Not Exactly Easy Sledding – April 14, 2023

Not Exactly Easy Sledding – April 14, 2023
Morgan Lewis Posted on April 15, 2023

Famed Austrian economist Ludwig Von Mises warned that the Keynesian means of delivering “apparent prosperity” was inherently unsustainable. The unsustainable pitfalls of modern monetary policy? If adhered to long enough, they eventually create a terminal dependance that requires endless credit expansion, endless debt accumulation, endless money creation, and the endless suppression of interest rates to keep the engine of Ponzi finance running. 

The Achilles heel is that these conditions all lead to inflation, and inevitably undermine the quality of both the sovereign’s debt and that of its currency. This situation’s inevitable end can be devastating for an individual country that engages in these policies. Even more serious, when inflation as policy is adopted by the country issuing the global reserve currency and the top global reserve asset (Treasurys), the unsustainable policies become every nation’s problem. Indeed, as former US Treasury Secretary John Connolly once proclaimed to a group of European finance ministers, “The dollar is our currency, but it’s your problem.”

In 1981 a Minneapolis Fed white paper observed that once Federal debt gets so high that lower interest rates are required to both service the debt and keep economic growth positive, the Central Bank’s ability to control inflation becomes compromised. According to the Minneapolis Fed of yesteryear, “If the fiscal authority’s deficits cannot be financed solely by new bond sales, then the monetary authority is forced to create money and tolerate additional inflation.” The paper continued, “suppose that the [weak] demand for government bonds implies [necessitates] an interest rate on bonds greater than the economy’s rate of growth [in order to attract needed buyers]. Then, if the fiscal authority runs deficits, the monetary authority is unable to control either the growth rate of the monetary base or inflation forever.” The essential point made by the Minneapolis Fed is that eventually a government with high enough debt and deficits is “unable” to apply monetary policy freely enough to effectively control inflation. In such an instance, the monetary authority (the Fed) is compromised.

This 1981 Minneapolis Fed observation is more than a little relevant to our modern moment and the Fed’s current predicament. The US hasn’t run a federal surplus since 2001, the four-month average US growth rate is 1% and down trending, and the yield on the US 10-yr Treasury as of Friday is 3.52% while the US 2-year Treasury yields 4.10%. In other words, according to the Minneapolis Fed’s criteria, our monetary policy is constrained and compromised, and the US no longer controls its own fate on inflation. The amount of debt and deficits means that the US cannot afford the positive real interest rates needed to take inflation back down to the Fed’s target “unconditionally” without incurring dire consequences. Instead, on the inflation front, the Fed must now rely on a recession, some serious good luck, or other external factors out of its control to help (at least temporarily) stabilize the rapid decrease of dollar purchasing power.

This week, the Consumer Price Index (CPI) indicated that inflation is showing some signs of easing in the US. Wednesday’s March headline CPI reading increased by 0.1% month-over-month (M/M) and was less than the 0.2% expected. Year-over-year (Y/Y), headline CPI came in at 5% vs 5.1% expected, and was down from last month’s 6% read. On the other hand, core CPI, excluding volatile food and energy, increased 0.4% M/M as expected. The Y/Y increase measured 5.6%, slightly higher than last month’s 5.5%. An outsized decline in the energy component was the outstanding disinflationary contributor to the headline CPI.

Responding to the CPI release, Richmond Fed President Thomas Barkin said, “I put particular focus on the core… And you know, we had some good news on energy, but there’s still more to do, I think, to get core inflation back down to where we’d like it to be.” As Mr. Barkin said, there was some “good news on energy” in the report. Unfortunately, however, since March, there’s been bad news on energy and commodity prices in general that aren’t going to help CPI going forward. The surprise decision by OPEC+ last week to cut oil production by a further 1.16 million barrels per day has already sent WTI crude prices significantly higher. Since the late March lows, prices have already rallied from the low $60s to the low $80s, boosting gasoline prices by 10%.

Meanwhile, Chile, which accounts for a quarter of the world’s mined copper and is the globe’s biggest producer, just announced that in March the country posted its lowest monthly production in six years. After that announcement, massive state-owned Codelco said its 2022 output problems will only worsen in 2023. The company is struggling to tap new areas of its aging deposits after decades of underinvestment. Even before the disappointing March production news and poor Codelco outlook, Goldman Sachs had already projected global copper stockpiles to be fully depleted by August. Without an offsetting recessionary hit to global demand, the increasingly bleak copper supply outlook and OPEC+ oil production cuts serve only to keep prices elevated and goods inflation pressures alive.

Also potentially adding fuel to the inflationary fire, data revealed this week that China is engaged in an aggressive round of stimulus. The country now looks all-in on throwing every bit of government stimulus at reflating its flatlined economy. “If the trend in credit growth extends into April and May, it would translate into significant support for the economy’s recovery through investment financing,” Raymond Yeung, Chief Economist, Greater China at Australia & New Zealand Banking Group, told Bloomberg. If China stimulus persists and gains economic traction, the added demand on tight global commodity markets could further reignite prices and be a nightmare for Western nations trapped in the inflation fight.

In addition, external factors and global dynamics do not look likely, over a long time frame, to help control inflation. Unlike the last several disinflationary decades, today, deglobalization, geopolitical fracturing, war, reshoring/friend-shoring of supply chains, resource nationalism, and tight commodity supplies combined with chronic underinvestment mean that the secular winds have, on balance, turned inflationary.

So if on the inflation front the Fed must now rely on a recession, good luck, or external factors for continued further progress towards the 2% target, and, as it now appears, good luck and external factors aren’t looking promising, then what of recession? This week offered additional important recessionary data points on the credit contraction story. According to a Monday report from the New York Fed, the share of American households that said credit is now harder to get versus a year ago rose to the highest level ever in survey data stretching back to 2014. The survey also found that, “respondents were more pessimistic about future credit availability as well,” as households expecting tougher credit conditions a year from now also jumped. 

Singing the same recessionary tune was the National Federation of Small Business survey of small businesses. The NFIB said that of small business owners who “borrowed frequently,” the number saying financing was harder to acquire than three months ago spiked to the highest level since 2012. The monthly deterioration in the series was the worst in 20 years. Furthermore, in the NFIB survey, the number of businesses that said now was a good time to expand plummeted to the lowest level since 1980. Recall that in our modern financial system, if credit freezes, so too does the economy—full stop. Amazingly, the recessionary writing is sketched clearly enough on the wall that this week the Fed admitted as much. After initial Fed expectations for a “soft landing” turned to a “soft-ish landing” in this week’s Fed minutes release, the committee again downgraded the expected comfort of the landing to “mild recession” later in the year. Perhaps the next update will include that the committee inadvertently forgot to even lower the landing gear.

Now, let’s pull back our scope and widen the lens to include the implications of the fact that, by the standards of the 1981 Minneapolis Fed white paper, the present Fed is fatally compromised in its ability to effectively fight inflation. When recession begins, the decline in GDP and resulting decline in tax receipts will trigger an accelerated debt doom loop. That will result in an even bigger debt and deficits problem. The emergence of an ensuing acute sovereign debt crisis would further destabilize global currency and bond markets to a dysfunctional state. For the sake of the system, policy makers would need to aggressively pivot back to inflationary policy. In such an instance, the only trick up policy makers’ sleeve is to again cut interest rates significantly and print the money to both stimulate the economy and finance the deficits. Put plainly, this doom loop just gets worse. Unless the decision is made to pull the plug, default on the debt, and let the system fail before restarting with new policy, the sovereign is left with little alternative than the path of inflation. Indeed, the US fiscal and monetary authorities have reached the compromised state described decades ago by the Minneapolis Fed.

Of critical importance, the excessive fiscal and monetary mismanagement by the US as issuer of both the global reserve currency and top global reserve asset, along with the US’s increased willingness to weaponize the dollar, are invoking the ire of a growing number of foreign nations. As it becomes increasingly clear that the US is likely trapped on the path of inflation, nations hijacked by the mismanaged dollar system are aware that they are holding their national wealth reserves in US Treasurys that are bleeding value with negative real (inflation adjusted) yields. Given such a proposition, it’s understandable that more nations are interested in diversifying reserves, including into traditional hard asset inflation hedges that act as a neutral store of value. It’s even less surprising when those neutral assets can’t be weaponized by the US government the way dollar reserves can.

At least two clear implications present themselves. The first is that gold is a particularly attractive competing potential reserve asset to Treasurys as a neutral store of value and as the prime inflation hedge, but also as a means of net settlement for multi-currency commodity trading. The second is that resource nationalism likely increases and that, at least on the margin, the foreign production, trade, and flows of highly valued critical natural resources in exchange for depreciating dollars and negative real yielding Treasurys is likely to be somewhat reduced. That’s an outcome that’s both an economic drag and inflationary for the more dollar-centric nations of the West.

In fact, we are already seeing this play out. Last week’s surprise OPEC+ production cuts and the preceding round of cuts in late 2022 were both made at higher oil prices than any cuts ever made previously. When oil prices are high, producers are incentivized to increase production as long as the medium of exchange is healthy. The last two cuts, however, came at Brent prices in the upper-$70s and mid-$80s. Previously OPEC production cuts had never been made at $70 or above, and most previous cuts came at much lower prices.

With the growing recognition that the Fed has reached the 1981 Minneapolis Fed’s “compromised moment,” foreign nations are increasingly incentivized and keen to find some modified version of the dollar reserve system. While there is no practical, obvious, or immediate alternative to the dollar as reserve currency at present, sovereign efforts to circumvent the dollar for a portion of their critical natural resource trades and diversify some national reserve assets outside of Treasurys is gaining steam.

As HAI has mentioned in the past, this is a slow burn issue. However, Credit Suisse analyst Zoltan Pozsar has championed this topic. He asserts that a limited de-dollarization is underway, and that a modified dollar reserve system is a building reality. The emerging system provides for greater multi-currency commodity trading with gold as net settlement. Such a system would certainly be positive for gold, which would increasingly compete with Treasurys as a global reserve asset.

In addition to Pozsar, this week former Treasury Secretary Larry Summers further validated much of the speculation over disgruntled foreign nations and marginal de-dollarization efforts. Speaking to Bloomberg, Summers warned of “troubling” signs that the US is losing global influence as other powers align and win favor among nations not yet aligned. “There’s a growing acceptance of fragmentation, and—maybe even more troubling—I think there’s a growing sense that ours may not be the best fragment to be associated with.” According to Summers, deepening links between the Middle East, Russia, China, and even Saudi Arabia and Iran are “a symbol of something that I think is a huge challenge for the United States.” The Treasury Secretary further observed that, “We are on the right side of history—with our commitment to democracy… But it’s looking a bit lonely on the right side of history… Those who seem much less on the right side of history are increasingly banding together in a whole range of structures.”

Summers concluded, “If the Bretton Woods system is not delivering strongly around the world, there are going to be serious challenges and proposed alternatives.” No doubt, these issues are partly responsible for recent strength in gold. HAI views that strength as another important secular trend.

Caught squarely between the Fed’s recessionary rock and its inflationary hard place, we carry on. Not exactly easy sledding for Powell and company.

Weekly performance: The S&P 500 was up 0.79%. Gold was down 0.52%, silver gained 1.47%, platinum was up 3.66%, and palladium gained 2.32%. The HUI gold miners index was up 0.68%. The IFRA iShares US Infrastructure ETF added 0.95%. Energy commodities were volatile and higher on the week. WTI crude oil gained 2.26%. Natural gas was up 5.12%. The CRB Commodity Index was up 1.56%, and copper gained 2.27%. The Dow Jones US Specialty Real Estate Investment Trust Index was down 1.34% on the week, while the Vanguard Utilities ETF was down 1.43%. The dollar was down 0.27% to close at 101.25. The yield on the 10-yr Treasury gained 22 bps to end the week at 3.52%.

Best Regards,

Morgan Lewis
Investment Strategist & Co-Portfolio Manager

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