largely psychological, but it is important nonetheless. When the central bank monetises government debt indirectly, that is, via intermediaries such as Primary Dealers, it is perceived to be conducting monetary policy (manipulating interest rates, that is). However, when the central bank monetises government debt directly it is perceived to be financing the government, thus eliminating any semblance of central bank independence and potentially setting in motion a large decline in monetary confidence.

According to the book Monetary Regimes and Inflation, ALL of the great inflations of the 20th Century were preceded by central bank financing of large government deficits. Furthermore, in every case when the government deficit exceeded 40% of expenditure and the central bank was monetising the bulk of the deficit, a period of high inflation was the result. In some cases hyperinflation was the result.

In summary, growth in the money supply matters, but not in the simplistic way suggested by the Quantity Theory of Money. There’s a good chance that this fact will be rediscovered within the next few years, especially if legislative changes enable/force the Fed to monetise government debt directly.

*In the US this would entail the Fed paying for government debt securities by depositing newly-created dollars into the government’s account at the Fed. The government would then spend the new money. Currently the Fed buys government debt securities from Primary Dealers (PDs), which means that the newly-created dollars are deposited into the bank accounts of the PDs.

One of the past month’s interesting stock-market developments was the strength of the banking sector in both nominal terms and relative to the broad market. The strength in nominal dollar terms is illustrated by the top section of the following weekly chart, which shows that the US Bank Index (BKX) is threatening to break out to the upside. The strength relative to the broad market is illustrated by the bottom section of the chart, which reveals a sharp rebound in the BKX/SPX ratio since the beginning of September.

Bank stocks tend to perform relatively well when long-term interest rates are rising in both absolute terms and relative to short-term interest rates. This explains why the banking sector outperformed during September and also why bank stocks generally have been major laggards since early last year.

Valuations in the banking sector are depressed at the moment, as evidenced by relatively low P/Es and the fact that the BKX/SPX ratio is not far from a 25-year low. This opens up the possibility that we will get a few quarters of persistent outperformance by bank stocks after long-term interest rates make a sustained turn to the upside.

On a related matter, the relative performance of the banking sector (as indicated by the BKX/SPX ratio) is an input to my “true fundamentals” models for both the US stock market and the gold market. However, when the input is bullish for one of these markets it is bearish for the other. In particular, relative weakness in the banking sector is considered to be bullish for gold and bearish for general equities.

Until recently the BKX/SPX input was bullish in my gold model and bearish in my equity model, but there was enough relative strength in the banking sector during the first half of September to flip the BKX/SPX input from gold-bullish to equity-bullish. As a consequence, during the second week of September there was a shift from bullish to bearish in my Gold True Fundamentals Model (GTFM). This shift is illustrated on the following weekly chart by the blue line’s recent dip below 50.

The upshot is that the fundamental backdrop, which was supportive for gold from the beginning of this year through to early-September, is now slightly gold-bearish. My guess is that it will return to gold-bullish territory within the next two months, but in situations like this it is better to base decisions on real-time information than on what might happen in the future.

The relationship between short-term market interest rates and the interest rates set by the Fed is a complicated one. The market makes predictions about what the Fed is going to do and moves in anticipation, but at the same time the Fed’s interest-rate settings are influenced by what’s happening to market interest rates. Also, market interest rates are determined by factors other than what the Fed is doing or expected to do to its official rate targets, and as a result there are times when the market and the Fed seem to be at odds with each other.

At the moment there is no doubt that the market is leading the Fed. In particular, the Fed has been swayed towards rate cutting partly by the fact that the market has discounted rate cuts. This can be established by comparing recent movements in market interest rates with changes in the Fed’s interest rate targets, which I’ll get to shortly. It can also be established by referring to the Fed’s own statements. For example, the minutes of the July FOMC meeting included the following assessment:

“Participants observed that current financial conditions appeared to be premised importantly on expectations that the Federal Reserve would ease policy to help offset the drag on economic growth stemming from the weaker global outlook and uncertainties associated with international trade as well as to provide some insurance to address various downside risks.”

In essence, the Fed has admitted here to being worried that if it doesn’t cut rates like the market expects then financial conditions could get a lot worse. The implication is that if the market expects the Fed to cut rates, then to avoid disappointing the market (and risking the deterioration of financial conditions) the Fed will cut rates.

I mentioned above that the market’s current leadership can be established by comparing recent movements in market interest rates with changes in the Fed’s interest rate targets. Displayed below is a chart that makes this case. The chart shows the performance of the 2-year Treasury yield and indicates the last two interest-rate changes made by the Fed. Notice that:

1) The 2-year market interest rate began trending downward in early-November of 2018.

2) The Fed made its last rate hike during the second half of December 2018, that is, the Fed was still in rate-hiking mode six weeks after a short-term market interest rate began trending downward.

3) The Fed made its first rate cut at the end of July 2019. By that time, the 2-year market interest rate had been trending downward for almost 9 months.

It’s reasonable to assume that additional Fed rate cuts are on the way. Bear in mind, however, that a few additional rate cuts have already been factored into market prices, so market prices won’t necessarily respond in the obvious way to future Fed rate cuts. Also bear in mind that market interest rates probably will begin trending upward while the Fed and other central banks are still in rate-cutting mode.

The euro may well gain in value relative to the US$ over the next 12 months, but three differences between the monetary systems of the US and the euro-zone guarantee that the euro will collapse (cease being a useful medium of exchange) before the US$ collapses.

The first difference is to do with the euro-zone system being an attempt to impose common monetary policy across economically and politically disparate countries. This is a problem. A central planning agency imposing monetary policy within a single country is bad enough because it generates false price signals and in so doing reduces the rate of economic progress. However, when monetary policy (the combination of interest-rate and money-supply manipulations) is implemented across several economically-diverse countries the resulting imbalances grow and become troublesome more quickly.

As an aside, money is supposed to be a medium of exchange and a yardstick, not a tool for economic manipulation. Therefore, it is inherently no more problematic for different countries to use a common currency than it is for different countries to use common measures of length or weight. On the contrary, a common currency makes international trading and investing more efficient. For example, there were long periods in the past when gold was used simultaneously and successfully as money by many different countries. However, if a currency can be created out of nothing then there is no getting around the requirement to have an institution that oversees/manages it. The euro therefore could not be ‘fixed’ by simply eliminating the ECB. The ECB and the one-size-fits-all monetary policy it imposes are indispensable parts of the euro-zone system.

The second difference is linked to the concept that a government with a captive central bank cannot become insolvent with respect to obligations in its own currency. For example, due to the existence of the Fed the US government will always have access to as much money as it needs to meet its obligations, regardless of how much debt it racks up. Putting it another way, should all other demand for Treasury debt disappear the Fed will still be there to monetise whatever amount of debt the US government issues. Consequently, the US government will never be forced to directly default on its debt.

It’s a different story in the euro-zone, however, because the ECB is not beholden to any one government. The provision of ECB financial support to one euro-zone government therefore requires the acquiescence of other governments. This hasn’t been a stumbling block to date and the ECB has provided whatever support was needed to prevent financially-stressed euro-zone governments from directly defaulting on their debts, but eventually a point will be reached when the governments of some countries balk at their interest rates and money being distorted as part of an effort to prop-up the finances of other governments. At that point there will be direct default on euro-zone government debt or the disintegration of the monetary union.

Once it becomes clear that direct default on government debt is a risk to be reckoned with, ‘capital’ will flee the euro-zone at a rapid rate. This is because the main (only?) reason to own government bonds is that they are supposedly risk free.

The third critical difference between the US and euro-zone monetary systems is similar to the second difference. In the US there is a symbiotic relationship between the Fed and the government, with one institution always prepared to support the other in a time of crisis. One consequence of this relationship is the impossibility — as discussed above — of the US government ever being forced to directly default on its debt. Another consequence is the impossibility of the Fed ever becoming bankrupt.

Several years ago there was much speculation that the Fed would go broke due to large losses on the bonds it was buying in its QE operations, but this speculation was never well-informed. Up until now the Fed has made out like the bandit it is on its ‘investments’ in Treasury and mortgage-backed securities, but even if these securities had collapsed in value it would not have resulted in the Fed going bust. It simply would have led to a line being added to the Fed’s balance sheet to keep the books in balance.

Again, though, it’s a different story in the euro-zone. Should the ECB begin to incur large losses on its bond portfolio there is no certainty that it would be able to keep going about its business as usual. To do so would require the support of governments/countries that never benefited from and never whole-heartedly agreed with the programs that led to the pile-up of low-quality bonds on the ECB’s balance sheet.

Summing up, the US monetary system is problematic in that it gets in the way of economic progress, but it is much less fragile than the euro-zone monetary system. That’s why the euro-zone system will be the first to collapse.

[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.

[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.

I haven’t discussed gold’s true fundamentals* at the TSI Blog since early December of last year, at which time I concluded: “All things considered, for the first time in many months the true fundamentals appear to be slightly in gold’s favour. If the recent trend in the fundamental situation continues then we should see the gold price return to the $1300s early next year…” The “recent trend in the fundamental situation” did continue, enabling my Gold True Fundamentals Model (GTFM) to turn bullish at the beginning of this year (after spending almost all of 2018 in bearish territory) and paving the way for the US$ gold price to move up to the $1300s.

The following weekly chart shows that after moving slightly into the bullish zone (above 50) at the beginning of January, the GTFM has flat-lined (the GTFM is the blue line on the chart, the US$ gold price is the red line). Based on the current positions of the Model’s seven inputs, its next move is more likely to be further into bullish territory than a drop back into bearish territory.

As an aside, the bullish fundamental backdrop does not preclude some additional corrective activity in the near future.

The most important GTFM input that is yet to turn bullish is the yield curve, as indicated by the 10year-2year yield spread or the 10year-3month yield spread. 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.

The US$ gold price could rise to the $1400s during the second quarter of this year as part of an intermediate-term rally, but to get a gold bull market there probably will have to be a sustained trend reversal in the yield curve.

*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.

[This blog post is a modified excerpt from a TSI commentary published about a month ago]

Modern Monetary Theory, or MMT for short, is gaining popularity in the US. It is based on the idea that under the current monetary system the government doesn’t have to borrow. Instead, it simply can print all the money it needs to fill the gap between its spending and its income. The only limitation is “inflation”. As long as “inflation” is not a problem the government can spend — using newly-created money to finance any deficit — as much as required to ensure that almost everyone is gainfully employed and to provide all desired services and infrastructure. It sounds great! Why hasn’t anyone come up with such an effective and easy-to-implement prosperity scheme in the past?

Of course it has been tried in the past. It has been tried countless times over literally thousands of years. The fact is that there is nothing modern about Modern Monetary Theory. It is just another version of the same old attempt to get something for nothing.

Most recently, MMT was put into effect in Venezuela. For all intents and purposes, the government of Venezuela printed whatever money it needed to pay for the extensive ‘free’ social services it promised to the country’s citizens. The MMT apologists undoubtedly would argue that the money-printing experiment didn’t work in Venezuela because the government didn’t pay attention to the “inflation” rate. It kept on printing money at a rapid pace after “inflation” became a problem. Our retort would be: “Great point! Who would have thought that a government with the power to print money couldn’t be trusted to stop printing as soon as an index of prices moved above an arbitrary level.”

In essence, MMT is based on the fiction that the government can facilitate an increase in overall economic well-being by exchanging nothing (money created ‘out of thin air’) for something, or by enabling the recipients of the government’s largesse to exchange nothing for something. It is total nonsense, although there is an obvious reason that it appeals to certain politicians. Its appeal to the political class is that it superficially provides an easy answer to the question that arises when politicians promise widespread access to valuable services free of charge. The question is: “Who will pay?” According to MMT, nobody pays until/unless “inflation” gets too high.

And what happens when inflation gets too high? Well, according to MMT the government simply ramps up direct taxation to reduce the spending power of the private sector, which supposedly quells the upward pressure on prices.

Therefore, MMT can be viewed as a case of heads the government wins, tails the private sector loses. As long as “inflation” is below an arbitrary level the government can extract whatever wealth it wants from the private sector indirectly by printing money, and if “inflation” gets too high the government can extract whatever wealth it wants from the private sector via direct taxation.

The crux of the issue is that new wealth can’t be created by printing money, but existing wealth will be redistributed. It’s like when a private counterfeiter prints new money for himself. When he spends that money he diverts real wealth to himself while contributing nothing to the economy. MMT is the same principle applied on a gigantic scale.

That being said, MMT does have its good points, just not the good points that its proponents claim.

As happens when money is loaned into existence under the current system, the application of MMT will affect relative prices as well as the so-called “general price level”. The reason is that the new money won’t be injected uniformly across the economy. However, it’s likely that the price increases stemming from the monetary inflation will be more uniform and direct under MMT than under the current system. In other words, under MMT the effects of monetary inflation should be reflected much sooner and to a far greater extent in the CPI than is the case with the current system.

That the application of MMT would lead quickly to what most people think of as “inflation” is a benefit, because the link between cause (monetary inflation) and effect (rising prices) would be obvious to almost everyone. A related benefit is that MMT would short-circuit the boom-bust cycle.

Booms happen when the Fractional Reserve Banking (FRB) system (with or without a central bank) expands credit and in doing so creates the impression that the quantity of real savings is much greater than is actually so. This prompts excessive investment in long-term business ventures that would not look viable in the absence of misleading interest-rate signals.

We assume that under MMT the commercial banks still would be lending new money into existence, but the temporary downward pressure on interest rates from the surreptitious money creation of the banks would be more than offset by the upward pressure on interest rates from the blatant money-printing of the government. The boom phase therefore would be very short, perhaps even barely noticeable. In effect, MMT would bypass the boom and go straight to the bust. Again, this would be beneficial because it would expose the link between cause (the application of a crackpot monetary theory) and effect (economic hardship for most people).

MMT is such an obviously silly idea that any economist, politician, journalist or financial-market commentator who advocates it should not be taken seriously. However, that they are being taken seriously opens up the possibility that MMT will be implemented in the not-too-distant future, with the ‘benefits’ outlined above.