The Coming Inflation Conflagration
As I noted in an earlier Patron Post we are entering the first period since I began writing this blog years ago when I am actually concerned about inflation blowing up. In my last article about all the variables creating insanity in the housing market, I noted that inflation (or expectation of it) has started to drive up bond yields at a blistering pace, which in turn are starting to ignite mortgage rates. Prior to that, I had stated that, if the ten-year bond broke above 1.25%, it would start to create downward pressure on stocks by competing for investor money.
The stock market's troubles continue to happen at the points where I've said the stresses would show up. We did, for example, get two ~10% corrections in September and October of last year, both of the months when I said we would most likely see the market fall. That breakdown, while not as big as I anticipated, was significant and looks like this:
Even though the market recovered after October; you can see it did not recover back to trend. Even in its latest insanity, it remains far from the trend line it had been on or even from the same rate of ascent.
If you look at where the US 10-year treasury bond first broke and held above a 1.25% yield ...
... you see that market mania in the S&P 500 topped out (for the moment anyway) at the same point, as I had said we could expect. It has been churning slowly downward since then as investors start to struggle over what to make of yields that are holding above one-and-a-quarter due to inflation concerns:
TIP rates are rising, adjusting for higher inflation rates. This is likely to cause a great deal of volatility as stocks re-price for these higher rates. The options market appears to already be pricing in some of these added risks....
Rates on the 10-year started rising at the beginning of August. But 10-Year TIPS [Treasury Inflation-Protected Securities] traded sideways until just recently. That has allowed the spread or the inflation breakeven rate to widen to its widest point since October 2018. Now, as inflation rates climb, it seems likely that those 10-Year TIPS will need to rise sharply....
Mott Capital, Seeking Alpha
TINA (There Is No Alternative) has been a major market accelerant. With inflation pushing mortgage rates higher and now causing bonds to become more competitive with stocks, there suddenly is an alternative -- bonds. So, TINA is losing out to her budding competition. Inflation clearly has the power to break both the insanely exuberant stock market and bond market. So, how bad is it and what are the risks that inflation spreads and rises faster?
Sachs of Gold weighs in on stocks and bondage
As Zero Hedge notes,
We pointed out that after being frozen for almost a year ... real yields finally surged, and nowhere was this more visible than 30Y real rates (i.e., TIPS).
Of course, the longer the term of the bond, the more sensitive it is to fears of inflation. The bond that is the benchmark for many interest rates (the 10-year) is also blasting off like the 30, even after factoring in loss to inflation (real yields versus nominal), indicating bond yields are running ahead of actual CPI in part because CPI is fake inflation (artificially lower than reality) and in part because bond investors are fearing greater inflation to come:
Goldman Sachs notes it is more the rate of rise in bond yields than the amount that should be of concern, as that is what will spook the stock market. Well, the current rate looks pretty close to straight up to me -- so that is likely why the market is acting spooky.
To gauge this concern, Goldman writes,
Looking back and looking forward at potential drivers and impacts of rapidly rising real yields. We examine three episodes of rapid increases in real rates over the last 15 years.... Then, we ... predict asset responses to scenarios under which real rates might rise sharply....
Past episodes of real rate spikes have generally followed a period of significant real rate decline; have come against a backdrop of improving growth views; and have generally featured either a perceived shift in central bank policy or in fiscal policy.
Check, check and check.
1) We are following a long period of declining real rates. Real rates have been dropping steeply since the start of 2019, and been on a longer-term trend since the start of the Great Recession:
Couldn't put a much bigger check on that one.
2) We have experienced a recent backdrop of improving growth news. While we are far from a V-shaped recovery, we have bounced back sharply from the greatest economic collapse since the Great Depression because what you turn off with a switch (by government mandated lockdowns) you can somewhat turn back on with a switch. A lot of damage remains, but most people are not perceiving how much sustained damage there is; they are just looking at the rebound and assuming it will continue as it has.
3) There is a generally perceived shift in central-bank and government policy that runs even more liberal with money supply and bond issuances than what we have seen so far. This is because of the recent election. As Goldman notes,
Investors have become more focused on the potential for and risks of higher US real rates after the shift to unified Democratic control.
No one doubts that Dems will run faster than ever into more social welfare and Modern Monetary Theory in the form of government stimulus of all kinds now that they control the entirety of the US government and have Yellen in charge of the treasury with her friend Jerome Powell's foot already hard down on the accelerator.
For stocks, more stimulus has been all-good ever since the Great Recession began. That, however, happened in a scenario where all money went to banks and a great portion of the bank money went to stocks so that it did not create general inflation. It created asset inflation. Now that it is going into the hands of the common people, it can create general price inflation at last, as I warned last year.
Inflation creates rising bond rates. That creates problems for the government in financing more debt, making the remainder of the stimulus path more fraught with difficulties, and it creates the mentioned competition for investor money between rising bond yields and stocks.
Yields going apeshit and taper is still 2 years away.
Good luck with that— zerohedge (@zerohedge) February 19, 2021
Consumer prices rise after producer costs rise
Inflation can be caused in various ways. It can happen when consumers face a shortage of goods and have the means to pay more. That is the worst driver because consumers are able to bid up the price of scarce goods. It is also pressured to rise when producers are putting more demand on resources, raising their resource costs, or when resources become more scarce. Currently critical resource prices are soaring.
"Dr. Copper" is particularly taking off. Copper gets that moniker because it is seen as diagnostic of the economy. The idea is that, if copper is rising, it must be because demand for products containing copper is rising. However, it can also be that it is rising in dollars because the value of the dollar relative to other currencies is falling, or it can be due to scarcity (such as because COVID is slowing down transportation or causing a drop in production of copper).
Copper is burning up the road right now, having risen back to the levels it had sustained for a couple of years just before the Great Recession. It is in so many products, so many products will be rising in price because producers will have no alternative.
It is only a matter of time before we see a new all time high. Indeed, overnight copper extended its surge to a nine-year high as Goldman Sachs warned of a historic shortage with "the market now on the cusp of the tightest phase in what we expect to be the largest deficit in a decade" as Chinese buying "triggers the next leg higher" adding to expectations that prices will near a record sooner rather than later....
The very low starting point for inventories at the beginning of this year has been further exacerbated by a counter seasonal stock draw so far in Q1 on a scale only seen once before in recent history (in 2004). These trends point towards a high risk of scarcity conditions over the coming months.
Artificially imposed trade barriers, COVID-forced transportation barriers, COVID-related slow-downs in production of resources as workers in some instances were forced to stay home, have all added to a shortage in materials -- copper being just the most-watched example.
In this case, copper is not so much rising because of a strong economy as it is because of shortages and transportation slowdowns and an internationally devaluing dollar. So, copper's rise may not be the harbinger for economic growth that some regard it as being. Scarcity is ruling the day.
The market is now on the cusp of the tightest phase in what we expect to be the largest deficit in a decade.... These trends point towards a high risk of scarcity conditions over the coming months.... To reflect the rising probability of scarcity pricing our new 3/6/12 [month] copper targets increase to $9,200/$9,800/$10,500/t (from $8,500/9,000/10,000/t previously).
Supply of copper is expected to fall short of demand for four out of the next five years.
Oil prices have also been continuously rising since the COVIDcrash, and oil, directly or indirectly, is in a whole lot more things and services than copper:
We've seen a lot worse, and the rise to the present level is essential to saving the oil industry that started to blow out during the COVIDcrisis; but it is one more factor pushing inflation on the production/transportation side. Oil gets factored out of the core inflation rate that the Fed goes by because of its volatility, but it is certainly not factored out of your and my equation.
Witness how things worked out in Texas the last two weeks when skyrocketing natural-gas prices caused people's electric bills in many place to shoot from $450 per month to $3,500 for the past month or even higher. Factor that!
Here is an example:
That is a prime example of how quickly hyperinflation can kick in when there are supply shortages (much more than from too much money) and how devastating it can be. In this case, it was regional and limited to energy-related living expenses, but it was severe. It's a case-in-point regarding what I said about hyperinflation happening when too much money chases too few goods with an emphasis on the "too few goods." The supply of energy suddenly dropped but demand kept up, so gas prices exploded. One person reported his energy bill blew up from under $700 a month to $17,000! He practically has to refinance his house to pay a one-month energy bill!
OilPrice.com ran the numbers of how much it would cost to charge a Tesla in Texas earlier this week. While a regular charge costs around $18 ... estimates showed that the surge in power prices would have cost $900.
(Does anyone even think about this as we move to turning the whole nation to electrical cars? Where is the energy going to come from? How many more supply shortages will we have because of the huge expansion in electricity demand? And how much does the massive increase in demand raise the regular price above the present cost and raise the cost of everything else that uses electricity?
Meanwhile some fish-for-brains person in the northwest wants to remove five hyro-electric dams for salmon runs ... but probably also wants us all to switch to electrical cars in order to be more environmentally friendly. How? Does ANYONE think these things through? Will we meet the huge increase in demand for "clean electricity" for cars by adding environmentally friendly Fukushima- fallout power to create more three-eyed fish to replace the salmon runs? Will we install miles of gigantic bird choppers along every mountain ridge ... like the kind that froze up in Texas or that catch on fire and can start forest fires? Alas, I digress.)
As we create an increasingly fragile economy, we can expect economic eruptions like this to happen more often. Fragile systems and overstressed systems break. Texas was an example of a fragile power grid that was overstressed. It was fragile because not enough investment went into making it weatherproof for 50-year storms. It was overstressed by a storm that overloaded it.
With so many fragile points, critical areas were bound to give out and then cascade into far more severe problems. For example, when gas valves started freezing several gas-processing plants had to flare off huge volumes of preciously needed gas to avoid further catastrophe in the plants, making the energy shortage even worse. That is what happens when your systems are not robust and do not have enough redundancy.
This is what happens when supply lines literally freeze up, but it's also indicative of what happens when the freeze in production supply lines of any kind is not literal but is just as terminal. COVID shutdowns have created numerous blockages in supply lines. Who knows what will go critical next? That's why I say hyperinflation is now a serious risk because we are multiplying opportunities for these kinds of shocks all over the place.
We hit the proverbial offerless market where any natgas that was available would be purchased at virtually any price, which is why midcontinent prices such as the Oneok OGT nat gas spot exploded from $3.46 one week ago, to $9 on Wednesday, $60.28 on Thursday and an insane $377.13 on Friday, up 32,000% in a few days.
Actually, by my calculation, that is roughly a 10,800% increase from one end of that spectrum to the other, but you get the point. Hyperinflation due to supply shortages can happen overnight, and prices can rise to whatever people are able to pay, which depends on how much money they have, or are willing to pay, which depends on how badly they need it. Thus, too much money chasing too few goods creates hyperinflation. In the Texas case, more people would have chosen not to use electricity and keep warm in their cars if they had known what kind of cost was going to hit them, but they were immediately blindsided.
Another place where we are really seeing inflation due to the declining dollar (versus other currencies) and due to supply interruptions is in import prices:
With all of that, it is no wonder the Purchase Manager's Index for the services industry is soaring for their input costs (red line) compared to their graph of prices charged (blue line) for services to customers. You know the blue line will have to catch up, as it normally shows no lag at all:
That's the highest input cost ever for the services sector. The disparity between the two lines means that, for now, the services sector is likely running in the red until prices can catch up. You can only wait out that kind of massive margin compression for so long, and by that, I don't mean very long. As you can see, the moves typically track tightly, so we're talking weeks not months.
And things are already coming home to rest with the consumer:
It’s odd that Powell would say he doesn’t expect a sustained increase in inflation, because food price inflation has consistently run 3.5 to 4.5 percent since April last year. That sure seems like a sustained increase in food prices.
That area of rising prices would factor as relatively significant to many of us, even if not to Jerome Powell.
What Powell seems to have “forgotten†is that some of the overall inflation includes negative energy price inflation (as low as negative 9 percent at one point). But now that the demand for fuel is returning, the official gasoline index rose 7.4 percent in January. It will be much more challenging for Powell to keep downplaying the risk of hyperinflation once energy price inflation rises back to “pre-pandemic†levels.
The negative prices for energy, due to all of us using less fuel during COVID, have pulled down the average price inflation ... like the tide runout before a tsunami. However, that tide returned in force with energy prices in Texas -- the US petroleum capital -- and a number of other states this winter. I predict the Fed will try to factor that out as "transitory." It might be, but the effect of the cost surge will hang on awhile, and the number of such surprises will rise due to our fragile systems and large swings in demand.
If inflation does hit 3%, it is more likely to go to 6% or higher, rather than back down to 2%. The process will feed on itself and be difficult to stop. Sadly, there are no Volckers or Reagans on the horizon today. There are only weak political leaders and misguided central bankers.... The foundation is already being laid for the “process to feed on itself.â€
Too much money chasing too few goods
If consumers don't have money, producers cannot pass on the rising costs because people won't buy their goods. But, if people are flush with cash at a time when production is getting more expensive due to resource shortages and transportation issues (supply chain problems), producers will find ways to keep producing and will also push the costs on to impatient consumers.
For now, the story is that the sudden and massive shifts in the economy in 2020 have caused shortages and distortions in the goods-producing sectors and in shipping and trucking, as consumer spending has shifted from services – such as flying somewhere for vacation and ... lodging and restaurants and theme parks – to goods, particularly durable goods.
The story is that prices are rising because components and commodities are in short supply, and supply chains are dogged by production issues, and are facing transportation constraints, as demand for those goods has suddenly surged.
Even with millions out of employment, many people are surprisingly flush with cash because of government helicopter money to the masses, great unemployment benefits, etc. But, being out of employment, means they are not producing or transporting. With many service-sector businesses shut down, there is nothing to go do, people stuck at home are spending some of their extra money on goods to play with.
The Fed sees all of that as transitory -- something that will quickly be sorted out. The Wall Street Journal does not.
Without restaurants to visit and trips to take, Americans bought out stocks of cars, appliances, furniture and power tools. Manufacturers have been trying to catch up ever since. Nearly a year since initial coronavirus lockdowns in the U.S., barbells, kitchen mixers, mattresses and webcams are still hard to find. A global shortage of semiconductors has forced many car makers to cut production in recent weeks....
Consumer spending on long-lasting goods in the U.S. rose 6.4% last year but domestic production of those goods fell 8.4%, according to federal data, leading to shortages and higher prices. Supply chains typically get beaten up during recessions. As sales decline, companies draw down inventories to conserve cash instead of purchasing more parts and materials. Entire pipelines of supplies get cleaned out.
The Journal article explains the extraordinary efforts producers are making to get international supply chains back up and running (damaged as they already were by the Trump Trade Wars before getting hit by COVID). One example they give is Wanxiang America Corp:
The U.S. arm of one of China’s largest auto-component manufacturers, quickly reopened its U.S. plants last spring. But transportation bottlenecks have lengthened the lead times needed to get parts from its sister plants and other suppliers in China to Chicago to 10 weeks from four typically.
“With three, four or 5,000 components in a car, you only need one to keep it from getting out of the factory parking lot,†said Pin Ni, president of Illinois-based Wanxiang America....
“The global supply chain is not as strong as people thought,†Mr. Pin said.
Transportation -- the spine of the supply chain -- got balled up from trade wars followed by COVID lockdowns:
Some companies who are reliant on foreign suppliers have been particularly hurt by delays as shipping containers have been hard to get and U.S. ports struggle to unload them. Peloton Interactive Inc. added two million monthly subscribers for its digitally connected exercise bikes in 2020 but the company said it was spending more than $100 million to reduce shipping times.
When production supply lines slow and customers get impatient because factories can't keep up, factories start using good ol' capitalism (where that is still allowed to function) to establish equilibrium by raising prices to reduce demand to the level they are capable of meeting:
Simplicity Sofas founder Jeff Frank said that he can’t find enough skilled sewers to staff new production lines, and that some fabrics take months to arrive from suppliers. He recently started charging prospective customers for fabric swatches that used to be free. “I’m basically discouraging people from buying,†he said.
It's like I said last spring: You can turn the economy off with a switch; but, just as some machines in big factories don't start as easily as a flip of the switch, so some aspects of industry in general do not so readily start back up.
You can’t just turn off supply chains and turn them back on and there not be hiccups.
The result is ...
If you walk into a lot of big retailers, the store shelves are really kind of empty.... They are looking for ways to fill the stores.
As that happens, retailers also start raising prices to slow demand down until they hit a price they can fill. That is how capitalism is supposed to achieve equilibrium in markets. They still find enough customers who have cash who are willing to pay the higher prices to sell out all their limited supply. That is the point where the pressure on prices eases off.
The federal government is now promising big infrastructure programs that will add considerable new demand for resources. Because the government can have its banker, Jerome Powell, print up money on demand, there is certainly a case of too much money chasing too little supply right there. So, that will raise resource costs and push up prices more for everyone from the manufacturer on down to the consumer.
Fed up again and again
If you add up all of the money the U.S. has ever printed… over 40% of it was printed in 2020 alone. In three months in 2020, the U.S. increased its deficit by more than it had during the past five recessions combined
In fact, Jerome Powell bought more US government treasuries in just six weeks last year than Ben Bernanke and Janet Yellen did in their entire Fed chair careers combined.
As Michael Every of Rabobank put it,
We officially have central planning with no plan.
We all know how forests filled with accumulated dead tinder resulted in devastating fires throughout the state of California. Imagine what an inflation conflagration is potentially laid in with all of the Fed's new money from 2020 laying around.
We all know the stock market is wedded at the hip to the Fed and its willingness and ability to create new money ad infinitum to keep inflating stock prices. Rising inflation -- now that the money is going to general consumers and now that we have supply shortages looming -- will cause the bond vigilantes to push up bond yields, quickly forcing the Fed's hand back into buying up more government bonds to keep bond rates from rising. Otherwise, government debt (and everyone else's debt, indexed to those bonds) will become unaffordable. In other words, the Fed will have to increase QE4ever, which is why I said it would be QE4ever when it began again in 2019.
The Fed is providing clear clues that it will keep pushing inflation up beyond a safe level:
There are reasons for investors to be concerned about inflation prospects, sending TIP rates substantially higher. The Fed minutes note that not all rising prices will be considered inflationary.
Mott Capital, Seeking Alpha
That's key.
The minutes noted: "Participants emphasized that it was important to abstract from temporary factors affecting inflation—such as low past levels of prices dropping out of measures of annual price changes or relative price increases in some sectors brought about by supply constraints or disruptions—in judging whether inflation was on track to moderately exceed 2 percent for some time."
In other words, the Fed is going to ignore all the inflation that happens due to the kinds of supply shortages talked about here as being transitory. It will, for example, ignore the massive Texas energy price hike, even though that hike certainly won't ignore you if you live there or businesses in Texas that may have to raise prices because of that cost. The Fed will do that because it sees those things as anomalies to be priced out. It may do that for months before it realizes some of the things it thought were transitory are not. As the supply anomalies stack up in this fragile COVIDcrisis environment, inflation will rise much further than what the Fed is counting or acknowledging as inflation. Some of that will almost certainly prove more than transitory. Will the Fed, then, suddenly include in its inflation statements a whole backlog of inflation it was factoring out for a whopping shock, or it will continue to deny the severe inflation is happening even longer, compounding the problem even more?
The bond vigilantes, on the other hand, will not be ignoring those factors. They will increasingly tell the Fed it's time to get real by forcing up the government's borrowing costs. That forces the Fed away from its slowdown in QE back to full-bore balance-sheet expansion (sucking up all the bonds the government wants to issue). As you can see, the Fed's balance sheet expansion is, in the last few months, continuing at the same rate as QE3 (the slope leading up to 2014), but the Fed is going to have to substantially up the pace of buying government bonds if it wants to reduce bond yields. That, however, could create its own upward pressure on inflation by giving the vigilantes more reason to fear the Fed is losing control.
The Fed could get caught in a trap. What the rising yields say is that the Fed thought it could slow down QE (buying government bonds), and that isn't working.
These kinds of misjudgments are why inflation can build underground and look fairly normal above, then suddenly erupt as visible hyperinflation on the surface.
As I've always maintained, the Fed has never had an exit plan from its original QE that won't ultimately result in crashing the stock market and now the bond market and the housing market together with it. That may be how the Everything Bubble falls down to earth again -- rising bond yields, causing bond prices to plunge, stock prices to plunge, and housing prices to plunge once rising bond yields push mortgage rates up high enough.
I'm not saying this great conflagration is coming. I'm just saying that the scenario I warned about last year is building in the manner I described, and we are starting to see the effects. We've moved from my amber warning to keep a watch out for signs of inflation to an orange warning that inflation is here and pressure is building. A red light means inflation is climbing out of control and is about to blow out into hyperinflation.
We're not there yet. However, with the Fed telling us all the inflation they do manage to see is transitory, I don't have much confidence they will prevent us from getting there before they figure out it isn't transitory. Remember, they thought QE was temporary, too, by design no less -- their design -- yet they recently did another $100 billion of QE in just one week. Remember, they quit doing QE at the end of 2014, and Janet Yellen told us there would not be another such need in her lifetime.
To see how that turned out, reflect back on the last graph above. When they tried to take their balance sheet back down in 2018, they created a huge stock-market crisis by the end of 2018, just as I said they would. That only ended because they promised to stop reducing QE. Because they didn't stop soon enough, even when they saw problems emerging, they also created a massive repo crisis toward the end of 2019. They, then, attempted to resolve that unsuccessfully with "not QE" -- the first rise in QE at the end of the graph, which they did their best to deny. The Repocrisis ("Repocalypse") only got worse until the COVID crisis ended the Fed's repo crisis by giving them carte blanche to return their balance sheet back to greater liftoff than seen in any period before ... and their still lifting.
That's how well the Fed understands "transitory." Don't worry: they'll pull all that new money created from renewed balance-sheet expansion back down to Earth in no time, just like they did so successfully in 2018; and they will promise, as Janet Yellen promised (just before she promised we would never see another financial crisis in her lifetime) "it will be as boring as watching paint dry." (From that graph, the Fed's balance-sheet reduction looks more like watching Olympic pole vaulting to me!)
If they cannot pull the money out without crashing everything ... again ... how will they stop inflation if all the money does start to create high inflation? Then inflation will crash everything. The rock and hard place.