This is an excellent piece from Lyn Alden that she just released and complements the discussions we’ve been having here rather well. She went out of the spotlight these last two years, mostly because she is not a perma-bull, but I’ve always appreciated her level-headed view on things. Good to see her coming back to the fore again.
The whole piece is worth reading with care. Highlighting the particularly interesting sections, with some commentary:
… due to years of low investment in commodities, the world is no longer oversupplied on many of those commodities, including oil and gas and copper and nickel. Supply is tight, and falling global trust between countries makes that supply effectively even tighter, since the smooth distribution of that supply globally is in question.
Looking at oil futures four or five years out, the prices are still in the $65-$75 range, compared to $110 today. The market expects oil to come back down sharply. If you’re an oil producer, why would you significantly ramp up capex and production with oil futures priced that low? The beatings (supply constraints) will continue until morale (market pricing) improves.
relevant to the oil thread. Worth keeping an eye on those futures.
Back in the 1970s, Paul Volcker (then-chairman of the Fed) famously spiked interest rates to double digits, well above the inflation rate, and put the US into a recession in order to stabilize the dollar. Combed with various policies to outsource labor globally to cheaper markets and thus keep wages low, the US entered a long period of rising asset prices, falling labor costs as a share of GDP, and declining inflation levels.
The problem, however, is that public and private debt as a percentage of GDP was very low back in the 1970s, and it’s very high now. The economy could take higher rates without going into a financial crisis back then. Wealth concentration was relatively low at that time, and since that time it has reached record highs.
In other words, the levers they used back then are a lot weaker now, with lower breaking points.
For context, here is the Volcker era. Do we have the fortitude to stomach double digit unemployment? His policies also resulted in two recessions in four years. It is political suicide to throw millions out of work and bring in a recession unless inflation is bad enough. Done after, one is a hero. Also, midterms are in Nov.
(Source)
The Fed can likely tighten for a period of time longer. However, if the Fed raises rates to 3%, 4%, 5%, and so forth when debt as a percentage of GDP is this high, the annual interest expense of the US Treasury would exceed $1 trillion, and many companies and households would run into trouble refinancing their debts. And by persistently drawing down their balance sheet with QT, it will be a negative drag on money creation and asset prices.
The dollar would likely strengthen further in that scenario, which would squeeze all of the countries that have a lot of dollar-denominated debt (which is primarily owed to places like Japan, Europe, and China). The foreign sector in aggregate would likely stop buying Treasuries, and might have to sell Treasuries to get dollars, like they did during March 2020:
relevant to the Yen thread to some degree, but really more relevant to all the other countries that hold dollar-denominated debt, but we’re not really looking at those closely at the moment.
The various yield curves would likely invert, the Treasury market would likely become illiquid, the high yield credit market would likely become illiquid, and recession indicators would probably worsen. Demand will have been reduced, but at the cost of a recession, and the financial system would start to seize up.
At that point, regardless of what the inflation number is, the Fed would likely have to loosen monetary policy again, and Congress may have to provide fiscal stimulus again, or face a protracted recession.
So, I think the Fed will probably get some signals to stop tightening monetary policy prior to hitting very high levels, once something in financial markets breaks. And I think that will happen before they reach 3% short-term interest rates, and/or before $1 trillion is off the balance sheet, but we’ll see.
Overall, my base case is that the Fed will tighten monetary policy until something breaks, which will force them to reverse course. …
In the prior cycle, it took a credit market freeze (late 2018, where they stopped raising rates), decelerating economic growth (mid 2019, where they did a mild interest rate cut) and a repo rate spike (late 2019, where they switched from QT to QE) for the Fed to reverse course on monetary tightening.
… Whatever breaks is usually not the specific thing that most people are looking for.
In each business cycle, the Fed is able to tighten monetary policy less than the previous cycle. Eventually, a stagflationary scenario, such as we are in now, is likely what will disrupt their approach. If the Fed is forced to stop tightening for any number of financial or economic reasons, while official inflation rates are still well-above their target due to supply-side shortages, then we’ll have effectively entered a new policy regime.
Well, there you have it folks.
We’re kind hosed. 