Investors are starting to worry about inflation. Some are even sounding alarms of potential hyperinflation, throwing around references to Weimar Germany and Zimbabwe.
This is quite a shift in stance. For quite a long time, Wall Street behaved as if inflation had been banished forever. Now there are fears, implied if not spoken aloud, that inflation is just around the corner.
The latest burst of inflation fear has to do with a sell-off in global bond markets. Rates are quickly rising at the long end of the curve. At 2.24%, the 30-year U.S. Treasury yield is back to where it was before the pandemic. Meanwhile, in Germany, the 30-year bund yield — which was negative a year ago — has moved back into positive territory.
We would argue it is the rate of change in long-end yields, more than their absolute level, that has investors mildly freaked out. In the big scheme of things, the 30-year yield is still not that high: Just 24 months ago, it was above 3%. But it is rising fast now, and that could spell trouble.
Yields are rising because the market expects ripping, roaring growth. The United States could see 5% GDP growth in 2021 — the fastest since the 1980s — and the rate could be higher still.
When asked in a question-and-answer session if 2021 growth could be 6% — a respectable pace for any emerging market, let alone a rich country — Jay Powell’s response was, “could be,” meaning yes, the Federal Reserve sees that as possible.
You can tell the market believes in growth by observing intermarket price action — the implied judgements of the market as evidenced by which prices are going up, which ones are not, and how fast the movements are happening.
Energy stocks are rocketing higher, for example. In December 2020, TradeSmith Decoder loaded up on energy stocks to specifically position for the recovery narrative. It is playing out in spades now.
Financials are also powering higher; bank stocks, by some measures, are showing their best performance since 2007. This is a function of the steepening yield curve, and expectation that profitable loan growth is about to surge.
And then you’ve got travel and leisure stocks like airlines, cruise ships, hotel operators — all surging. These are hallmarks of an aggressive recovery narrative.
The thing that isn’t surging — but instead is slumping lower — is gold. The gold price continues to shuffle and slump lower, as it has done for months.
Gold is telling us the alarmist inflation views are wrong — or that they are wrong for the foreseeable future, anyway, which amounts to the same thing.
Over a period of many years, we see strong inflation as almost inevitable. That, in turn, means an inflationary crisis is highly likely. But the key qualifier there is “over a period of many years.” Inflation is not a light switch; rather than flipping on instantly, it can take a long time to build momentum.
Our concern, for our TradeSmith audience in particular, is that investors will focus on the first-order impacts of money supply growth and fiscal stimulus and assume it is time to buy gold with both hands.
The price action is saying something else, though. It is telling us that growth will come first.
Many are skeptical that government spending can buy economic growth. In the long run, so are we. But in the short run, in conjunction with a coiled-spring economic environment where consumer demand was pent-up anyway, fiscal stimulus can absolutely buy growth — and possibly extend the “growth first, inflation later” narrative over multiple quarters.
In the third quarter of 2020, the world looked quite different — it didn’t have 95% effective COVID-19 vaccines.
Lest we forget, for most of 2020, it wasn’t clear a safe and effective COVID vaccine would be developed in a short period of time, or that it could even be developed at all.
In our view, the absence of a safe and effective COVID vaccine would have brought on inflation much faster.
That is because, if pandemic uncertainties had stretched out interminably — along with the threat of rolling lockdowns, overflowing hospital beds, and so forth — economic growth would remain somewhere between weak and non-existent.
In that counterfactual “no end in sight” environment, heavy fiscal spending would have been tantamount to the U.S. government pushing on a string alongside the Federal Reserve. With the economy still weak, and consumers fearful and exhausted, surplus funds from ever larger helicopter drops would have flowed increasingly into haven assets like gold.
Vaccines changed the game, though. The arrival of astonishingly safe and effective vaccines in November 2020 — along with the feasible possibility of rolling them out quickly — put economic growth back in focus. The vaccines powered an optimistic set of forward expectations, centered around growth, that reverberates to this day.
That is why energy stocks, financial stocks, and travel and leisure stocks are all flying. Real growth, and a real release of pent-up demand, is coming.
To put it another way, this is not a great environment for inflation, because economic growth absorbs inflation. If wages, employment, consumption, and corporate profits are all rising, those factors can enable a sustainable rise in long-term interest rates.
Then, too, the Federal Reserve is logical in wanting to see a period of moderate inflation. If we see inflation run at, say, 3% for a while, that would again allow jobs, spending, and corporate profits to pick up, with workers and companies and banks all making money even as debt burdens were eased (by modest inflation eroding the value of the debt).
Eventually, in our view, a real inflation problem will arise. But for investors worried about inflation — or those who want to invest around inflation expectations — the operative question has to be, how much time will pass before inflation becomes a problem?
Let’s say that the five-year breakeven inflation rate — currently at 2.35% of this writing — hits workable levels of 3%, then 4%, then 5% — and starts becoming a problem at the 5% threshold and above, with the Federal Reserve unable to rein things in.
We can imagine four stages of the coming inflation cycle, like this:
moderate inflation → problematic inflation → severe inflation → crisis-level inflation
The problem for inflation alarmists is that the process of traversing from the first stage (moderate inflation) to the fourth stage (crisis inflation) is likely to take years.
If each of the first three stages last six to 12 months, for example — not an unreasonable estimate — it could be 2023-2024 before crisis inflation arrives.
Real economic growth can absorb inflation pressure because a rising tide of productivity and profits enables the handling of higher costs. As workers get paid, they can save and spend more; as businesses accrue more profits, they can handle higher financing costs for the purpose of further expansion.
This is why a vaccine-powered recovery is such a negative prospect for inflation-haven assets in the near term. Real growth prospects mean capital can be put to work, which increases confidence in the currency and makes debt burdens easier to shoulder.
If the United States had faced an extended COVID recession in 2021, with no amount of spending able to overcome the harmful impacts of the virus, it would have been a different picture. In an economy rendered lethargic and sick via COVID, adding to the money supply would merely have eroded confidence in the currency, magnifying problems across the board.
Prior to the game-changing vaccine news, America appeared headed down a path of parabolic money supply growth, with economic activity to absorb it.
That pre-vaccine outlook was one of the reasons we wrote about Weimar Germany in September 2020.
The Weimar experience was one where, due to a crushing debt load of World War I reparations, Germany engineered a deliberate policy of double-digit inflation to erode the value of those debts. They ran the printing presses not just hot, but white hot, as a way to survive economically.
The double-digit inflation plan then got out of control — with hyperinflation kicking in — after France and Belgium decided to occupy the Ruhr in 1923, causing German industrial production to grind to a halt.
So a key thing to understand — especially if one wishes to equate U.S. money supply growth to the Weimar experience — is that even in Weimar Germany, the crisis inflation stage (full-on hyperinflation) took years to play out, and furthermore required a crisis trigger (the occupation of the Ruhr).
Another thing to understand is that Weimar Germany saw hyperinflation because its heavily expanded money supply was suddenly juxtaposed against a halt of economic production. That matters because, if a national economy becomes ten times smaller overnight, it can have the same effect as making the money supply ten times too big — and the U.S. in 2020 is nowhere close to replicating that experience.
Our base case is for real inflation pain to be felt when the vaccine-powered growth boost starts to wear off. But again, when will that be? And what will the gold price do in the meantime? If the mid-1970s are any measure — another inflationary period when the U.S. experienced growth coming out of a recession — the gold price could fall by a lot as interest rates rise faster than inflation.
In a sense we wholly agree that trillions of dollars in stimulus, combined with a massive spike in money supply growth, amounts to a wild experiment that could end quite badly.
It’s the timing of inflation’s arrival we dispute, because official inflation measures could oscillate between “moderate” and “problematic” for months to come, if not years — which would mean now is not the time to be bullish on gold. And as for when that time comes — let the charts tell you!
