4700 words (15 minutes)
It's very human to get seduced by concepts in your head that don't map to the limits or reality of how the physical world works. I seem to be less burdened by this phenomenon because the only things in my head are tumbleweeds and crickets. Recently, I promoted myself to chief economist at my house, and I hosted a symposium in my basement called Rages In The Cages. My announcement as keynote speaker was met with mockery and derision. A hater might describe the attendance at this inaugural event next to the laundry room as underwhelming. In fact, the only one who showed up was my five-pound yorkie who I tricked there with her favorite treat, and even she left during intermission when the bagpipes came out. Despite the profound lack of media coverage, I remain undeterred. What follows are the highlights from my speech "Monkeys Throw Turds."
This rise in CPI certainly had causes based in supply chain disruptions and the Putin oil spike, but it was at least half, and I'd argue more, due to the Covid Cash.
Inflation is only a monetary phenomenon and there are several reasons. When M2 increases it improves the balance sheets of individuals and businesses for as long as the money flows. When oil rises it hurts the balance sheets of individuals and businesses like a tax by consuming disposable income and compressing margins. CPI driven by money is potentially infinite in nature, as seen in hyperinflations where the nominal prices of everything spirals ever upwards. CPI driven by oil is finite in nature and causes an economic slowdown to restore balance when it hits the limits of balance sheets.
You can't compare the current inflation to the 1970s, which, despite its reputation of stagflation, was one of the strongest economies ever. Is there another decade that absorbed oil rising 10x while interest rates rose to 20% with only a couple brief recessions? If you take a median oil price over the last decade of $60 that would be like oil going to $600. The pain at $130 over the summer was palpable. The reason the 70s could absorb such a tax was because the underlying economy was driven by a decade of peak baby boomer borrowing, which was the inflation that subsided as the bulge of boomers tapered off. There was also less indebtedness so balance sheets were able to absorb the expense. Our current inflation is an unprecedented one-off Covid stimulus package with nothing in its wake. Technically, we've been in a structural inflation for 100 years, but CPI measures the rate of change. This is not to say a structural oil deficit doesn't have investing implications.
The current inflation is not the result of the Fed repressing interest rates and doing QE for a decade, which is a symptom, not the cause. Interest rates were low because the economy was weak due to globalization stripping away our manufacturing base and overall risk aversion post GFC, so the Fed inflated asset bubbles with only a minor effect on CPI from a weak wealth effect because reserves don't end up in the hands of consumers. The US has been in a stealth depression since the turn of the century as globalization kicked into high gear. Fiscal and monetary policies have simply masked the symptoms along with unprecedented-in-size global companies that boosted the stock market and intensified the illusion. There is no such thing as a service based economy. That is called a broken economy. The whole idea is to produce goods and services and sell them to the rest of the world. To be fair, globalization has uplifted the living standards of other parts of the world by introducing them to the need to gather money instead of food directly. Globalization can also be viewed through the lens of funding the expansion of freedom and democracy, albeit deeply corrupted by self-interest and systemic flaws, but it's still better than allowing socialist dictatorships to flourish in its absence. Some set of culturally organizing ideas are going to be in charge. Do you want it to be a socialist dictatorship or the flawed expression of American ideals that can be course corrected if enough people cared?
Deglobalization implies jobs are moving back here. They're not, and they won't be. An accurate way to describe an exodus from China would be reglobalization and it won't have the slightly impact on CPI for several reasons: 1. It would take a decade and CPI measures the rate of change. 2. China isn't even the lowest cost labor anymore. 3. It's not just cheap imports suppressing CPI, it's the lack of (what could have been) 20+ million onshore well-paying, stable, union jobs, and the dollars circulating domestically. That would move the needle on CPI. REglobalization won't, at all. That doesn't mean prices won't go up. It's the pace that matters. And the subsidies for Chips, which only mask the actual cost of the products with taxpayer funds, have to be permanent now; otherwise, when they expire and the real costs are not competitive with chips made overseas, they will fail. So we have a new permanent bill, which btw, I agree with as a geopolitical strategy, I'm just saying it's not happening organically because the global structure is changing; it's being forced by government.
Oil is disinflation wrapped in inflation's clothes. There has never been a hyperinflation caused by the supply side. And the Treasury is limited by the Joe Manchin effect, which prevents egregious spending Acts outside a crisis. The usual annual deficits are too narrowly focused to influence CPI. The current inflation was caused mostly by distributing money directly into people's hands (amplified by supply disruptions and Putin, of course). Married couples with 3 kids received $24k (including the regular credit tax credits) and that doesn't include if either of them worked under the table and collected the extra $600/week in unemployment. (Details of the Acts are at the end if you never added it up).
When that lotto money is spent it will end up in the bank accounts of businesses and be restrained by banking practices to qualify for a loan (aka creditworthiness) and the proper stewardship of money controlled by business owners, which is keeping velocity in check. If this was an expanding economic environment like the 70s, you would see businesses investing that lotto money in all kinds of Capex that could keep the inflation going, but they're not. Inflation has to be funded. In fact, inflation IS the funding. Bank of America and JP Morgan estimate there's about 1.2 Trillion of the Covid cash left, but a lot of that is in the hands of people who don't need it, so quite a bit could go unspent. The only structural inflation argument I agree with is Russell Napier's notion that the government will start guaranteeing bank loans of all kinds.
A "wage price spiral" is the most absurd concept in finance. We want wages to go UP. That's how we would avoid recession and reduce the burden of debt by increasing the nominal prices of everything around it. Is there a single instance in any culture in history when a nation collapsed because wages were too high? Omg, did you hear what happened in Madagascar? Their currency collapsed because everyone was making so much money. It's silly. If this was a problem there would be instances in history called The Great Wage Price Spiral of 1867. This is the same mistake as the "oil is inflation" idea, which is the false assumption of an infinite consumer balance sheet. Wages tend not to keep up and raises don't happen to everyone simultaneously, which acts as a spiral limiter.
I don't get the impression everyone realizes the financial system is in stage four terminal cancer, which is probably due to a "frogs boiling in water" effect. The evidence is staring at you in the form of the balance sheet of the Fed and the US gov't, which are enormous malignant tumors that will continue to worsen over time. The only cure is either a new innovation like fusion that essentially creates near free energy, or a new monetary system, which is what will happen reactively like the three other times in the last century if we don't do anything proactive to stop it.
Here's what our country would look like if it was run by responsible adults from the beginning:
We wouldn't have a general treasury market because the politicians wouldn't be able to spend money beyond what they collect in real-time taxes. The only treasuries that existed would have a specific purpose like The Mississippi Bridge Project etc.. They would pay whatever interest rate the buyers demanded and the debt would extinguish at maturity. The problem of allowing unaccountable politicians to spend future taxpayer money via nonspecific treasury bonds to appease voters is so deeply ingrained that we teach the treasury market like it's a natural part of how the world works when no, it's not, it's a cultural choice, and it has inevitable consequences. Our predecessors made decisions that are nearly impossible to undo. Once you deviate from sound money, once you export your manufacturing base, once you institute a policy of the Fed put, there is no going back, and they end in a currency crisis unless we choose to course correct with innovation.
The inflation to be concerned about is when the dollar is collapsing. That's the one that takes away the Fed put. This is not it. And if Powell thinks he can be the tough guy to end the Fed put, he will learn the same lesson as all the armchair Austrian would-be Fed chairs who claim if they were in power they would raise rates and tame that junky stock market only to realize upon its collapse that the real problem is the structure of globalization that forces the Fed and Treasury to continually inflate the gaping holes caused by a lack of domestic production. It's not a person or the people in power to blame, it's the institutional decisions made long ago that now must be perpetuated in cycles of easing and tightening, inflating and deflating, ad infinitum.
I've noticed a pattern of people who are value investors, or sound money advocates, or those who don't participate in the bubble expansion phase, always saying this is the time the Fed put won't be there, or this is the time we're returning to normal, but they are simply not adapting to the bind the Fed is in. They want the economy to be back like it was pre-globalization when things made more sense to them.
Apparently, if you read the Fourth Turning, you're assigned a therapist and put on suicide watch. Pessimism and repression win battles while optimism and freedom win wars. If you want to know the future, extrapolate optimism, freedom, and technology to its logical conclusion, and you will realize the world is turning into a giant interconnected computer with a mysterious intelligence emerging within it as its innate designer. The challenges and conflicts along the way are a feature not a bug.
Of the current 7.1% YoY inflation rate, 6.1% happened last Feb - July (release dates). If we grant the upcoming print on January 12th a .2 or .3 and then annualize the previous six months, the current economy is running at a 2.4% - 2.6% inflation rate, so the Fed's target will be hit in July. This easy run of CPI comps, which were caused by the freakish rate of change of peak stimmy spending, peak reopening, and peak Putin oil spike, is not repeatable outside World War 3.
The easy CPI comps end around the same time Jamie Dimon estimates most of the remaining Covid cash will be spent. It also happens to be around the time when the lagged effects of Fed tightening will be kicking in for realz yo. Here's an updated version of the CPI chart with the easy comps in yellow.
I don't see why CPI won't collapse from Feb - July, which, in theory, should cause quite a bounce in stocks, gold, treasuries, the Euro, and possibly the dream killer: oil. In other words an unwind of the Fed must-tighten-to-infinity inflation trade.
However, I believe this bounce in stocks no matter how high it goes will be a bear market rally. If it happens, you'll hear excited chatter about a soft landing and how the market is endorsing higher rates, etc., but what would really be happening is a freak window of easy comps before the true effects of Fed tightening emerge, powered by a FOMO that, if harnessed, could end the energy crisis, and a complete devastation of shorts and puts.
Here's some things that could go wrong:
1. The economic data could deteriorate so severely during the process that the "recession now" narrative poses a bigger problem for stocks than a plunging CPI can overcome. I'm more inclined to think there's enough Covid cash, wage increases, and people in jobs that the data will hold up enough, and earnings will be weak but not catastrophic (yet). And the dollar should help this quarter. For stocks, though, it's definitely a race between the easy run of CPI comps and recession.
2. As CPI collapses, oil could rally enough to ruin the last three months of it, offsetting the effect. This would be temporary because it would consume disposable income, but it would likely keep Fed Funds high and even moving higher to stop a dreaded second wave. Powell has repeated ad nauseum he wants to be an anti-Burns mafioso tough guy so he doesn't repeat the second wave of the 70s. Once the easy comps are over it won't take but a blip in oil for CPI to rise, which could develop such a twitchy trigger finger in Powell that he starts doing pressers in a grim reaper costume.
3. I've never seriously considered a geopolitical threat as something to worry about, but it's worth considering what would happen to your portfolio if a nuclear weapon was detonated this spring by that cornered animal, or a China invasion of Taiwan. Do you shrug your shoulders like you can't make investment decisions on unknowns like that anyway, or do you maintain a more defensive approach because this geopolitical environment is rife with potential disasters unborn in previous decades?
4. The CPI collapse could be right but the markets react in a way that is suboptimal. Or maybe CPI drops but PCE sticks and Powell shakes his fist and reminds everyone they're focused on that. In other words, stocks have economic data risk whereas something like gold only has second wave risk.
This is actually a three phase idea because a CPI collapse should cause rates to fall across the curve, so anyone still sitting on Covid cash looking to move will see lower mortgage rates and buy a house, which could result in a less severe second wave which could have a more severe PTSD effect. If Fed Funds stay at 4.5 during the CPI collapse, and oil starts rising, and homes get bought up, once the easy comps are over, and CPI rises from zero base effects alone, I suspect the Fed will push even higher. The terminal rate might end up in the 6-6.5% range, and despite all the grand theories, we live in the same 2% world we lived in before the pandemic. There's been no population boom, no free energy discovery, and no productivity innovations that would have a lasting effect on growth or inflation. The only thing that happened was a sugar rush of free money that is working its way through consumer spending to once again get stuck behind a wall of creditworthiness at banks. This is the only reason the Fed is even capable of raising rates. Even a mild second wave would cause a resumption of the bear market that likely breaks something as Fed overtightening ripples through the economy, THEN we get the real Fed pivot as economic data quickly deteriorates into recession while the stock market plunges. There will be no bull market until QT stops and the Fed pivots. There will be no bull market with short-term rates above 4%, or even 3%. Even a move back to the highs would be a hibernating bear.
While I am open to the "recession now no matter what CPI does" view, which causes stocks to go down as bond prices and gold go up in the first half of 2023, I favor the delayed version of recession not coming until late 2023 or even 2024, which would result in everything going up in the first half of 2023. In this delayed scenario, the first rate cut wouldn't happen until like October 2024, so the Fed Funds inversion will be correct, it just might be early and need to push out again.
*I don't need to point out this is my understanding, and my speculation on the turn and river cards to come, which are always unknown. Disagree as you please. Here's some charts.
SPX Daily. I don't have an opinion for January. It could rise to the trendline or a Fib retracement into the 3980 area, but I don't see how this could possibly breakout until after earnings, and I'm thinking it might be setting up for the big breakout on CPI day in Feb. There's a lot of time until then. Ideally, this chops around and fills in this triangle for a month and then either takes out the low of the January price action with a classic reversal or a double bottom. The first week of February has the Fed meeting on the 1st (along with ISM), AMZN is the last megacap to report on Feb 2nd, and NFP is on Feb 3rd.
Let's say the top of the triangle is 4050 and the bottom is 3650. I expect there will be too many sellers at the top and too many buyers at the bottom for a sustainable breakout without a major change, which is likely to occur either around Fed day, or CPI on Feb 14th. If you ask yourself what is the nastiest thing that could happen it is violent chop with a downward bias toward the bottom of this triangle through earnings, then a washout on Fed day with a massive reversal during the presser if Powell suggests a pause, then I would expect dips get bought into CPI and a big breakout. Too perfect? Yes. The ideal scenario never happens, but that's an idea of what I'm thinking at the moment.
Gold daily. This is a tough one. I have the highest conviction in gold going lunar but the challenge is not screwing it up. I have some call spreads and I bought a put spread to hedge a retracement in January, but that's only a starter position. This is kinda the same problem as stocks. If you get too big too early then a simple retracement that you should be waiting to buy, hurts, and what if it's wrong? And yet the really strong trends don't retrace much, so you end up waiting for Godot.
I've learned nearly every trading decision boils down to this: what will you regret less? I prefer to miss out then give back. You have to pick one, and the only way to soften that is to layer in and out. You sell some when you're the most excited, and if you don't have on your full position, which you shouldn't, you add when you're most disappointed and ready to throw in the towel. You're supposed to use the same size on every trade and never lose more than .5 - 1%. But some trades are just better setups than others so I don't believe in that myself. The problem is if you're wrong on the special setups, it takes an even more special run of normal wins to make it up. But if you're right, boom stick. The bottom line for gold is the chart pattern isn't complete. It may not complete, but if this comes down closer to 1700 it will form a perfect inverse head and shoulders. The left shoulder low is 1679. Gold is a notorious heartbreaker. I think it's setting up for a huge move. In five years, I think gold will be double in price.
Oil daily. I don't care about oil except that it could ruin everything. Incidentally, the psychopath trade is long oil, short treasuries, and short equities. If that's your jam you might want to keep it on the low, or show up outside homes and businesses with a flamethrower and torch them directly. At least, you'd be seeing the people you're hurting. Do I mean that? As a trader, no, but as a business owner, yes. Incidentally, my business continued similar results. Q4 was approximately 60% of the Q4 in 2020 & 2021, but up 50% from 2019. Not catastrophic, but reflective of the Covid cash spike. Through Xmas, December is the same as 2019, but 1/3 of 2020 and 1/2 of 2021. People are spending less on consumer discretionary, which makes sense since they ran out of lotto winnings.
10-year yields, daily. Fib retracements: 38% is where we're at, 50% is 3.86, and the 61% is basically 4. There's nothing magical about Fib retracements. They're just levels you'd expect the one side of the trade to defend if they're in control, and when they don't it's an insight into underlying strength.
EUR/USD daily.
I will note again these are just probabilities. The whole game is losing small when you're wrong, and winning big when you're right.
BONUS (details on the Covid cash Acts)
Stimmi-flation
Cares Act: $1200 per individual, $2400 per married couple, $500 per dependent under 17 (phase out above $75k for the individual and $150k for couples)
Coronavirus Relief Act: $600 per individual, $1200 couple, $600 dependent under 17 (same phase out)
American Rescue Plan: $1400 individual, $2800 couple, $1400 dependent under 19 (24 if student) (similar phase out)
Total Stimulus Checks: $804B
Small Business PPP Grants: $1T+
Unemployment Extra Benefits: $567B
Plus, there was an extra $1600 child tax credit (in addition to the usual $2k) for children 6 and under, and an extra $1k for those older than 6.
If you haven't added it up, a married couple with 3 kids was entitled to: $6400 (for the couple) + $7500 for dependents + $6k (for normal child tax credits) + $4200 in additional child tax credits (say 2 kids below age six and 1 above). That equals $24,100 (and it's not considering if one (or both) of them collected extra unemployment money.
Consider how many self-employed, contractors, and other businesses who found a way to operate during the shutdown and paid themselves or their employees in cash so they could collect the extra unemployment. I know a 19-year-old who collected over $16,000 in unemployment while he worked under the table. Pretty much anyone working a cash business could have done this, so it's not unreasonable to assume a healthy percentage of the married with kids people who collected the $24,100 also collected an additional amount like this 19-year-old in unemployment, which means it was possible for households to collect $50k as a family and work under the table on top of it, and while I'd assume most were closer to the baseline, it may have averaged out closer to $30k.
Fancy Pants Livin'
If you live in a fancy pants town you might not realize how much more affordable real estate is in other parts of the country and therefore probably dismissed the idea that the Treasury sent down payments to everyone for houses. In mid-size cities like mine (or smaller), a pre-Covid 1970s/80s 1800 sq ft 4-bedroom house in the 'burbs with 1/4 acre yard where you never have to lock your door was like $140k-$160k. It peaked around $225k-$250k. One of my employees had a starter house he bought in 2015 that was 1100 sq ft for $85k. He just sold it in October for $195k to upgrade because they had another kid. In comparison, my friend in Maui has a 1600 sq foot house with a tiny yard that was $600k pre-Covid and it's now $1.1M.
Since the stimmies were directed at the lower 75% of the income scale (and definitely the lower half), most of the recipients were in the market for houses $150k and less, so a 10% down payment would be in the ballpark of $15k, and as prices rose maybe up to $25k. This housing bubble inflated from the lower end up as all these people suddenly had down payments, which pushed up the prices of the middle and higher end houses too, and those in more expensive areas. A lot of people in the middle income cohort already had the down payment, so the stimulus provided the added confidence to go for it, which was often motivated by the newfound freedom of remote work.
The bubble inflated from both a supply shortage because Blackrock is buying up America to turn the country into renters (as well as the Covid shutdown stopping construction for awhile), and from the demand side as buyers flush with stimmy cash chased offers ever higher, and I've never met a real estate agent who didn't have a hot competing offer on the other line to drive up the price. Not to mention the moral hazard of the Fed buying up MBS so the banks don't have to worry about issuing mortgages at the top of a bubble because they'll just flip them to the Fed if there's any trouble.
The same thing happened in the auto market. The Covid cash was not money restrained by banking practices that require provable income, or collateral, and it wasn't a loan that needed to be repaid. It was the rocket fuel of actual inflation that was broadly distributed, and caused the prices of CPI to rise.
A Horse Named CPI
Imagine it's the Kentucky Derby but there's only one horse named CPI and he's trotting toward the starting gate at his natural pace of 1.5, then all of a sudden he comes to an unexpected halt in the gate. The politicians and central bankers freak out and load a rocket engine on his back. The gate finally reopens and he launches forward at an unprecedented acceleration, but eventually the fuel runs out, so he can't do anything else but slow down to his natural pace all on his own - there's nothing else that can happen. But the politicians and central bankers start freaking out in the other direction because they misjudged the effect of the rocket fuel, so they start piling sandbags on the horse in ever increasing amounts, instructing the jockey to pull back the reins!
If you measure the rate of change in CPI's speed as he burst from the starting gate (both from the reopening and the stimmies) and compare that to measurements of the rate of change at 10 yards, 50 yards, 100 yards...it would show a burst followed by a leveling off followed by a descent back to his natural pace. It's impossible for the artificial rocket-fuel-tainted initial rate of change to be sustained without ever increasing amounts of fuel.
THOUGHT EXPERIMENT
What would happen if after the Fed enabled the Treasury's Covid cash distributions, they closed the institution and left with Fed Funds at zero? The answer is the entire point: markets would take care of the inflation. High prices would cure high prices. There would be no wage price spiral. The inflation would simply burn through the system like a drug followed by a hangover. But what if I'm right (I am) that the structure of globalization is the underlying disease that is forcing the Fed and Treasury to treat the symptoms of low growth, populism, civil unrest, balance sheet debt saturation etc. with continual stimulus in ever increasing amounts to prevent a deflationary collapse?
There's only 3 possible cures: a new monetary system that allows the world's sovereign currencies to be devalued into it, thereby reducing the burden of debt; a new innovation that creates practically free energy, thereby reducing the burden of expenses; or a breakthrough in general artificial intelligence that launches an era of enhanced productivity, thereby improving the flow of incomes.
I believe all three are coming - when the time is right.
