Something like $7 trillion of sovereign debt is negative yielding. Stop and think about that for a second. Almost 29% of the Bloomberg Global Developed Sovereign Bond Index has a guaranteed nominal loss built into the investment. The only reason this makes even the tiniest amount of sense is that the market is convinced deflation is the boogeyman in the closet.
At the turn of last century, pundits were adamant “Japanification could never happen in the US or Europe.” The idea zero rates or quantitative easing would spread outside Japan was ludicrous. Deflation was unique to Japan.
When fellows like Gary Shilling warned about deflation, they were labeled cranks and “just didn’t get it.”
Yet here we are today with market pundits falling all over themselves predicting years (and even decades in some cases) of moribund growth and inflation. Everyone has given up on inflation.
Reverse Volcker moment
In the spring of 1979 it snowed in the Sahara desert. What was unimaginable happened. During that same year, the idea inflation would stop rising was almost viewed with as much ridicule. Runaway double digit inflation was inevitable and the market was convinced there was no way to stop it.
During the next two years Volcker raised Fed funds from 11% to 20%. In doing so, Volcker cut off the knees of inflation and ushered in the unthinkable. Inflation, previously believed to be unstoppable, was firmly in the rear view mirror.
What if we are in the throes of a Reverse Volcker Moment? What if the market panic about deflation is just as ill timed as the late 1970s conviction about inflation?
As Volcker raised rates, it did not have an immediate effect. He needed to take Fed Funds to a truly breath taking level to stop inflation. I remember reading about Jim Rogers’ shorting gold into the $800 price spike because he believed Volcker was serious about stopping inflation. You know it was a different world when Jim Rogers was shorting gold because he believed a Central Banker would be successful.
In what universe does this make sense?
According to Bloomberg, since late 2014 Japan’s government has been paid at least 52 billion Yen ($464 million) to borrow. Instead of a charge, their borrowing results in a credit to the government. That is just bat shit crazy. I can’t express how asinine negative rates are for the most indebted developed nation on the planet. It’s like the market has completely lost it.
Between Europe and Japan, the two Central Banks have committed to creating inflation with Volcker-like determination. Yet no one believes they will be successful.
What if the negative rates coupled with obscene QE programs are the equivalent of Volcker raising rates to 20%? I know, I know… A decline in money velocity will offset any Central Bank easing. Right… Just like it has never snowed in the Sahara desert and inflation would never succumb to Volcker’s sky high rates…
Some actual ideas
Longer term, I am a big inflation bull. Eventually the Central Banks will push too hard and the monetary base will be set ablaze in a bonfire that scares everyone. In the mean time, the lack of any spark only encourages the Central Banks to put even more fuel on the fire. The delay in lighting the fire does not necessarily mean the fire can’t be lit, but instead only ensures the fire will be even more gigantic once it does ignite.
But this prediction doesn’t help much in the day to day trading of the squiggles of the market. So instead of just pontificating about the inevitability of the return of inflation, let’s dig into something a little more concrete.
Last week I watched this terrific presentation by Julian Brigden from Macro Intelligence Partners on RealVisionTV. I didn’t agree with all of Julian’s analysis, but there were portions that were brilliant.
The one section I would like to highlight is Julian’s comparison of the recent crude oil sell off to the 1985 decline. Although I was aware of that period’s market movements, I did not realize the potential analogy to today’s environment.
1985 versus today
During the early 1980s, US crude oil production was steadily climbing.
But then in 1985 Saudi Arabia made a dramatic shift in strategy. From Wikipedia:
In September 1985, Saudi Arabia became fed up with de facto propping up prices by lowering its own production in the face of high output from elsewhere in OPEC. In 1985, daily output was around 3.5 million bpd, down from around 10 million in 1981. During this period, OPEC members were supposed to meet production quotas in order to maintain price stability; however, many countries inflated their reserves to achieve higher quotas, cheated, or outright refused to accord with the quotas. In 1985, the Saudis tired of this behavior and decided to punish the undisciplined OPEC countries. The Saudis abandoned their role as swing producer and began producing at full capacity, creating a “huge surplus that angered many of their colleagues in OPEC”. High-cost oil production facilities became less or even not profitable. Oil prices as a result fell to as low as $7 per barrel.
Sound familiar? It is almost the exact same situation as 2014 when Saudi Arabia lowered the price of their oil exports.
This time instead of other OPEC nations being in the Saudi cross hairs, it was the US shale producers. The similarities are striking to the 1985 experience.
What about other markets
Julian from Macro Intelligence Partners then proceeded to examine how other markets reacted to the 1985 crude oil decline.
Faced with disinflation from the declining oil price, the Federal Reserve aggressively eased bringing Fed Funds down from 8% to 5.875%. In essence they followed crude oil down.
This was perfectly logical as the massive decline in crude oil caused inflation to fall.
But as the Federal Reserve eased, the stock market took off.
Bringing it all together
Faced with collapsing oil prices, declining inflation and a slowing economy, the Federal Reserve did what should be done and eased into the disinflationary conditions. Unfortunately in hindsight it is obvious they eased too much.
As Julian said in his presentation, “the Central Bank eased into a deflationary pulse caused by oil.” He goes on to argue the oil price decline is actually stimulative, and the Fed threw gas on a lit fire. This argument is best exemplified with Deutsche Bank’s G7 growth chart:
But in 1985 the Federal Reserve did not have faith oil price decline would cause economic growth. So they stepped on the accelerator. But in doing so, inflation came roaring back. Bonds, sensing the danger, sold off hard. The yield on the US 30 year treasury went from 7.5% to 10% in the first 9 months of 1987. In the meantime, stocks were screaming higher fueled by all the liquidity.
This backup in yields eventually proved too much for the stock market to handle. In October of 1987 the market suffered the infamous Black Monday crash. At that point bonds rallied, but inflation still headed higher as the Federal Reserve pushed even more liquidity into the system.
Differences between 1985 and today
There can be no denying that the current environment is remarkably similar. However there are some differences that need to be addressed. In 1985 the Federal Reserve eased aggressively into the oil price decline. This time the Fed has been raising rates and until recently, been the most hawkish Central Bank. Yet this hawkishness actually caused other Central Banks to be even more easy than would have otherwise been the case. So yes, maybe the Fed has not monetized the decline in the price of oil, but Europe and Japan have more than made up for their reluctance.
You could argue Yellen’s recent shift to less aggressive tightening is a form of easing. Combined with all the other Central Banks easing, the amount of monetary stimulus applied during the past year and a half has been unprecedented.
The current scenario might yet end up playing out very closely to 1985. Julian even went so far to create an analogy of the previous market cycle to today’s action:
If he is correct, then we might have a pause in the resurgence of inflation, but by summer it should start increasing in earnest.
Nothing is exactly the same
Market action rarely repeats, but it often rhymes. This is especially true of price behaviour that has long been forgotten. Too many traders are looking for a repeat of the 2008 credit crisis. I doubt very much it will play out like that. Traders always hedge for the last crisis instead of the next one.
Bill Fleckenstein is fond of saying Central Bankers will continue easing until the market takes away the keys. This will not happen until inflation comes back. If you are really bearish wouldn’t a return of inflation be the ultimate bad news? Sure, it might be good over the short term, but in the long run, this will be the end of the financial bull market. Call me crazy, but I think it might be closer than anyone imagines…
Thanks for reading,