All Roads Lead to Inflation
Late last Friday, the Treasury Department released its latest Monthly Treasury Statement. As of the end of September, gross interest on US debt has now reached $1.133 trillion for fiscal 2024, almost 30% higher than the $879 billion in gross interest expense just one year ago. The government’s interest expense has now surpassed spending on Income Security, Health, Veterans Benefits, Medicare, and most recently Defense spending. Interest on debt is now the second biggest outlay of the US government, second only to Social Security, which is roughly $1.5 trillion per year. Critically, the interest expense is on pace to close out calendar year 2024 at $1.3 trillion and then overtake Social Security spending as the government’s largest single outlay in 2025.
This week, according to Bloomberg, U.S. Treasury Secretary Yellen said that “fiscal deficit reduction is required over the coming years,” and added that “bringing deficits under control will help ensure demand for U.S. debt.” Yellen’s comments seem to acknowledge a key point. The bond market, under the weight of current debt and deficits, is strained. Furthermore, Yellen’s comments underscore the notion that the ability to foster sufficient ongoing demand for the amount of U.S. debt needed to finance the government is a rapidly mounting clear and present concern.
This week, Yellen seemed to be echoing what former Director of Columbia Business School Program for Financial Studies Charles Calomiris told CNBC a year ago. In October of 2023, Calomiris warned that, “what’s absolutely agreed upon [is that] if we don’t do something about the cumulative deficits that are being forecasted… [it] will lead to some sort of convulsion in the bond market followed by a very big increase in inflation.”
Should spending cuts be made, the only government spending line items big enough to matter for meaningful deficit reduction are Entitlements, Interest Expense, and Defense spending. Material cuts to entitlements or Defense spending, however, seem incredibly unlikely at this point.
As former Fed Chair Alan Greenspan said in 2015 at a Peterson Institute Fiscal Summit regarding potential entitlement cuts, “The term Social Security ‘Trust Fund’ is nonsense… it is a mandatory outlay and there is a 0% chance that outlay will not get made. When the fund runs out, there is no chance anything will change. The US has committed to pensions it cannot pay… We’re not getting like Greece, we’re getting like Illinois.” In other words, according to the former Fed Chair, we are so far from possible entitlement cuts to reduce the deficit that even when the “trust fund” runs out, the U.S. will go so far as to print the obligations rather than default. As Greenspan pointed out in a 2005 testimony to Congress, the inflationary implications are stark: “We can guarantee cash benefits as far out and at whatever size you like, but we cannot guarantee their purchasing power.”
As for the likelihood of Defense spending cuts, consider the implications of findings by the Commission on the National Defense Strategy. In July of this year, the Commission warned that:
“The threats the United States faces are the most serious and most challenging the nation has encountered since 1945 and include the potential for near-term major war. The United States last fought a global conflict during World War II, which ended nearly 80 years ago. The nation was last prepared for such a fight during the Cold War, which ended 35 years ago. It is not prepared today… The Commission finds that the U.S. defense industrial base (DIB) is unable to meet the equipment, technology, and munitions needs of the United States and its allies and partners. A protracted conflict, especially in multiple theaters, would require much greater capacity to produce, maintain, and replenish weapons and munitions. Addressing the shortfall will require increased investment, additional manufacturing and development capacity, joint and coproduction with allies, and additional flexibility in acquisition systems.”
Based on those findings by the Commission on the National Defense Strategy, HAI isn’t expecting cuts to Defense spending any time soon, rather HAI expects Defense spending increases.
So, where will Yellen’s much needed deficit cuts materialize? By default, HAI expects policymakers will zero in on significant Fed rate cuts to meaningfully reduce the Treasury Department’s interest expenses – despite the inflationary implications of those rate cuts.
So, it seems, take your pick, significant inflationary rate cuts, despite the fact that inflation is already well above target, or extremely inflationary money printing to finance deficits once the bond market has, as Calomiris described, “some sort of convolution.”
This week on CNBC, reflecting on the current fiscal and monetary policy powder keg in Washington D.C., hedge fund legend Paul Tudor Jones warned that “the playbook to get out of this is to inflate your way out… I think all roads lead to inflation. I’m long gold…” HAI couldn’t agree more.
Importantly though, even if the western investor consensus is still playing by the old rules, the rest of the world seems to grasp Washington’s predicament and also seems to grasp the inflationary writing on the wall. The combination of expected inflationary dollar debasement and the realization of a weaponized dollar following sanctions on Russian FX reserves post-Ukraine invasion have created the most pronounced global de-dollarization campaign since Nixon ended U.S. dollar to gold convertibility in 1971.
In the Financial Times this week, highly respected mainstream economist Mohammed El-Erian highlighted the consequential issues surrounding global de-dollarization in an article titled “Why the west should be paying more attention to the gold price rise.” In the op-ed, El Erian wrote:
“Something strange has happened to the price of gold over the past year. In setting one record level after the other, it seems to have decoupled from its traditional historical influencers, such as interest rates, inflation and the dollar. Moreover, the consistency of its rise stands in contrast to fluctuations in pivotal geopolitical situations.
“What is at stake here is not just the erosion of the dollar’s dominant role but also a gradual change in the operation of the global system. No other currency or payment system is able and willing to displace the dollar at the core of the system, and there is a practical limit to reserve diversification. But an increasing number of little pipes are being built to go around this core; and a growing number of countries are interested and increasingly involved.
“What has been happening to the gold price is not just unusual in terms of traditional economic and financial influences. It also goes beyond strict geopolitical influences to capture a broader phenomenon which is building secular momentum.
“As it develops deeper roots, this risks materially fragmenting the global system and eroding the international influence of the dollar and the US financial system. That would have an impact on the US’s ability to inform and influence outcomes, and undermine its national security. It is a phenomenon that western governments should pay more attention to.”
In HAI’s view, the Fed is now cornered, and we are likely only a few short quarters, or maybe a few even shorter months, away from western investor consensus fully realizing that when it comes to the historical norms of fiscal and monetary policy, we’ve “jumped the shark” on the post-Bretton Woods dollar based global financial “petrodollar” system and are no longer in policy-Kansas anymore.
As Russian President Putin said, ahead of the game, in June of 2022, U.S. dollar “reserves are devalued at an annual rate of about eight percent. Moreover, they can be confiscated or stolen any time if the United States dislikes something in the policy of the states involved… A conversion of global reserves will begin… They will be converted from weakening currencies into real resources like food, energy commodities, and other raw materials. Other countries will be doing this, of course. Obviously, this process will further fuel global dollar inflation.”
Again, even if the western investor is behind the curve, the dollar rebellion is alive abroad. Also in 2022, the head of Russia’s state energy giant Gazprom, Alexey Miller, told the BBC that “The world economy is experiencing a global tectonic shift, with commodities becoming more valuable than money, from now on it is a case of ‘our product, our rules.’” Miller continued, “The game of the nominal value of money is over, as this system does not allow to control the supply of resources. Our product, our rules. We don’t play by the rules we didn’t create.”
In HAI’s view, a wake-up call to the western investor is imminent, and it’s set to be a smelling-salts moment for the ages that’s very likely to supercharge the recently-renewed western interest in gold and hard assets more broadly.
The move higher in the price of gold is real. In HAI’s view, it has far more legs than western financial consensus presently grasps. That said, recent comments from Fed officials, Jeff Currie, Mohammed El-Erian, Paul Tutor Jones, and Treasury Secretary Janet Yellen herself all suggest that the West is beginning to wake up. As the West overly abuses the old dollar-based financial system, the new reality is “our product, our rules. We don’t play by the rules we didn’t create.” In the new rules, gold is the neutral reserve asset of choice. Regardless of the fact that the gold price has already gained appreciably in the last year, until western consensus understands the new rules and has reallocated significant amounts of capital accordingly, the yellow metal remains the top buy to position for the new paradigm already underway.
Weekly performance: The S&P 500 was down 0.96%. Gold was up 0.90%, silver was up by 1.64%. Platinum was up 1.19%, and palladium surged 10.86%. The HUI gold miners index lost 3.92%. The IFRA iShares US Infrastructure ETF lost 2.44%. Energy commodities were volatile and higher on the week. WTI crude oil was up 4.50%, while natural gas surged by 36.94%. The CRB Commodity Index was up 1.84%. Copper lost 0.32%. The Dow Jones US Specialty Real Estate Investment Trust Index lost 0.78%. The Vanguard Utilities ETF was off 1.91%. The dollar index was up 0.80% to close the week at 104.13. The yield on the 10-yr U.S. Treasury was up 16 bps to close at 4.24%.
Have a wonderful weekend!
Best Regards,
Morgan Lewis
Investment Strategist & Co-Portfolio Manager
MWM LLC
