Inflationary Boom or Deflationary Bust?
After decades of deflationary growth, the U.S. economy is in transition in the business cycle. Many believe we are about to experience an inflationary boom, while a few believe the more likely outcome will be a deflationary bust. The stakes are high for both sides. Whoever gets the call correct stands to make a lot of money during the next cycle, while those who are wrong will likely incur significant losses.
There have been several inflationary booms in the United States, but they aren’t very common. They tend to occur when debt levels are very low, when there is a high amount of pent-up demand among consumers, when the savings rate is high, and when interest rates are high. Banks begin to ease their lending standards going into an inflation boom, aided by the central banks who are also lowering interest rates. Consumer prices are low going into inflationary booms and begin rising due to demand outpacing supply.
Deflationary busts are the exact opposite of inflationary booms. Debt levels are usually high and there is little pent-up demand. Savings rates and interest rates tend to be low. Banks start curtailing their lending standards and increasing their reserves, while central banks tighten monetary policy by raising interest rates. Consumer prices tend to be high with supply outpacing demand.
The easiest way to identify an inflationary boom is through the year-over-year rate of change on the Consumer Price Index (CPI). The St. Louis branch of the Federal Reserve maintains the FRED database which has a vast amount of historical data and charts which are free and available for reference. (All charts referenced in this update are covered in the video and are available in PDF format for you to download at the bottom of your e-mail.)
Since 1948 there have been four inflationary booms, shown by a large multi-year spike in the year-over-year rate of change in the CPI. The four inflationary booms were in 1950-51, 1972-74, 1978-80 and 2009-11. These spikes in the CPI commonly lasted two years and the year-over-year growth rate in the CPI usually triple tripled or quadrupled over that period.
Inflation, which is an often misunderstood concept, is the debasement or intentional expansion of the money supply. During the age of Kings, a ruler would confiscate all the money in his realm, melt it down, then return the same number of coins to his subjects, but with a lower precious metal content. The King would use the excess precious metal to make more coins for himself, which he would spend throughout his realm. These new coins expanded the money supply, which caused inflation. It is important to understand that inflation can only occur when the money supply expands.
To validate that inflationary booms can only occur during an expansion of the money supply, I overlaid the year-over-year growth rate of the M2 Money Supply over the CPI chart. Unfortunately, the FRED database only has data for the M2 Money Supply going back to 1982, but I do have a chart showing the year-over-year growth rate of the M2 Money Supply since 1900. By comparing the data points between the year-over-year growth rate of the M2 Money Supply and the CPI, the idea that inflationary booms only occur when the money supply expands is validated.
The money supply cannot magically expand on its own. The Federal government does not have the ability to expand the money supply because it can only borrow money. Borrowing does not create or destroy money, it just repositions money from the public to the government. The Federal Reserve Act of 1937 prevents the Federal Reserve from printing money, but they can create excess bank reserves, as we saw with their multiple Quantitative Easing programs. The Fed can only encourage or discourage lending through policy tools, which is used to expand or contract the money supply through the banking system.
Our banking system functions on fractional reserves, which means a bank can lend nine times against its reserves. If a bank holds $1 billion in reserves, it can lend out $9 billion into the economy, thus turning $1 billion into a total of $10 billion. Our banking system is critical to the expansion, deceleration, or contraction of the money supply in our country.
Fortunately, the FRED database has bank lending data to match the CPI data. I overlaid the year-over-year growth rates of the CPI and Commercial and Industrial loans, which revealed every expansion in Commercial and Industrial loans had been followed by an expansion in the M2 Money Supply which, in turn, follows the expansion in the Consumer Price Index. This validates my thesis that an expansion of the money supply through the banking system can cause inflation.
The Federal Reserve can encourage or discourage the banks from lending through its various policy tools and the most common tool the Fed uses is the Federal Funds rate, or overnight bank-lending rate. When a bank is short on its overnight reserve requirement, it must borrow the shortfall from another bank at the Federal Funds rate.
When charting the historical Federal Funds rate against Commercial and Industrial loans, it shows Commercial and Industrial lending decelerating as the Fed raised the Federal Funds rate. According to the overlain graphs, there isn’t always an immediate reaction to bank lending when the Fed raises the Federal Funds rate, but as the Federal Funds rate rises, bank lending did begin to decelerate. The deceleration of bank lending can lead to a contraction in bank lending, which is commonly observed during recessions.
The growth rate in Commercial and Industrial lending peaked in 2012 at a little over 13% and began a slow deceleration. In December 2015 the Fed decided to begin a path of normalizing the Federal Funds rate by hiking rates from zero percent to 0.25%. Each quarter-percent increase in the Federal Funds rate removes approximately $60 billion from the money supply. The deceleration in Commercial and Industrial lending intensified. In October 2017 the Fed began unwinding its balance sheet at a rate of $10 billion per month. By December 2017 the deceleration in Commercial and Industrial lending nearly reached a point of contraction.
At this point, the Fed had increased the Federal Funds rate five times and unwound $30 billion from its balance sheet. Since each rate hike effectively removes $60 billion, the Fed had removed a total of $210 billion from the money supply ($60 billion times 5 plus $30 billion) by the end of 2017.
The economy would have likely slipped into a recession in the first quarter of 2018 if it wasn’t for the tax cuts. The tax cuts added $150 billion to the money supply upon passage and the growth rate of Commercial and Industrial lending immediately began to accelerate.
By March 2018 the Fed hiked rates once again and continued unwinding their balance sheet. As of April 2018, the Fed had destroyed a total of $180 billion in 2018 alone, thus negating the entire benefit of the tax cut in a four-month period. After peaking at a 3.5% growth rate in April 2018, Commercial and Industrial lending has once again begun to decelerate.
It is important to understand the Fed decelerated Commercial and Industrial lending from a 13% growth rate to nearly zero by removing $210 billion from the money supply. The Fed has suggested they will hike the Federal Funds rate three more times by year-end and continue unwinding their balance sheet, which will remove $390 billion from the money supply. In a matter of months, the deceleration in Commercial and Industrial lending should turn into a contraction in lending.
Every time Commercial and Industrial lending has contracted, there has been a recession. Banks create money when they lend out more than they receive back in payments. When banks receive more money than they lend, money is destroyed. Based on the Fed’s desire to increase the Federal Funds rate and unwind their balance sheet, I predict they are going to cause Commercial and Industrial lending to contract in a matter of a few months. This is significant because I have said the tax cut delayed the onset of the next recession, which the numbers now validate.
Investors have been dumping bonds and shorting bonds this past year which are driving interest rates higher. Interest rates are determined by supply and demand, along with loose and tight monetary conditions. When bank lending is decelerating, interest rates should fall. Charting 10-year Treasury yields against Commercial and Industrial loan growth shows yields falling as loan growth decelerates and yields collapsing when loan growth contracts. Given the Fed is tightening the money supply and Commercial and Industrial lending growth has been decelerating since 2014, interest rates should be much lower than they are today.
Most retail investors and money managers are positioned for an inflationary boom. For their positions to pay off, bank lending needs to accelerate, the money supply needs to accelerate, and consumer prices need to continue rising. But the economic data suggests something completely different is going to happen due to the actions of the Federal Reserve.
The more likely outcome is a deflationary bust. In the case of a deflationary bust, investors will want to own long-term U.S. Treasury bonds, agricultural commodities, the U.S. Dollar and gold. Gold tends to perform best during periods of inflation but can be a hedge against future money printing during times of financial crises. Based on the economic data and the Fed’s plans, most investors are mispositioned for what is coming by year-end.
Q&A with Steve – Your Questions Answered
- What happened to the stock market on Monday?
Markets started out with a bang on news the U.S.-China trade war is being put on hold. I’m not sure why stocks rallied on this news, considering China’s largest imports from the U.S. are Treasuries, agricultural commodities and oil. Apparently, any news to buy stocks near a market peak is good news. Trading volumes were once again low, showing buying interest isn’t very strong.
Interest rates dipped slightly as Speculators hold their record short positions on bonds, while Asset Managers are holding very long positions on bonds. The Smart Money is positioned for yields to fall and bond prices to rise.
Agricultural commodities popped over their 50-, 100-, and 200-day moving averages. I thought the “golden cross,” when the 50-DMA crosses upward through its 200-DMA, would bring in buyers, but it will be hard to ignore all the moving averages rising. When it comes to moving averages, a bullish picture is when the 50-DMA is rising faster than its 100-DMA which is rising after than its 200-DMA. That is the setup for agricultural commodities. I expect buyers to take notice and join in soon.
Gold is fighting a key support level, which I don’t expect it to hold. Speculators have been backing off their gold futures contracts, which in the past has signaled a strong buy. I expect gold to fall to the $1,250-$1,265/oz zone where it will signal a matching buy for the gold and silver mining ETFs.
- What happened to the stock market on Tuesday?
If this is starting to sound repetitive… trading volumes were even lower today, which is impressive. Bulls are calling for a major break higher in prices, but there’s a severe lack of buyers. The Dow closed back under its 100-day moving average, which has been a point of overhead resistance since mid-March.
Bonds were flat for the day, but yields have been falling in overnight trading as Asian investors have been buying bonds.
Agricultural commodities are slowing moving higher. Tomorrow we should see the moving average trifecta where its 50-day moving average is higher than its 100-DMA which is higher than its 200-DMA. The last two times this happened, agricultural commodities when on to generate a +15-20% return in the weeks that followed.
Gold miners tried to break over their 50-day moving average but failed. This should push prices down into my target buy zone with a matching move in physical gold.
- What happened to the stock market on Wednesday?
Asian and European markets were down in overnight trading on news Turkey is having a major problem with their currency and that Italy’s new government is going to try to get the European Central Bank to forgive all its loans – a sovereign debt default. Both on their own are bad news.
The US stock market opened down a bit, but investors happily stepped in to buy. After the minutes from last month’s Fed were posted showing they are likely to raise rates but keep monetary policy accommodative, everything was fine, and stocks went up. Notably, trading volumes were low, but average for the past several trading days.
You might think bond yields would rise on news the Fed was going to be “accommodative,” buy yields had their largest one-day drop in quite some time. New homes sales fell, and mortgage applications fell, so lower demand should equal lower yields. The short-bond crowd seems to think yields are going to 4.5% on the 10-year Treasury, but they don’t seem to understand that tighter monetary policy leads to lower long-term bond yields.
Agricultural commodities are back on the rise and were boosted by news of China telling its member states to increase their purchase of US grains. I expect further strength in this sector.
Gold miners closed over their 50-day moving average, but physical gold barely budged. For the past six trading days, someone has put the brakes on every move up in gold, which tells me someone wants gold prices to go down more. If that happens, I expect the gold miners will fall as well, which is what I am hoping for.
- What happened to the stock market on Thursday?
Equity markets opened lower and traded lower early this morning on continued news of problems with Germany’s largest bank, Turkey’s currency, and ongoing issues with North Korea. Fortunately, American investors aren’t concerned, because they stepped in to buy stocks, which pushed the major indices back near their opening price.
There are automated computer trading programs called CTA’s, who are currently programmed to buy stocks, sell bonds and sell volatility. When the market opened with stocks down, bonds up and volatility up, the computer programs had no choice but to get things back to “normal.”
The 7-year Treasury auction had a strong interest and sold with a yield lower than expected. Treasury yields fell in overnight trading as foreign investors weigh risks with Germany’s largest bank, Italy’s incoming administration and Turkey’s currency problem.
Agricultural commodities hit their upward “Sell Zone” or resistance level in early trading and sellers, sold. Prices dropped a little, but buyers held steady. Commodities traders are talking about how there is a near-term breakout in grains coming, so I suspect they are looking to buy as sellers are exiting.
Physical gold was up a bit, but I don’t believe this part of a larger move. The miners responded accordingly, but I expect the big money to push prices down one last time. Russia has been buying large amounts of gold over the past two years, so that news may have encouraged gold investors to buy today.
- What happened to the stock market on Friday?
This week can be summed up as follows: US market closes flat on Thursday. As the Asian markets open, traders push US equity futures up and bond yields up. Stock market bulls flood to Twitter to brag about how they are right and stock prices are going higher. European markets upon where risks in Turkey, Italy, and Spain are at the forefront of investors minds. US equity futures cool off and European investors begin to buy US Treasuries. The US market opens with stocks flat and interest rates down. Investors and computer algorithms attempt to bid stock prices higher, yields higher and volatility lower. By the end of the day, stocks were down slightly, yields were down, and volatility was up.
Video Topic of the Week –
In layman’s terms, how support and resistance levels work.
Chart of the Week –
A revisit of my long-term projections of where the gold and silver mining stocks are headed.