Financial markets, particularly those in risk asset classes such as equities, both developed and more so emerging market equities as well as commodities are having a great run. Whilst good news around the vaccine and the expectations of a consequent return to economic normalcy justify this, there is no denying the effect of liquidity as a result of the central bank actions over the past year. With the US Fed and other western central banks pledging to keep interest rates low for another two years atleast, the markets don’t seem to be concerned. However, there are repercussions – US interest rates (10yr treasury yields) have now climbed over 1%, reflecting the weakness in the dollar and risks of inflation rising. Few experts have been vocal on the latter but here’s an interview with Louis Gave, the founder of the highly respected macro research house – Gavekal research. For those of you who want to keep an eye on what could go wrong in the global economy and implications for markets, the interview is a brilliant read as Gave talks about interest rates, currencies, inflation, oil prices and the geo-political battle around semiconductors. He starts off by explaining why the US is more and more looking like a ‘sick emerging market’:
“When I look at markets, there are three key prices in the world economy: Ten year Treasury yields, oil, and the Dollar. One year ago, yields were going down, oil was going down, and the Dollar was going up. Today, Treasury yields are going up, oil is going up, and the Dollar is going down. This is a huge reversal. When I see a market where interest rates are rising and the currency is falling, alarm bells go off. This is what you would see in a sick emerging market. If you’re invested in, say, Indonesia, rising interest rates and a falling currency is a signal that investors are getting out, because they don’t like the policy setting there. Today, the US is starting to act like a sick emerging market. We even have a question mark over whether they have the ability to run a fair election. Suffice to say that at least 30% of Americans believe their election system is rigged. This is mindblowing.”
He goes on to explain that at the centre of this is the massive increase in US debt most of which is unproductive:
“Government debt in the US has increased by more than $4 trillion this year, which adds up to $12,800 per person….When China did this in 2008, they funded massive infrastructure projects: airports, railroads, roads, ports…But this year, the debt buildup in the US has funded zero new productive investments. No new roads, no airports, railroads, nothing. They were basically just sending money to people to sit at home and watch TV. In the end, this buildup of unproductive debt can be reflected in one of two things: Either in the cost of funding for the government, i.e. in rising interest rates, or in a devaluation of the currency…very soon, this is going to put the Fed in a quandary.
They will have to decide whether to let bond yields rise or not. If they let them normalize to pre-Covid levels, 10-year Treasury yields would have to rise to about 2.5%. But if they do that, the funding of the government becomes problematic. A 50 basis point increase in interest rates is equivalent to the annual budget for the U.S. Navy. Another 30 bp is the equivalent for the U.S. Marines, and so on. The U.S. is already borrowing money to pay its interest today. If rates go up, they’re getting into the cycle where they have to borrow more just to be able to pay interest, which is not a good position.”
Gave reckons the Fed will step in to cap interest rates and then the dollar will take a 20% hit. “…come this spring, the base effects for growth and for inflation will kick in. Growth will be very strong, and so will inflation, which means that yields will quickly try to get back up to 2%….at which point the Fed will introduce some variant of yield curve control. In this case, the Dollar would tank, real interest rates would drop and gold would thrive.”
And the falling dollar will drive inflation as US imports become that much dearer:
“I think inflation will come back with a vengeance. One of the key deflationary forces in the past three decades was China….every company in the world would focus on what they can do best and outsource everything else to China at lower costs. But now, we’re in a new world, a world that I outlined in my last book, Clash of Empires, where supply chains are broken up along the lines of separate empires. Let me give you a simple example: Over the past two years, the US has done everything it could to kill Huawei. It’s done so by cutting off the semiconductor supply chain to Huawei. The consequence is that every Chinese company today is worried about being the next Huawei, not just in the tech space, but in every industry. Until recently, price and quality was the most important consideration in any corporate supply chain. Now we have moved to a world where safety of delivery matters most, even if the cost is higher. This is a dramatic paradigm shift….It adds up to a huge hit to productivity. Productivity is under attack from everywhere, from regulation, from ESG-investors, and now it’s also under attack from security considerations. This would only not be inflationary if on the other side central banks were acting with restraint. But of course we know that central banks are printing money like never before.”

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