Here is an inflationary storm like none before

The United States treated inflationary storms before. However, none started in such an unprepared financial environment. Therefore, expect the effects to come to be chaotic.

(See “Inflation messages: the recklessness of 2021 versus the wisdom of 1981”For the justification of a period of rising inflation to come)

Preparation has been stymied by the Great Recession curative measures that have been taken to extremes in size and time. Because these stocks fuel inflation, they must be tempered in the face of a growing inflationary environment. Failure to do so would raise the specter of stagflation (poor economic growth in a context of rising inflation) or hyperinflation (the vicious cycle of ever-rising inflation).

And that brings the fourth, and perhaps the greatest, danger: investor belief that we are in a “new normal” period.

The last 10 plus years of easy money, deficit spending and low interest rates have created the “new normal”. It has been fully supported by economists (especially those at the Federal Reserve), government leaders and Wall Street. So, naturally, many (most?) Investors view these actions as acceptable, necessary and permanent. Change them and investors will react negatively.

How the “new normal” was created

During and after the Great Recession, three important external forces were at work:

  • Huge deficit spending and the level of indebtedness of the US government
  • The massive creation of fiat money by the Federal Reserve through bond purchases (“fiat” means money not backed by or convertible into something of value, like gold)
  • The Federal Reserve’s extensive use of negative real interest rates (“real” meaning after subtracting inflation – that is, the decline in the purchasing power of the dollar)

The first two are preconditions for an environment of rising inflation rates.

The third is the tactic that produced the abnormal incentives and actions of borrowing, lending and investing – in other words, the “new normal”

How to find a “real normal”

Much of America’s financial history is marked by external forces of one kind or another – booms, busts, wild optimism, fearful pessimism, and all the points in between.

The chase takes us back 25 years, to 1996. Federal Reserve Chairman Alan Greenspan had reverted to market-based interest rates after the bank and S&L collapse and recession of 1990- 91. Although he viewed the rising stock market as exhibiting “irrational exuberance,” he was three years premature. The economy was growing, the government was focused on both expanding and reducing the deficit, and the financial system was stable.

After 1996, five overlapping episodes of various external forces at work:

  • Formation of Internet bubbles and implosion / recession
  • Real estate bubble with financial fiasco linked to subprimes and prolonged fallout
  • The Great Recession and the rebound-recovery
  • The actions induced by the Federal Reserve’s still ongoing Great Recession consisting of abnormally low interest rates combined with abnormally high money supply creation
  • Abnormally large deficit-funded U.S. government fiscal spending programs, such as the 2018 tax cut bill

The vision of normality in 1996

Below are the yields, price changes and growth rates for the year. Note the “real” positive interest rates that always occur in normal environments. They are based on the fundamental truth of investing in normal capitalist markets: investors demand that the return be proportionate to the risk. This means a risk-free rate (short term US Treasury) higher or close to the rate of inflation with increased rates and potential returns for higher risks (e.g. longer term and / or lower credit) .

The view of annual averages and growth rates for 1996:

CPI –

  • Total: 3.4%
  • Less food and energy: 2.6%

US government returns –

  • 90-day Treasury bill: 5.0%
  • 1-year Treasury bill: 5.2%
  • 5-year US Treasury: 6.2%
  • 10-year US Treasury: 6.4%

Corporate bond yields –

  • Moody’s AAA: 7.4%
  • Moody’s BAA: 8.1%

Bank prime rate: 8.3%

Mortgage rates –

  • 15 years: 7.3%
  • 30 years: 7.8%

Rising house prices –

  • National Index of U.S. S & P / Case Shiller Houses: 2.5%
  • Median new home sales: 4.5%

Growth rate of the economy –

  • GDP (nominal – i.e. not adjusted for inflation): 6.2%
  • Corporate profit (after tax): 7.4%
  • Personal income: 6.2%
  • Personal consumption expenditure: 5.7%

Financial growth rate –

  • Commercial and industrial loans (all commercial banks): 7.9%
  • Consumer loans (all commercial banks): 6.3%
  • Federal debt: 5.3%

Unemployment rate –

  • Overall: 5.4%
  • 25-54 years: 4.3%

Stock market earnings –

Now think about normalizing today’s environment more have rising inflation rates

Take the 10-year US Treasury key yield of 1.66% today. How far does this yield have to increase to have a normal position? Compared to other rates in 1996, the spreads were + 1.6% (for risk free vs CPI) and + 1.4% (for 10 years vs risk free) = 3.0% of total spread.

Cautious savers and investors have quietly accepted the 2% loss of inflation (loss of purchasing power) over the past 10+ years, even though the cumulative loss is now around 20%. Push that annual wastage rate up to 2.5%, 3% or more and the noise will start.

In addition, professional investors will begin to demand higher yields on longer-term bond issues again. In the past, long-term yields were more independent of what the Federal Reserve did with short-term rates.

The Bottom Line – Many don’t believe times are abnormal, increasing the risks of a rising inflation environment

The image above is not a low probability risk. This is a “normal” reaction with a high probability of leaving an abnormal environment. This makes interest rate disparities particularly worrying.

Whether or not Federal Reserve Chairman Powell tries to raise rates to a “neutral” level, rising inflation rates will produce pressure for higher yields. While inflation expectations drop from 2% to 2.5% to 3% to -not-, this UST yield of 1.66% at 10 years will necessarily jump up to catch up. How far? It depends on how quickly normalcy returns to pricing risk

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About Robert Valdivia

Robert Valdivia

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