Our view of inflation is complicated, but not too complicated.
In TradeSmith Decoder, we have large-sized bullish U.S. dollar forex positions as of this writing, and short precious metals positions, because the near-term mantra is “growth first, inflation later.” These positions are doing quite well.
A little bit of history may help clarify our stance. While the 1970s were a spectacular decade for gold, the middle-going was quite rough.
In an interim period spanning most of 1974 to 1976, the gold price fell 47% peak to trough. Why? Because the U.S. was coming out of its 1974 recession, allowing long-end rates to rise, and inflation concerns to retreat, as growth picked up temporarily. Sound familiar?
The gold price then bottomed out in August of 1976, and more than quadrupled into the 1980 peak. Right now, in growth-versus-inflation terms, we are closer to 1974 than 1976.
Ultimately, though, we do see inflation taking hold — even if it takes another six months, or 12 months, or 24 — because the powers that be will ultimately desire it to happen.
This means that, at some point, we will be aggressive buyers of gold again — but not yet.
That is what we mean by complicated, but not too complicated. In the medium-term, our conviction right now is almost “anti-inflation,” because growth comes first: This favors our temporary bullish U.S. dollar and bearish precious metals stance.
But eventually that stance will reverse dramatically back toward inflation, with a follow-on sentiment reversal for the dollar versus precious metals — and a combination of economic data points and price action signals (the message of the charts) will tell us when.
Then, too, in recent weeks there has been an active debate over whether government stimulus can create inflation. Those who are skeptical of government stimulus as even a temporary transformative agent still doubt inflation will come.
Bitcoin, meanwhile, continues to trade on a wholly separate dynamic from gold at the moment — it is all about the adoption curve — and TradeSmith Decoder continues to be aggressively long (as we have been consistently since March 19, 2020).
But getting back to the longer-term outlook for inflation, there are grumpy bond bulls — who have been grumpy bond bulls for quite a long time — who think the U.S. economy will soon enough sink back into the deflationary muck, based on the rule-of-thumb argument that you can’t buy growth with government spending.
There are multiple things the long-term inflation doubters fail to see.
First, it’s true one may not be able to “buy” long-term growth with government spending — but one can certainly rent it.
Give any business in the world a trillion-dollar credit line, and it’s guaranteed that the business can find, at the minimum, near-term ways to make the growth numbers look good.
Then, too, there is a big difference between a tidal wave of government spending in the depths of malaise with sentiment bleak, and a tidal wave of government spending that comes on top of a robust recovery, with breakout levels of optimism from consumers and CEOs alike, that was already in the making pre-stimulus (by way of pent-up consumer demand and a world-beating vaccine rollout).
And of course, there is a jaw-dropping difference between monetary policy effects — lowering the interest rate at which businesses can borrow, for example — and the bunker-buster fiscal effects that come from enabling mass-scale “helicopter drops” (where currency is sent directly to bank accounts).
But most importantly — and this is perhaps the biggest thing the malaise crowd misses — the real question is not even what impacts the $1.9 trillion stimulus (which passed muster in the U.S. Senate this weekend) will have.
The real question is whether trillion-dollar stimulus packages will be seen as a one-off — a kind of historical anomaly born of the pandemic — or the beginning of a policy paradigm shift.
Consider: The $1.9 trillion “stimmy” (to use the trading desk nickname) now on the way is neither the first, nor the second, but the third in a sequence.
Two data points make a trend, and three make a story. So who is to say the stimulus story ends here? What if, instead, the story is only beginning?
More simply put, the forward-thinking investor has to ask: What happens when stimulus becomes a normalized paradigm, where the stimulus keeps coming in various forms, for various reasons?
Some talking heads have argued the market is over-reacting to inflation concerns, on a longer-term basis, relative to what the $1.9 trillion stimulus will do. This is possible.
It is also possible, however, that the market is looking farther into the future, and seeing the sequence: After this $1.9 trillion round, another $2 trillion round for infrastructure and a comprehensive overhaul of the aging electric grid. Then another trillion-plus round when the post-pandemic rebound has a hiccup. Then another round because stimulus is deeply popular with the American public, with critical mass percentages of both Democrats and Republicans demanding it, and so on.
The political popularity of stimulus is one of the key data points to consider, in our view. The level of bipartisan support for direct transfer payments, all across the political spectrum, is little short of stunning.
And yet, it makes sense when one considers the majority of Americans have more debt than savings.
The simple fact that most Americans are indebted — with notably more debt than savings — leads to another conclusion the financial press seldom talks about: Inflation is a desirable outcome for the powers that be. And we don’t mean just a little bit of inflation either, but a lot.
Both the U.S. government and the Federal Reserve have their own reasons — which they will never admit out loud — why letting inflation run “hot” for a number of years, even 1970s-style hot, could be a useful thing.
This means that, when the day comes where inflation starts to feel wild and woolly, we may hear lip service to resisting it from both politicians and central bank officials — but actual resistance will not be found. Instead, inflation will be allowed to roar.
There are two big reasons for this:
- Inflation is an egalitarian force in a society where the majority are heavily indebted, meaning that persistent inflation is a way to reduce the inequality gap.
- Persistent inflation is the easiest way to escape a government debt trap; instead of defaulting on the debt or sacrificing heavily to pay off the debt, you just inflate away the nominal value.
It may sound strange to think of inflation as egalitarian — a kind of equalizing force that reduces the gap between, say, the top 10% and the bottom 70%.
It makes sense, though, when you think about who benefits on a net basis from aggressive inflation, if a particular mix of policies are in place that generally favor the labor economy.
Jeff Currie, the global head of commodities research at Goldman Sachs, has pointed out that the most “equal” period in America’s history — in terms of a minimized economic gap between rich and poor — came at the end of the 1970s.
Why would that be so? Because, in the 1970s, inflation was eating away the debt burden, even as powerful unions used negotiating power to keep wage growth in line with inflation.
As a general rule, inflation helps the debtor and harms the creditor. Inflation reduces the nominal value of debt, which gives relief to whomever who has taken on the debt. At the same time, inflation erodes the value of debt as an asset, which reduces the real value of the creditor’s debt holdings.
Since most Americans have more debt than savings, inflation thus reduces the debt burden for most (in the same manner it reduces the debt burden for the U.S. government).
The pain of this process then falls on those with the most savings — call them the “creditor class” — who happen to be the top 10% or even the top 1%.
Ah, but what about inflation’s impact on the cost of living? In the 1970s, that is where the power of the labor unions came in. As the unions negotiated persistent wage increases — which contributed to inflation — union workers were protected from inflation, at least somewhat, by seeing the size of their pay packets increase. So their nominal wages were keeping pace with inflation on the one hand, and the value of their debts were falling on the other.
Fast forward 40 years or so, and unions have far less power than they did in the 1970s.
But this is where normalized stimulus comes in: To the extent that the U.S. government starts engaging in normalized transfer payments to the lower half of the economy, it is the functional equivalent of negotiated wage hikes for the labor sector on a regular basis.
Some who fail to connect these dots argue that you can’t have real, sustained inflation unless wages are persistently going up. But that argument fails to see that normalized stimulus — if that is what we get — is a de facto implementation of the same idea, in an even more efficient way.
If the government is routinely sending checks to households below a certain income level on a routine basis, it is like the labor unions doing a bulk agreement with Uncle Sam directly once or twice per year, rather than going industry by industry.
Again, too, political popularity is the key to understanding this. Deficit hawks tend to reside exclusively among the creditor class.
The average American doesn’t really care about the deficit at all, regardless of political persuasion. Republicans seem to care more than Democrats, but not by a supermajority (and not by enough to make a difference).
One may hear lip service paid to the virtues of fiscal prudence — a classic instance of telling the pollster what conventional wisdom says they want to hear — but the actual response to stimulus offers tells the real story. Just as the Reddit army likes to chant “WE LIKE THE STOCK!,” Americans seem to chant “WE LIKE THE CHECKS!”
Grumblers as this point will highlight a rising cost of living as something that will hurt low income Americans, and they will have a point. But guess what the politically popular solution for cost of living discomfort will be: “More stimmy!” To the extent rising inflation makes life more expensive, the go-to answer will be more transfer payments.
The technology deflation thesis plays into this, too — to the extent that rapid advances in software and machine-learning eat into job security and earnings prospects for the white-collar middle-class.
The New York Times recently ran a piece titled “The Robots are Coming for Phil in Accounting,” essentially arguing that, while Phil himself may not be replaced right away, larger and larger chunks of his job are being automated at the margins, with the net effect of only needing, say, two human bean counters in the accounting department rather than the previously required six. As more and more Phils hit the bricks, their jobs eaten by software, guess what they will favor: More stimmy!
Then, too, “hot” inflation (meaning inflation that runs uncomfortably above trend, even far above trend) has another unspoken virtue in the eyes of debt-burdened policy makers: It is the only realistic way to reduce America’s debt-to-GDP level over time.
The difference comes down to nominal numbers versus real ones.
- Say the U.S. national debt is around $28 trillion while U.S. GDP (the size of the economy) is $22 trillion. That is a debt-to-GDP ratio of 127%, which exceeds World War II levels.
- Now say inflation cranks up, and the nominal GDP level (the size of the economy expressed in dollars) grows to $50 trillion — a number that reflects a modest portion of real growth with lots of inflation (a mega-scale increase in the money supply) on top.
- If the nominal debt goes up less than nominal GDP during that time, rising sharply but not by as much — to, say $44 trillion — then the debt-to-GDP ratio has improved: At $44 trillion (debt) versus $50 trillion (GDP), the debt-to-GDP ratio fell to just 88%. This fall happened even as the nominal debt level rose, because inflation caused the nominal GDP level to rise even faster.
The upshot is that you really can inflate away debt, presuming the underlying economy has a sustainable rate of growth as such that society can handle the inflation without falling apart.
Nor is it a magic trick — instead it is a wealth transfer, in the sense that the creditor class (those with net savings in treasury bonds) wind up transferring a chunk of wealth to the debtor class (those whose net worth is negative by way of holding more debt than savings).
When we say “this is probably the way it will go,” we are neither endorsing a path of events nor offering a policy recommendation — both actions would be pointless. Instead we are simply observing the U.S economy as a system, one which intertwines democracy and capitalism, and gauging the likely emergent effects based on where the system is going.
In the title of this note, we said “it begins” because, in our view, the passing of the $1.9 trillion stimulus is likely to be remembered as a watershed moment.
In our view, the $1.9 trillion stimulus is almost certainly not just the third round of relief in an effort to slingshot America out of the pandemic; it is the beginning of a paradigm shift in which direct transfer payments, and a government-level embrace of eventual “hot” inflation, whether admitted out loud or aggressively denied, becomes a normalized part of American life, as a means of both closing the yawning wealth gap and inflating away the national debt.