Goldilocks and the Two Bear Markets
The stock market needs things to be not too hot and not too cold. Inflation must be around 2%, but not above 4%, nor below 0%, to keep stocks rising. The trouble is that the Goldilocks zone is getting harder and harder for policymakers to achieve. The tightwire act is getting ever more dangerous.
Let’s see how far we can push these mixed metaphors…
On the one side of the tightrope, there’s a plunge into a deflationary bear market. This bear is very sensitive to being poked by recessions, financial crises, bubbles bursting, bank crises, debt defaults, sovereign debt crises, and many more dangerous threats.
The bear is unleashed when central bankers tighten monetary policy too much and the porridge goes cold.
That’s the sort of crisis that financial market pros have become very familiar with ever since central banks were formed to prevent them from ever happening again…
Instead, they cause them by inflating bubbles with loose monetary policy and then popping them with tight monetary policy. 2008 is, of course, the best example of such a boom and bust, but just about all the major financial crises of the past few decades coincided with a central bank tightening cycle. Eventually, someone can’t handle the high interest rate, and chaos begins.
On the other side of the tightwire, we have the inflationary bear market. This bear poses a risk to stockmarket valuations, real returns (meaning adjusted for inflation), the general economic chaos of inflationary periods and plunging living standards even as financial and real assets boom in meaningless ways.
This is known as a crack-up boom because it looks like a boom as asset prices rise, but it’s really the economy falling apart and people flocking away from money and into inflation-proof assets, which bids up their prices.
If that sounds at all familiar in an age of booming house prices, spiking commodity prices, economic chaos, and soaring inflation, you’ve understood what a crack-up boom looks like in its early phases.
But true crack-up booms occur when central bankers fail to rein in inflation and aren’t likely to get it under control again anytime soon. That latter bit is especially important, but back to why in a moment.
Inflation getting out of hand is an unusual state of affairs. I mean, how hard is it to rein in inflation? You just tighten monetary policy, right? And then Goldilocks gets her porridge just right and stocks go up. Simples.
The problem is that even a small dose of the tried and trusted medicine for inflation now risks triggering the deflationary bear instead. I mean, can you imagine double-digit interest rates when debt is at more than 250% of global GDP?
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Heck, financial markets have been crashing at the mere prospect of small increases in interest rates at some point in the future. Imagine what’ll happen if rates actually do rise!
And so the tightwire is becoming impossibly thin. And, as a former tightwire instructor (those who can’t do teach), I can tell you this does make things more difficult.
Which brings us to what happens when central bankers cannot rein in inflation without causing a deflationary crisis. This is the traditional ending of a monetary system that has exhausted itself. Which, in our case, means too much debt.
Once financial markets realise that central banks will do anything to avoid the deflationary bear, and the Goldilocks zone is no longer achievable, there is only one way for them to go. They’ll fall off the inflationary side of the tightwire.
The prospect of continuous, steady inflation that isn’t reined in begins to emerge as the likely future. And then the crack-up boom is on.
Of course, all this may be part of a deliberate policy of financial repression — repaying debt by way of high inflation and low interest rates. That’s how war debts were repaid in the past.
But it’s important to note what this means for investors, especially in the age of decade-long retirements, which will supposedly be financed from investments.
Inflation combined with low interest rates is a dispossession of the purchasing power of our investment assets. It’s a hidden tax. Not because the price we pay for this policy is hidden — we can see it every day in the rising price we pay for goods while our investments do not keep up.
I say it’s hidden because voters don’t realise that this outcome benefits the government’s financial position by reducing debt levels. It’s a lot easier to repay a billion when inflation creates trillionaires.
Inflation may also aid those who are in debt themselves. From memory, I think it’s Jim Rickards who likes to point out that his mother panicked when she discovered the double-digit interest rate on the mortgage he took out in the ‘70s. But it was well below the rate of inflation.
But leverage strikes me as a risky strategy. The man who most famously and effectively used it was Hugo Stinnes, known as the ‘Inflation King’. He went from being the richest man in Germany to going bust when Germany’s hyperinflation ended with a deflationary shock. Well, he died shortly before, but you get the idea.
A better way out is fairly simple, theoretically speaking. Historically it was to own foreign currencies, which were not seeing the same inflation. In fact, exchange rates become a better indicator of inflation than government statistics once inflation gets out of hand.
Alternatively, you can invest in inanimate objects because those don’t change their nature even as the financial world around them becomes bizarre.
Gold is the best option for a long list of reasons, the most interesting of which is its role as a monetary metal. For people to begin to trust the financial system again, it must usually be reborn with gold and silver backing. And so gold and silver absorb the chaos of the past by seeing their prices rise. Its immunity to the meddling of fiat money makes it more valuable.
But central bankers may not yet be at the end of their fraying rope after all. What about continuing QE while hiking interest rates? This idea was raised by Michael Every of Rabobank:
‘Why can’t you raise rates AND do QE? Yes, “they run in opposite directions on yields”. But if you want to finance a huge budget deficit while cooling the heels of the rest of the economy, buy freshly issued government bonds, with higher coupons flowing back to the treasury to boot, and raise rates. It’s what one sees in a war economy.’
The idea here is for the central bank to tighten monetary policy by increasing interest rates, which makes debt more expensive, while also continuing to buy government bonds with newly created money, thereby keeping the government’s finances manageable.
This may be the next increasingly bizarre step central bankers need to take to keep the party going.
Funnily enough, central bank profits, which would rise if interest rates rise, get remitted back to the government. So if the central bank owns enough of the government’s bonds, then raising interest rates actually raises government revenue! It is paying itself the interest increase…
The point is, we’re exploring increasingly bizarre, fraught, and desperate ways to keep our current financial and monetary system going. From 0% interest rates to QE to negative interest rates to deeply negative real interest rates to QE combined with interest rate hikes.
Things are getting downright weird. But they have to if central bankers want to keep us in the stockmarket’s goldilocks zone.
And so, the side effects of such policies are growing too. Increasingly odd economic phenomenon and an increasingly unstable financial system.
The breakout of inflation is, however, one thing central banks might not be able to handle. And so, we may be nearing the end at last.
Editor, The Daily Reckoning Australia Weekend
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