Three Longs & Three Shorts

If Inflation Is Coming, the Market Isn’t Ready

Modern Monetary Theory is referred to the approach used by governments and central banks globally since the Lehman crisis in 2008, primarily involving pumping money into the financial system by expanding the central banks’ balance sheet. Whilst the positive effects on the economy, particularly in the US cannot be denied, the effects of money printing has been far more positive on financial markets. Naysayers have pointed to the inflationary effects of such an approach as the key risk when eventually central banks will have to raise rates and suck liquidity out which could pull the rug under the market’s feet. Indeed, everytime the Fed has signalled a rise in rates, the markets have been jolted. However, the real risk of inflation has been elusive. Indeed, the great lockdown has doused any such inflationary trends cropping up just as US unemployment had reached a multi-decadal low. To tackle the recessionary effects of the lockdown, central banks have unleashed liquidity pumping measures at an all-together different scale. This has further emboldened market participants to believe that easy money is here to stay.
Now, two very well-accomplished and often contrarian strategists have raised the inflation alarm that could spoil this party – Russel Napier, who authors the highly regarded report Solid Ground and Albert Edwards of Societe Generale. They refer to the government loan guarantees that could trigger commercial banks lending and private money creation that could eventually stoke inflation. Napier predicts inflation in developed markets to hit 4% next year.
“Governments, he thinks, have finally found a way to ensure that commercial banks lend: promise to cover bad debts. Heads, the banks collect the (slim) interest; tails, the government ends up with the losses. Of course banks will lend. “It’s pure politicization of credit,” Mr. Napier said. “This is the magic money tree.” In one way, guaranteeing lending is a stroke of genius. Money quickly gets into the real economy, unlike with Fed bond buying. Sure, people and companies end up with more debt. But that just ups the political incentive for governments to invent new lending programs to refinance each round of debt; Mr. Napier suggests reconstruction loans will come next, then environment loans, maybe even equality loans. Extend and pretend and the bad debts are never realized.
The downside is that the more the government is involved in supporting lending, the more pressure there is to direct the loans to politically popular causes, or at least away from unpopular ones. Private equity can expect to find it harder to borrow, while green energy may find it easier. Businesses might find it harder to access loans if they aren’t in favor with the government of the day. In the long run, having politicians pick winners usually crimps economic growth.
Inflation is both the result of out-of-control private money-creation financing consumption, and the easiest cure for excessive debt. Calling in the bad debts once the economy recovers and the government wants to pull back is politically difficult, and while turning debts into grants is possible—and explicit in the U.S. small business lending program—that would make the debt appear on the government balance sheet. So long as the bad debt keeps being rolled over into new loans, the loan guarantees have a mysterious twilight existence as contingent liabilities, not fully recognized as government debt.
Both this route to inflation and the simpler monetary financing possibility require tacit assent from the central banks, which could stop either by jacking up interest rates. And both are at heart arguments about politics: Is it more likely that governments and central banks will overstimulate and accept higher inflation, or take back from voters in good times what they have given when times are hard?”
Whilst there is no certainty that inflation will spike given the truly uncharted territory we are in, the author worries that the market isn’t pricing in anything remotely close: “True, the natural winners—gold and Treasury inflation-protected securities, known as TIPS—have performed very well this year. But the bond market’s expectation of inflation, calculated as the ordinary Treasury yield minus the TIPS yield, shows inflation of just 1.5% over the next 30 years, and below 1% for the next five years. TIPS yields are low (and gold high) mostly because ordinary Treasury yields are so low. Inflation options allow us to look at the odds: Data from the Minneapolis Fed for late May, the latest available, show only a 5% chance of inflation over the next five years averaging more than 3%. The chance priced into options of inflation averaging less than 1% over the period was 52% (down from 85% in March).”