IN-DEPTH: TRANSCRIPTION - UnderTheLens - 06-21-23 - JULY - Central Banks v the Forcing Functions
Thank you for joining me. I'm Gord Long.
A REMINDER BEFORE WE BEGIN: DO NO NOT TRADE FROM ANY OF THESE SLIDES - they are COMMENTARY for educational and discussions purposes ONLY.
We are in the midst of:
- The Fourth Turning,
- Inflections in Long Term Societal Cycles and
- The ending of the Era of the Great Moderation,
All around us we are witnessing changes in America and around the world that only 10 years ago would have seemed unimaginable.
Whether we are talking about changing Cultural attitudes towards Wokism, 2SLGBTQI+, media Censorship, OR DEI & ESG, OR Open Borders & expanding government controls the list of proof of change is everywhere.
The financial markets are no different with initiatives like QE, QT, YCC, central bank lending facilities, massive RRP operations .. And the list goes on here also.
There is a sense that the system is in trouble and breaking down. Falling Public confidence is endemic as political wrangling reaches levels never before seen in America. We may face a Presidential election where both candidates are either under criminal charges or being threatened by the other party to soon be.
What can we make of this?
If you want a political or policy discussion on all this then this is not where you are going to find it. We at MATAII.com are investors – not social warriors nor advocates of political policy. However, as Investors we can’t live under a rock as these issues materially affect our investment thinking.
We are going to touch on some of this as it regards the changing role of central banks and the new Forcing Functions they are facing. These are Forcing Functions that will have potentially profound changes going forward.
As such I will address the subjects outlined here.
The purpose of a Central Bank is most fundamentally to ensure adequate funding of the country – whether its Financial or Industrial Corporations, Consumers or Governments of all levels (Federal, Regional /State or Local).
Since the Governments (or the “G” of a country) are completely supported by the output of Individuals and Corporations it is the effective Productivity of those two that Monetary Policy must address through its mandates of price stability and full employment.
However Monetary Policy must also accommodate Government Fiscal and Public Policy which in concert are additionally intended to addresses the productive needs of Consumers and Corporations.
This works well in a Capitalist System until the government becomes too big a part of the economy, its Fiscal & Public Policies impede financing and/or simply pull too much available resources away from productive investments.
Then the role of Monetary Policy becomes increasingly focused on the financing of the government!
The “I” for Investment is primarily about attracting foreign investment to finance mass debt levels and Government transfer payments to finance an increasing social entitlement net.
The GDP formula becomes highly distorted in that GDP becomes ineffective in measuring the actual productive growth of a nation.
The US and many of the developed nations have already reached that point.
If the current system is to be sustained the two areas in the red circles must be addressed – most likely in a fashion that few recognize or are willing to accept – today.
We will come back to this slide a little later but first we need to understand some realities facing global central bankers.
Corporations, Investors and Consumers expect the economy to run in a balanced & stabile manner fostering an increasing standard of living.
The Growth of the Central Bank Balance Sheet runs in concert with expanding asset values, productivity and Standard of Livings.
However, that ideal hasn’t existed since the US came of the Gold Standard in 1972 and trade balances went into deficit as the US increasingly consumed more than it produced over the last 50 Years.
A growing shell came has increasingly existed. All the never before contemplated QE versions (and other games) have been used to keep the house of cards from folding.
The growth of debt and the central bank balance sheets to accommodate it have grown at truly unimaginable rates since the Dotcom Bubble Implosion.
What I find interesting is no one asks why nor seems to care much?
On the surface there are some quick answers like as shown at the bottom, the advent of the EU and ECB which propelled the Eurodollar, the federal Reserves reaction to the 2008 Financial Crisis or the global reaction to Covid?
To some degree many could ask if this is a chicken and egg question. Did one cause the other or the needed response to the other?
If we look at the Blue line we see that the ECB has required simply massive growth in debt since the 2008 Financial Crisis to sustain the overall EU’s fragile banking system, weakening industrial prowess and onerous social entitlement programs.
Ukraine and the accompanying Russian Energy dependency would suggest the EU would be the biggest financial backers of the Ukraine War – but they are not! The geographically and energy removed US and UK amongst other are?
Is it not desire and politics but are simply unable to finance more?
The Federal Reserve’s balance sheet in red has clearly exploded to a new rate of increase since Covid-19.
The BOJ and PBOC though increasing appear relatively more tempered since Covid.
However, that can be mis-interpreted since on a GDP basis Japan clearly has experienced a massive debt increase as basically the Japanese sovereign debt market has been nationalized.
Clearly continuing to increase debt at these rates was going to become problematic before the Great Moderation came to an end.
This year’s MATASII Thesis paper outlined this is detail so for more detail I refer you our web site.
The ending of the Era Great Moderation has already resulted in dramatically higher inflation rates. The policy reactions to Covid were clearly an initial driver to this but the fact that debt levels were taken to such levels and attributed to Covid is not valid.
- The American Rescue Plan Act
- Infrastructure Investment and Jobs Act
- The Inflation Reduction Act
.. and the list goes on with Climate Change, Green Energy other initiatives that blew fiscal spending through the debt ceiling and the Fed Balance Sheet to over $9T . This was not about Covid – this was about keeping the debt machine from failing to deliver sufficient debt to keep the machine running!
The end of the Era of Moderation means:
- Slowing Globalization which has delivered low import costs due to labor arbitrage,
- Slowing Financialization which has delivered every smaller debt carrying costs, and
- Slowing Mercantilism which has delivered the financing of US Debt and a Strong US Dollar and is now resulting in increasing Risk Premiums in the form of dent duration premia and equity premiums.
So what are the Central Banks currently doing about these Forcing Functions?
They are currently consumed with trying to get the inflation genie back in the bottle. A battle they are not yet winning when understood properly.
The Federal Reserve has long used the Core PCE to gauge Inflation since even former Fed Governors Kevin Warsh has stated the administrations BLS’s data can no longer be trusted.
This Federal Reserve graphic shows that the Core PCE is dramatically above the long term downward Great Moderation trend line and still at levels not seen since the Great Inflation era of the 1970’s and Volcker era.
What is a major concern is that despite massive increases in the Fed Funds Rate at an unprecedented rate, it is not coming down anywhere fast enough.
This is the Fed Balance Sheet going back to the Dotcom Bubble implosion and highlighting the dramatic surge since the US abandoned any charade of Fiscal Responsibility with Covid-19.
We overlay on it the Fed Funds Rate increase relative to it.
We have never experienced this level of rate on this level of debt. As an aside it shows that Debt interest financing payments is the obvious short term problem with the central bank’s current fight against inflation (and everyone else’s holding adjustable rate debt or needing to borrow.
Here we overlay the Core PCE. The good news is though the Core PCE may not have come down a great deal at least the Fed Funds rate has been raised sufficiently to close on it. The Fed Funds Rate must be above the Core PCE if we have any chance of getting inflation under control.
What must don’t know is what the Fed chooses not to tell us.
First, the bad news and then the good news.
The bad news is the Fed actually uses a modified version of the Core PCE. It is called the Trimmed Mean PCE Inflation Rate. It is an alternative measure of core inflation in the price index for personal consumption expenditures (PCE). It is calculated by staff at the Dallas Fed, using data from the Bureau of Economic Analysis (BEA).
It shows more volatility as can be seen on this Fed graphic on the right measured on shortest degree changes.
Here we overlay it on our previous chart with some required smoothing for clarity.
We suddenly see that using the Trimmed version that the Fed’s PCE according their own preferred view is much worse than currently perceived.
There are reasons why the Fed uses it which I won’t go into here,
..but one way to view its’ importance is against the Federal Reserve’s Balance Sheet.
You can see that there is a delayed correlation between the Fed’s Balance Sheet and the Trimmed Mean Core PCE.
The Fed can isolate with some degree of measure its balance sheet growth or shrinkage with the delay and level of the Core PCE.
It would appear that the Fed policy planners know they must get its balance sheet down and rates up further if it is to achieve its stated goal.
That’s the bad news. Now the good news most are still unaware of.
Fisher’s Equation tells us that nominal rates are equal to the addition of the real interest rate and the expected inflation / deflation rate.
Whether the 10Y Bond Rate to finance the government or the Fed Funds Rate the equation is the same adjusted for the appropriate durations.
What does this mean?
It means since the real rate which has been steadily rising in 2023 because of central bank actions IF maintained, and that is a big if, then it will help the central bank’s efforts in closing the gap towards fighting inflation.
How that is happening is that the US CPI-fixing swaps shows that even if the Fed holds rates steady, slowing inflation ensures the real rate will rise the equivalent of five more rate hikes by the late summer, or eight by next April.
Meanwhile Global real policy rates are now flat will soon be firmly positive as inflation keeps falling.
The trick will be to keep Central Bank Rates on hold (or higher) for the remainder of 2023.
We now need to switch subjects slightly and talk about the US Dollar.
Though the US Dollar is under attack because of shrinking FX needs and De-Dollarization due to the ineffective use of “weaponizing” the dollar as an instrument of foreign policy it is still the global currency of choice. There are many reasons for this which I have outlined in recent newsletters as a counter balance to my 2019 Thesis paper entitled “De-Dollarization” which spelled out the whole notion before anyone was writing about it.
The bottom line is that the US Dollar is required for Balance of Payments to ensure Current Account Balances equal the Financial & Capital Accounts ledger for a country.
To see the importance of this let’s look at an example country like Vietnam.
Like many countries it has a net import from China. Its imports are larger to China than its exports and therefore no Chinese currency surplus is injected into Vietnam. This is not unusual.
.. nor is the fact that Vietnam’s exports to the US dwarf its imports from the US. The result is a surge in US Dollars which enables the Vietnam through fractional reserve banking system to have its banks finance massive amounts of growth.
Until China or any other country replaces the US in becoming a net exporter destination the US dollar will be around and very important.
This doesn’t mean its value won’t continue to erode. This is because a large number of countries are net exporters of commodities and are increasingly having positive net trade balances with China.
This creates Yuan bank balances to finance growth.
This is why China through its BRI, BRIC Alliances and Shanghai accord are binding commodity players together through alternatives to the US Dollar.
Why is this important?
Because the US and developed economies are increasingly experiencing pressures on maintaining their GDP levels.
This chart of the US shows a steady lowering of the GDP level.
We are clearly entering a recession which will bring dis-inflationary and deflationary pressures with it. Also a compression or possible reversal of the Wealth Effect.
No doubt, lowering rates will be needed to combat a worsening or protracted hard landing and central banks will be forced politically to react accordingly
The real question is how does it get back out of it without re-igniting inflation?
It will need growth but not at the expense of excessive debt creation.
The problem is more clearly shown when we understand that US GDP normally approximates the 5 year US Treasury Note. It is shown here in gold.
It diverged since the 2008 financial crisis due to Quantitative Easing which has inevitably resulted in inflation.
The current 5Y note approximates 4%with GDP below 2%.
After the recession the Target for GDP will likely needed to head towards 2% or higher.
That level of GDP suggests on the right that the 5Y will need to approach 5%.
The benchmark 10 year note (added in turquoise) will also need to be in this range – maybe higher –or slightly lower depending on demand and inflation expectations.
Central Banks and governments are going to need a new approach to get growth up without inflation creating stimulus and sustained low rates!
But the problem is much more complex than I have real time to get into.
There are many more Forcing Functions at play
There is the Triffin Paradox that says the world growth or GDP is dependent on the expansion of the US deficit for financing – as we discussed earlier.
A US Problem is a world problem and the global problem is a US problem.
As an off-shoot of the Triffin Paaradox the expansion of the EuroDollar System must be maintained.
The coming recession can’t be allowed to be protracted nor take us into a depression nor experience a global recession.
The US Consumer is tapped out and a Major Reverse Wealth Effect occurring is a real possibility. A 70% Consumption dependent economy has never experienced a situation where the consumer has serious inabilities to maintain even its current level of consumption.
We have a Global Derivative structure that is on the cusp with global interest and currency swaps alone at 7-8X the size of the global economy.
Any shocks here and the problem may not be able to be contained!
What is the plan? Is there one?
Will we just just plunge into some abyss.
No one knows but it appears then answer will take the form of the following.
I said earlier I would return to this slide.
To get GDP up to 3-4% without using the single increasingly destructive tool of fiscal stimulus and more debt it must additionally solve the problem of the export-import problem on the right.
We have concluded this will mean governments will be forced to become increasingly more of a Regulatory or Administrative State. Mandates, Restrictions, Controls will increasingly be the order of the day.
84 thousand new IRS agents, armed IRS agents, postal workers and other federal agencies, a new FBI building larger than the pentagon won’t in the future draw the attention it currently does
The government will begin to guarantee Credit, Debt and Loans in the form of what accountants call Contingent Liability Accounting. This will be seen to foster growth without inflation.
Modern Monetary Theory will increasingly replace Keynesian Economics
- Nationalization & Conservatorships
- Lowered Standard of Livings & Expectations,
- Open Borders
- Universal Basic Income (UBI),
- Domestic On-Shoring Production and increasing reductions of foreign supply chains
The Apparent Turmoil and Chaos Today Are Signs Of Thins To Come
As I always remind you in these videos, remember politicians and Central Banks will print the money to solve any and all problems, until such time as no one will take the money or it is of no value.
That day is still in the future so take advantage of the opportunities as they currently exist.
Investing is always easier when you know with relative certainty how the powers to be will react. Your chances of success go up dramatically.
The powers to be are now effectively trapped by policies of fiat currencies, unsound money, political polarization and global policy paralysis.
I would like take a moment as a reminder
DO NO NOT TRADE FROM ANY OF THESE SLIDES - they are for educational and discussions purposes ONLY.
As negative as these comments often are, there has seldom been a better time for investing. However, it requires careful analysis and not following what have traditionally been the true and tried approaches.
Do your reading and make sure you have a knowledgeable and well informed financial advisor.
So until we talk again, may 2023 turn out to be an outstanding investment year for you and your family?
I sincerely thank you for listening!