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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The measuring stick is critical when determining whether an asset is in a bull market. If a measuring stick is losing value at a fast enough pace, then almost everything will appear to be in a bull market relative to it. For example, pretty much everything in the world has been rising in value rapidly over the past several years when measured in terms of the Venezuelan bolivar. It should be obvious, though, that not everything can be simultaneously in a bull market. To determine which assets/investments are in a bull market we can’t only go by performance relative to any national currency; we must also look at the performances of assets/investments relative to each other.

That’s where the gold/SPX ratio (the US$ gold price divided by the S&P500 Index) comes in handy. Gold and the world’s most important equity index are effectively at opposite ends of the ‘investment seesaw’. Due to their respective natures, if one is in a long-term bull market then the other must be in a long-term bear market. In multi-year periods when they are both trending upward in dollar terms it means that the dollar is in a powerful bear market, not that gold and the SPX are simultaneously in bull markets.

The following weekly chart removes the US$ from the equation and measures gold against its main competition (the SPX). The blue line on the chart is the 200-week MA. In the past, crosses through the 200-week MA by the gold/SPX ratio have been useful in confirming changes to gold’s long-term trend, although there were two false signals (October-1987 and March-2020) that resulted from stock market crashes.

The chart shows that the gold/SPX ratio recently broke below its 2018 low and is at its lowest level of the past 15 years. This implies that the gold bear market that began in 2011 has not ended.

Over the past 12 months a monetary-inflation-fuelled economic boom has been in full swing. This is not the sort of environment in which gold should perform well. On the contrary, gold tends to come into its own after a boom starts to unravel, that is, after a boom-to-bust transition gets underway. This could happen during the first half of next year.

The real interest rate is the nominal interest rate adjusted for the expected change in the associated currency’s purchasing power, where “expected” is the operative word. It is not the nominal interest rate adjusted for the currency’s loss of purchasing power over some prior period.

To further explain, when you buy an interest-bearing security the ‘real’ income that you receive will be determined by the future change in the currency’s purchasing power. For example, the real return from a note that matures in 12 months will be determined by the change in the currency’s purchasing power over the coming 12 months, not the change in the currency’s purchasing power over the preceding 12 months. Of course, when you buy the security you have no way of knowing what will happen to the currency’s purchasing power in the future, but your decision to buy will be based on the nominal yield offered by the security and what you EXPECT to happen to the currency. What happened to the purchasing power of the currency in the past is only relevant to the extent that it affects the expectations of investors.

Consequently, it is not appropriate to estimate the ‘real’ interest rate by subtracting a measure of historical purchasing power loss, such as the percentage change in the CPI over the last 12 months, from the current nominal yield. Doing so would result in a meaningless number even if the CPI were a valid indicator of purchasing-power loss.

A knock-on effect is that the numerous articles and reports that attempt to explain how the price of something responds to changes in the real interest rate, where the real interest rate is calculated by subtracting the change in the CPI over some prior period from the current nominal interest rate, can be put into the “not even wrong” category. They are nonsensical.

Just to be clear, the CPI and similar price indices are inherently flawed indicators of “inflation”, but even if they were good indicators of “inflation” it would make no sense to subtract the historical index change from the present-day nominal interest rate when attempting to estimate the ‘real’ return.

If the main concern is the effects of interest rates and “inflation” on the prices of assets, commodities and gold, then the numbers that matter are today’s nominal interest rates and inflation expectations. In the US these numbers are combined to generate the yields on Treasury Inflation Protected Securities (TIPS), in that the TIPS yield is the nominal yield minus the expected CPI. The TIPS yield is not an accurate indicator of the real interest rate in absolute terms, but it is an accurate indicator of the real interest-rate TREND and whether the real interest rate today is high or low relative to where it was in the past.

The following chart compares the 10-year TIPS yield with the US$ gold price. A negative correlation is apparent (the trend in the TIPS yield is often the opposite of the trend in the gold price), especially since 2007. The negative correlation doesn’t always apply, though, because the gold price is not determined solely by the real interest rate. There are several other fundamental influences, including credit spreads and the yield curve (the TIPS yield is just one of seven inputs to our Gold True Fundamentals Model).

Treasury Inflation Protected Securities were first issued in 1997 and the Fed’s data used in the above chart doesn’t go back further than 2003, so the TIPS market can’t tell us what happened to real interest rates in the 1970s and 1980s. However, the non-availability of a valid number or methodology is not a good reason to use a bogus number or methodology.

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

There are two things that always happen at or prior to the start of a boom-to-bust transition* for the US economy. One is a clear-cut widening of credit spreads. The other is pronounced weakness in the Industrial Metals Index (GYX) relative to the gold price. These indicators have been known to generate false positives, meaning that there have been times when they have warned incorrectly that a bust was about to begin. However, as far as we can tell they have never generated a false negative, that is, they have never failed to signal an actual boom-to-bust transition in a timely manner.

There are many different credit-spread indicators. We use three, one of which is the US High Yield Index Option-Adjusted Spread (HYIOAS). As illustrated below, over the past month this indicator has risen slightly from a 10-year low. This means that credit spreads in the US are close to their narrowest levels of the past ten years.

After the HYIOAS has dropped well below 4%, a reversal is signalled by the index making a higher short-term high AND moving back above 4%. At the moment, the first of these criteria would be triggered by a move above 3.5%.

Turning to the second of the reliable boom-bust indicators mentioned above, displayed below is a weekly chart of the GYX/gold ratio. To generate a boom-to-bust warning the line on this chart would have to reverse downward and move below its 50-week moving average. Given that it made a new 2-year high last week it is a long way from doing this.

Summing up, neither of the indicators that in the past have always warned prior to the start of a boom-to-bust transition for the US economy is currently close to triggering. However, within a boom there will be ebbs and flows in economic growth and confidence. Economic growth and confidence have declined a little over the past two months and it’s possible that the decline will become more pronounced over the coming two months, all within the context of a boom that currently shows no signs of ending.

*A boom is defined as a period lasting 2-3 years or longer during which monetary inflation creates the illusion of robust economic progress. A bust is a period usually lasting 1-3 years during which the mal-investments of the boom are liquidated, leading to general economic hardship. Bust periods sometimes, but not always, contain official recessions.

[This blog post is an excerpt from a report recently published at TSI]

The spectacular rise in the money supply growth rate that began in March of last year predictably led to an equally spectacular decline after the effects of the central banking world’s initial frenzied response to the ‘coronacrisis’ dropped out of the year-over-year calculations. Displayed below are charts showing the spectacular declines over the past few months in the monetary inflation rates of the US, the euro-zone and the G2 (the US plus the euro-zone).

Note that the steep declines probably will continue for one more month, after which the year-over-year growth rates should level out. Also note that the vertical red lines on the G2 monetary inflation chart indicate the starting times of US recessions.

As mentioned in previous TSI commentaries, the monetary backdrop will stop being supportive for the US stock market after the annual TMS growth rate drops below 6%. This could happen as soon as the first quarter of next year, but a lot will depend on commercial bank lending. For example, if commercial banks ramp-up their lending then the US monetary inflation rate could stay in the 7%-10% range for a long time even if the Fed ‘tapers’. Something along these lines happened during 2014-2016.

The monetary situation in China is very different. As illustrated by the following chart, the year-over-year growth rate of China’s M1 money supply is close to a multi-decade low.

All else remaining the same, the relatively small amount of monetary inflation in China over the past 16 months would pave the way for China’s economy to be relatively strong over the next few years. However, all else isn’t remaining the same, in that the Communist Party of China (that is, Xi Jinping) is becoming increasingly dictatorial and heavy-handed in its dealings with the private sector.

We’ve written previously that the H1-2021 global monetary inflation reversal probably won’t be a major driver of prices over the balance of this year. This is due to the time it takes for a change in the money-supply growth trend to ‘ripple through’ the financial markets and the economy. However, unless the Fed and the ECB generate a new monetary tsunami over the next several months, the G2 monetary inflation rate could become low enough by early next year to set off a boom-to-bust transition.

[This is a modified excerpt from a commentary published at TSI on 18th July 2021]

One of the most useful intermediate-term indicators of the financial/economic landscape is the performance of industrial metals relative to gold as indicated by the GYX/gold ratio. This ratio turns down prior to financial crises and major economic slowdowns and turns up in the early stages of recoveries. It occasionally makes a ‘head fake’ move, but over the 25 years of its history it has never failed to reverse course in a timely manner.

With reference to the following weekly chart, we define “reverse course” to mean cross from above to below or below to above the 50-week MA (the blue line). For example, GYX/gold turned down ahead of the 1998 Russian/LTCM crisis, the 2001-2002 recession and equity bear market, the 2007-2009 Global Financial Crisis, the 2011-2012 European debt crisis, the 2015 Yuan-devaluation panic, and the Q4-2018 stock market panic that forced the Fed to do an about-face. Note that after turning down ahead of the Q4-2018 panic it didn’t turn back up until the great reflation trade got underway in Q2-2020.

As an aside, ratios that use gold would not be such reliable indicators of important economic and financial-market trends if the gold price were distorted in a big way by manipulation.

Currently there are signs in the equity, bond, commodity and currency markets that a shift away from risk is underway. These signs actually began to appear in March and became more pronounced over the past few weeks. For example, we have been fixating on the ratio of the Russell2000 Small-Cap ETF (IWM) to the S&P500 Large-Cap ETF (SPY), which peaked in March and broke out to the downside early this month. With the early-July downside breakout, this indicator changed from a ‘yellow flag’ to a ‘red flag’ as far as the stock market’s short-term prospects were concerned.

However, there is no evidence in the performance of the GYX/gold ratio that we are dealing with anything more serious than corrections to the major trends that got underway during the second quarter of last year. At least, there isn’t yet.

It’s possible that such evidence will emerge over the months ahead, so we must pay attention to new data and not blindly assume that the future will be a simple extrapolation of the past.

We asked and answered the above trick question in a blog post on 22nd March. It’s a trick question because although rising interest rates put downward pressure on some stock market sectors during some periods, they are never the primary cause of major, broad-based stock market declines. After all, the secular equity bull market that began in the early-to-mid 1940s and ended in the mid-to-late 1960s unfolded in parallel with a rising interest-rate trend, and the preceding secular equity bear market unfolded in parallel with a declining interest-rate trend.

As explained in the above-linked post from March-2021, when assessing the prospects of the stock market we should be more concerned about monetary conditions than interest rates. The reason, in a nutshell, is that it isn’t always the case that rising interest rates indicate tightening monetary conditions or that falling interest rates indicate loosening monetary conditions. For example, there was a substantial tightening of monetary conditions in parallel with falling interest rates during 2007-2008.

When attempting to determine the extent to which monetary conditions are tight or loose, one of the most important indicators is the growth rate of the money supply itself.

Rapidly inflating the money supply leads to a period of unsustainable economic vigour called a boom, while a subsequent slowing of the monetary inflation rate leads to a transition from boom to bust. Furthermore, once a boom has been set in motion a subsequent unravelling that eliminates all or most of the superficial progress becomes inevitable. The unravelling can be delayed by maintaining a fast pace of money-supply growth, but doing so will have the effect of making the eventual bust more severe.

Over the past 25 years, booms have begun to unravel within 12 months of the year-over-year growth rate of G2 (US plus eurozone) True Money Supply (TMS) dropping below 6%. In the typical sequence there is a decline in the G2 monetary inflation rate to below 6%, followed within 12 months by the start of an economic bust (the unravelling of the monetary-inflation-fuelled boom), followed within 12 months by an official recession. Usually, the broad stock market begins to struggle from the time the boom starts to unravel, that is, from the time the G2 monetary inflation rate drops below 6%.

In the above-linked post from March-2021, we concluded:

“…it’s likely that the unravelling of the current boom will begin with the monetary inflation rate at a higher level than in the past. However, with the G2 TMS growth rate well into all-time high territory and still trending upward it is too soon (to put it mildly) to start preparing for an equity bear market.”

It is still too soon to start preparing for an equity bear market (as opposed to a significant correction, which may well be on the cards), but the following chart of the G2 TMS growth rate shows that there has been a dramatic change over the past few months. Based on what has happened and what probably will happen on the monetary front, the conditions could be ripe for the next boom-to-bust transition to begin during the first half of next year.