May 19, 2024
The topic for this issue focuses on when and how the bond market lost its predictive power regarding the economy and inflation. This is relevant because the bond market is enormous, and serves as a core asset class for central banks and for investment portfolios.
Recently published content:
From Small & Fast to Big & Slow
The bond market has historically been known as “smart money”, in contrast to equity markets that are more of a mix of smart money and so-called dumb money.
This is because the bond market is generally characterized by professional investors and traders, whereas the equity market is a mix of all sorts of different investors and traders, including many hobbyist retail investors.
A commonly cited example of bond market intelligence is the predictive power of the yield curve. Every time the 10-year Treasury rate (which is mostly determined by the private bond market) has gone below the 3-month Treasury rate (which is closely tied to the current rate that the Federal Reserve is setting) in recent decades, it has correctly foreshadowed a recession. Recessions are marked in gray on the chart below:
However, here in the 2020s the bond market is riding on a lot of reputational momentum. The things that made it the smart money previously are now largely gone. That’s not to say that the people trading it are any less intelligent than before, but rather it is to say that the structure and size of the market is such that intelligent bond traders are not the primary movers of the market anymore. As a result, the informational value that we can get from the bond market is now greatly diminished.
One basic metric I like to look at is nominal GDP growth relative to bond yields. Whenever nominal GDP growth is structurally higher than bond yields, investors are usually better off owning just about anything other than bonds on a multi-year timeframe. In contrast, when bond yields are higher than or similar to nominal GDP growth (yellow areas in the chart below), the risk-adjusted return potential of bonds is quite high. And it was during the 1980s-2000s period where the bond market built its reputation as smart money, and that was indeed the best time to be a bond investor:
From the early 1980s through the 2000s, interest rates were high and steadily heading down, which meant bond prices were steadily going up while also paying their holders a hefty income along the way. And quite usefully, their price action tended to be inversely correlated with equities; bond prices normally went up in recessions while stocks went down, which made them good diversifiers.
When the bond market entered its golden era and became known as smart money, the U.S. federal debt-to-GDP ratio was only about 30%. That was a small and nimble market, and one that was effectively priced by professional traders.
But now that bond yields bounced off of zero and are trending sideways or up, at a time when the United States has over 120% federal debt-to-GDP and is running structural growing deficits with ballooning interest expense payouts, it’s a big and slow market with frequent interventions from the central bank on all parts of the duration curve. The Federal Reserve is now the largest individual holder of government debt, and at any given time is often the largest buyer or the largest seller (through maturation) of Treasury securities. Here are their holdings over time:
According to the NY Fed’s annual report on open market operations, they expect the Fed balance sheet to bottom in 2025 and start heading structurally higher again, meaning that the Fed will have a re-occurring bid for Treasuries:
In other words, the market developed its reputation when it was a fast and nimble speedboat, whereas now it’s a big ship that takes forever to turn and sometimes runs into things while moving extremely slowly. Big ships have professional captains of course, but the structure of the ship itself is inherently less responsive and more awkward than a nimble speedboat.
Declining Liquidity in Treasuries
Ironically, as the Treasury market has increased its size, its relative liquidity has decreased.
“Liquidity” in this context refers to how easily you can sell large amounts of something without greatly affecting that thing’s price. In other words, for a liquid asset the daily trading volume is large relative to the total amount of that asset that exists, so that even large investors can enter or exit positions in a short period of time with minimal market disruption. Any big seller only wants to be a tiny % of daily trading volume so that he doesn’t meaningfully impact the price as he sells it.
Examples of highly liquid markets include major currencies, stocks of large companies, and at least historically, the big sovereign bond markets. In other words, it is easy to buy or sell a very large number of Apple (AAPL) shares since at any given moment there is a huge number of buyers and a huge number of sellers, and each share is the same as any other.
Examples of illiquid markets are real estate and private equity. They have low turnover in a given period relative to total market value, and each unit is unique which requires a lot of manual negotiation between buyers and sellers to determine a price and finalize a sale.
Most other assets are somewhere in the middle. Publicly-traded stocks and bonds of smaller companies tend to have medium liquidity, for example.
Over time, the total supply of U.S. Treasury securities outstanding has increased faster than the daily trading volume of Treasuries. During the past decade, for example, the Treasury security supply outstanding soared 122% from $11.8 trillion to $26.3 trillion, while the daily trading volume only inched up 39% from $546 billion to $760 billion:
Source: SIFMA
As a result, the ratio of daily trading volume to the size of the market decreased considerably.
But under the hood, liquidity is worse than that, because there are a lot of different types of Treasury securities (various durations from 4 weeks up to 30 years, and either inflation-adjusted or not), and each one of those sub-markets has its own smaller less-liquid market. Off-the-run securities are the most problematic in terms of liquidity.
Suppose that the U.S. Treasury Department auctions new 10-year Treasury notes. Entities can buy them, and easily trade them on the secondary market to others. Those are on-the-run securities. But then, three months later, the Treasury Department auctions off another round of 10-year notes. Those prior ones are now 10-year notes with only 9.75 years left until maturity, which as an asset is a bit awkward compared to a fresh 10-year note. And maybe the round that was issued before that now has only 9.50 years until maturity, and so forth. Those notes are all now off-the-run securities, meaning that they are older vintages of bonds than the newest batch. The secondary market for off-the-run securities has weaker liquidity in general, and it has been deteriorating.
Back during the March 2020 sharp stock market crash, investors initially fled into bonds as one would expect in a risk-off crisis, meaning that bond yields went down and bond prices went up. But then as the dollar index spiked, the crisis became bad enough that there became a large number of forced sellers of bonds in order to get dollars and service their dollar-denominated debts. As a result, bond yields actually started to spike back up during the very worst part of the crash, and the off-the-run Treasury market became acutely illiquid and seized up. The price aspect wasn’t a big deal, but the acute lack of liquidity was a huge deal.
So, the Federal Reserve stepped in and bought $1 trillion worth of Treasuries with newly-created base money in a matter of weeks:
The Federal Reserve subsequently remarked on this in their March and April 2020 FOMC minutes:
In the Treasury market, following several consecutive days of deteriorating conditions, market participants reported an acute decline in market liquidity. A number of primary dealers found it especially difficult to make markets in off-the-run Treasury securities and reported that this segment of the market had ceased to function effectively. This disruption in intermediation was attributed, in part, to sales of off-the-run Treasury securities and flight-to-quality flows into the most liquid, on-the-run Treasury securities.
Treasury markets experienced extreme volatility in mid-March, and market liquidity became substantially impaired as investors sold large volumes of medium- and long-term Treasury securities. Following a period of extraordinarily rapid purchases of Treasury securities and agency MBS by the Federal Reserve, Treasury market liquidity gradually improved through the remainder of the intermeeting period, and Treasury yields became less volatile. Although market depth remained exceptionally low and bid-ask spreads for off-the-run securities and long-term on-the-run securities remained elevated, bid-ask spreads for short-term on-the-run securities fell close to levels seen earlier in the year.
Several participants remarked that a program of ongoing Treasury securities purchases could be used in the future to keep longer-term yields low. A few participants also noted that the balance sheet could be used to reinforce the Committee’s forward guidance regarding the path of the federal funds rate through Federal Reserve purchases of Treasury securities on a scale necessary to keep Treasury yields at short- to medium-term maturities capped at specified levels for a period of time.
Since 2022 as the Fed has switched from being a buyer to a seller, liquidity has once again become problematic. And so recently, the Treasury re-introduced buybacks for the first time in decades. With buybacks, the Treasury can buy off-the-run illiquid securities with newly-issued on-the-run securities. Despite the fact that their total debt is growing, the Treasury is regularly buying back some of the bonds it has previously issued.
Although it sounds funny, from the Treasury’s perspective this is completely rational. Regularly buying back illiquid off-the-run securities by issuing more liquid on-the-run securities has the effect of improving overall liquidity in the market, and by extension, it can moderately lower the interest expense for the government by reducing the illiquidity premium.
But when taking a step back, this isn’t a good sign. Treasury securities are the primary global reserve asset due to their high stability and liquidity. They built that reputation primarily from the early 1980s until around the global financial crisis in 2008/2009.
When what is supposed to be among the most liquid markets in the world has re-occurring liquidity problems and requires regular intervention by central authorities, that’s not great. Imagine if this were to be the case for a collectible, like say a trading card manufacturer, where the trading card manufacturer that sells the cards is also a big re-buyer and re-seller of its own cards due to an illiquid secondary trading card market. That doesn’t exactly inspire confidence.
In the Treasury market’s case now, both the Fed and the Treasury intervene on a regular basis. Sovereign bond markets that are even further along in terms of debt-to-GDP ratios, such as Japan, tend to have even more central invention like this, and consequently even worse private sector liquidity. At that point, bond markets become increasingly artificial, and increasingly devoid of useful information for economic forecasting.
The Fed’s Inability to Forecast
The U.S. Federal Reserve’s track record of forecasting future inflation, future short-term interest rates (which they themselves set), and future economic growth, is very poor.
That’s partially because almost everyone’s ability to forecast the future is poor. We all struggle with it. But it really matters here because the Fed determines the base price of money for the 336 million population U.S. economy and the world reserve currency for billions of people more broadly. So when they are incorrect, it has big consequences.
Back in 2007, Fed Chairman Bernanke infamously said that the problems in subprime mortgages were contained and would not spread to the broader economy. Absolute calamity ensued in 2008 and 2009 as it became uncontained and spread to the broader economy.
Federal Reserve Chairman Ben Bernanke said Thursday that he didn’t believe the growing number of mortgage defaults would seriously harm the economy, and also noted that banks share significant risks when financing private equity deals.
[…]
Bernanke said while it was likely that there would be further increases in mortgage delinquencies and foreclosures this year and in 2008, he did not believe this problem would be enough to derail the overall economy.
“We believe the effect of the troubles in the subprime sector on the broader housing market will be limited and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system,” Bernanke said in his remarks, copies of which were distributed in Washington.
-May 2007 (CNBC)
After the Fed embarked on its second round of quantitative easing (which entails creating brand new base money to buy government bonds from the secondary market), Bernanke insisted in Congress that it was not debt monetization because it’s just temporary and the Fed’s balance sheet will go back down to pre-crisis levels. It never did. Instead, it was a permanent increase in money outstanding and the Fed’s balance sheet.
REP. RYAN: It seems to me that the argument here is that the intention of QEII is what we ought to be focusing on because the intention is to bring rates down through economic growth, and therefore, the intention is what should matter here. But this is debt monetization. So isn’t that really a distinction without a difference?
MR. BERNANKE: No, sir. If monetization would involve a permanent increase in the money supply to basically pay the government’s bills through money creation, what we’re doing here is a temporary measure, which will be reversed so that at the end of this process, the money supply will be normalized. The amount of the Fed’s balance sheet will be normalized and that there will be no permanent increase either in money outstanding, in the Fed’s balance sheet or in inflation.
-February 2011 (Wrightson ICAP, referencing Congress)
In 2015, the then-retired Bernanke said that the Fed does not need to shrink its balance sheet at all.
The Federal Reserve does not need to shrink its $4 trillion-plus balance sheet by even “a dime” for it to normalize monetary policy when the time comes, former Fed Chair Ben Bernanke said on Monday.
“The Fed has worked very carefully to figure out how to raise rates at the appropriate time,” Bernanke told a monetary policy conference. “That will eventually happen – we hope it happens because that means the economy is going back to normal.”
When the Fed does tighten, he said, “you can have some bumpiness” as markets potentially react to the changes. But in all, he said, “it will be a fairly normal process.”
The Fed under Bernanke bought trillions of dollars of long-term securities to help boost the U.S. economy and keep deflation from taking hold.
As the Fed exits from those extraordinary policies, Bernanke said, “There is absolutely no need or requirement for the balance sheet to go back to normal as monetary policy normalizes. The balance sheet could be kept where it is for a very long time if necessary.”
-May 2015 (Reuters)
In 2017, Bernanke said that the Fed could reduce its $4.5 trillion balance sheet by as much as half, to under $2.8 trillion.
But as it turned out, they couldn’t even get it below $3.7 trillion by 2019 when banks experienced the repo rate crisis and the Fed had to go back to structural balance sheet expansion in September 2019 (which was several months before the March 2020 pandemic).
Former Federal Reserve Chairman Ben Bernanke says the central bank could reduce its $4.5 trillion balance sheet by as much as half.
“I think they’re aiming for something in the vicinity of $2.3 to $2.8 trillion, something like that,” he said Monday on CNBC’s “Squawk Box.”
Bernanke did not expect the Fed would return its balance sheet to pre-crisis levels of less than $1 trillion.
-May 2017 (CNBC)
When Fed Chairman Janet Yellen was leaving her role as head of the Fed after Bernanke, she commented that her biggest regret was that inflation ran too low under her watch.
At her final news conference as Fed chair Wednesday, Yellen said the Fed’s failure to bring inflation up to the central bank’s 2 percent mandate is her single disappointment.
“We have a 2 percent symmetric inflation objective. For a number of years now, inflation has been running under 2 percent, and I consider it an important priority to make sure that inflation doesn’t chronically undershoot our 2 percent objective,” she said.
-December 2017 (CNBC)
In June 2020, the current Fed Chairman Jerome Powell infamously said “We’re not thinking about raising rates. We’re not even thinking about thinking about raising rates.”
Employment was expected to take a long time to recover from the pandemic/lockdown losses, and significant inflation was not expected to materialize.
In late 2021, the Fed was still performing quantitative easing. And despite the fact that above-target price inflation was already materializing, the Fed’s forecast for future inflation and future rates for 2022, 2023, and 2024 was low:
By early 2022, price inflation reached levels not seen in four decades, far higher than their projections, and the Fed had to abruptly pivot its course.
They subsequently raised rates at the sharpest pace in modern history. Here in mid-2024, above-target price inflation is still an ongoing issue, and the Fed’s interest rates are more than twice as high as they ever projected they would go. A number of banks went insolvent in 2023 due to not accounting for that level and speed of interest rate rise.
Overall, the institution that sets short-term interest rates and buys or sells longer duration Treasury securities in large volumes on a regular basis (thereby greatly impacting the bond market on a regular basis) lacks the ability to forecast accurately. It doesn’t know what the inflation rate will be, what it’s own interest rates will be, or what the size of its balance sheet will be.
The Bond Market’s Inability to Forecast
Back in 2019, there was over $16 trillion worth of negative-yielding bonds in Europe and Japan, and bond yields in the United States were still positive but super-low.
As is classically the case, there were magazine covers being published that asked if inflation was dead for good.
I wrote an article warning about this likely being a bond bubble in July 2019, and described how easy it would be for fiscal and monetary forces to cause inflation despite the broad belief to the contrary at the time:
Lately, Modern Monetary Theory is the hot topic in financial media. It’s an approach that blends central bank policy with fiscal policy to print as much money as needed up to the point where inflation becomes a problem, and is what some politicians and economists advocate should be done in many developed countries.
So far, central bank tools have not been inflationary because they have primarily benefited asset prices rather than middle class consumption. They printed money, but kept the money on the central bank balance sheets by buying bonds.
If central bank actions get more aggressive, combine with fiscal policies, and start targeting the middle class, they have the power to override these various deflationary forces with sheer monetary expansion. They can issue helicopter money to pay off debts, boost inflation, build infrastructure, bail out unfunded pension systems, and prop up the middle class if that’s what policymakers decide to do.
I wouldn’t want to be holding a 20-year or 30-year bond at super-low fixed yields in that kind of environment. Negative yields would be even more vulnerable.
-July 2019: “Are We in a Bond Bubble, or is This the New Normal?”
As the stock market crash played out in 2020, and the bond market froze, both fiscal policymakers and monetary policymakers came in with multiple rounds of bazooka stimulus. The broad money supply increased by 40% within a two-year time period, which with a lag contributed to a persistent uptick in prices for many goods and services from 2021 to the present day.
Starting in 2020, I began emphasizing the topic of fiscal dominance. And in August 2020, my newsletter issue was called “Treasury Market Dissonance“, where I discussed the changing role of quantitative easing, and how it was increasingly used to support functioning of the Treasury market rather than to stimulate markets.
If we draw the line at the beginning of Q4 2019 for a clean starting point, which was a couple weeks after the repo spike, there has been a little under $4 trillion in net Treasury security issuance since then, and the Federal Reserve has accumulated about $2.2 trillion in Treasuries, which is more than half of the net issuance.
In fact, the Fed accumulated more Treasuries since the beginning of Q4 2019 than the entire foreign sector accumulated over the past eight years since 2012.
So, we’re eating our own cooking; the U.S. Federal Reserve is the biggest buyer of U.S. federal government debt, and they print new dollars to do so.
What should we do about this fact? Does this throw off market signals about what the bond market is telling us, since the “bond market” in reference to actual private bond investors is less than half of the recent Treasury demand, while a semi-government institution is more than half of Treasury demand, against a backdrop of record Treasury supply for the largest fiscal spending environment since World War II?
I would say so. But we’ll get back to that in a minute. Let’s first look at the counter-argument.
Quantitative Easing and Treasury Yields
Some analysts are quick to point out that just because the Fed buys Treasuries, doesn’t mean it necessarily drives yields down.
During the period of quantitative easing in the Treasury market from late 2010 through late 2014, Treasury yields had a tendency to rise when the Fed was purchasing them, which is counter-intuitive. One would assume that with the Fed as an artificial marginal buyer on an otherwise private market, the Fed’s purchases should move the supply/demand equation in favor of demand, and thus drive bond prices up and yields down. That wasn’t the case:
However, I think it’s important to understand the reasons for why the Fed is buying Treasuries at any given time, as well as keeping in mind the magnitude of their purchases. Back during the 2010-2014 period in particular, the Fed was buying Treasuries as a somewhat optional way to boost the wealth effect, provide extra liquidity, and recapitalize the banking system.
The U.S. federal debt-to-GDP ratio was still rather moderate back then, as the federal government went into the 2008 global financial crisis with around 65% federal debt as a percentage of U.S. GDP, and the foreign sector was still buying Treasuries rapidly, since it was a relatively weak-dollar period (which is when the foreign sector tends to buy Treasuries).
In the years after the crisis, the Fed bought Treasuries to boost liquidity by recapitalizing banks and other large Treasury holders. Treasury yields rose along with economic growth, which is normal.
The rate of Treasury purchases by the Fed back then was about a $500-$1,000 billion annualized rate when active, which they spread over two separate periods. One period was a bit shorter than a year, and one was longer. The result was that during a four-year period from late 2010 through late 2014, they bought a little over $1.6 trillion in Treasuries.
However, the 2019 and 2020 period is a different matter. Foreigners have barely been accumulating Treasuries since 2015, which commonly happens in strong-dollar environments, meaning that domestic balance sheets (pensions, insurance companies, mutual funds, hedge funds, corporations, and banks) had to fund U.S. federal deficits, and those deficits began growing quickly in recent years even during an economic expansion.
The U.S. ran out of domestic balance sheet room to hold an ever-increasing amount of Treasury issuance in late 2019 and encountered the repo rate spike in September 2019, so the Federal Reserve took over as the primary buyer of Treasury issuance. In other words, we ventured into deficit monetization during an economic expansion.
Then, COVID-19 happened, with the biggest unemployment shock since the Great Depression, and the biggest modern example of government transfer payments and fiscal spending as a percentage of GDP in response to that unemployment shock. All of this money for fiscal spending had to come from somewhere, and the private Treasury market wasn’t enough to provide that amount of lending, so it came in significant part from the Federal Reserve via new dollar creation.
Whether you want to call it a dollar shortage or Treasury security oversupply, there just haven’t been enough dollars in the domestic U.S. financial system or international financial system to hand over to buy more and more of Uncle Sam’s Treasury security issuance.
So, the Fed’s recent period of buying massive amounts of Treasury issuance with new dollar creation to keep yields stable and liquidity high within the Treasury market, against a backdrop of insufficient real buyers, is quite different than optional QE to inject some extra liquidity and boost the wealth effect. The Fed’s buying of Treasuries was far more rapid this time around, and for different reasons.
This type of buying keeps yields lower than they otherwise would be by fixing the supply mismatch between Treasuries and dollars, via the mechanism of taking a big chunk of that extra Treasury supply off the market with new dollar creation and letting the real Treasury market price the remaining amount.
-August 2020 Newsletter, “Treasury Market Dissonance”
For the rest of that newsletter, I went on about how we’re starting to get disorder in the Treasury market, as the Fed tapers their purchases. I argued that the bond market was not a good predictor of forward inflation, that it was heavily moderated by the Fed, and that as the Fed increasingly tapered their asset purchases, the bond market was showing increasing signs of stress.
What followed from 2020 to 2023 was the literal worst bond sell-off in modern financial history. The year 2022 in particular was the deepest annual drawdown in the 10-year Treasury note price in a dataset going back to 1928.
I expected it would be bad in inflation-adjusted terms, but it was even worse than I thought it would be in nominal terms. Owning almost anything else was better than bonds for years.
I got plenty of stock picks right and wrong over the years, but simply not holding almost any long-duration bonds, and re-iterating that view over and over, was one of the best decisions for my portfolio. That’s why I got more heavily into macroeconomic analysis in the first place: getting those huge pieces correct was more important than micro factors in this unusual time period.
My first three Macro Voices interviews are interesting to look back on, because they focused on the topic of upcoming inflation and the inability of the bond market to forecast it.
- July 16, 2020: “The Road to Inflation“
- February 21, 2021: “From Monetary to Fiscal Dominance“
- November 24, 2021: “Revisiting Inflation/Deflation Signals“
Specifically, I argued that what was happening in 2020 and 2021 was different than 2008 and 2009.
Back in 2008 and 2009, there was a lot of base money creation, but not a big fiscal transmission mechanism to transfer it to the broad money supply. The fiscal deficit basically just balanced out the major loan losses of the time, so the net result was anti-deflationary but not greatly inflationary.
But 2020 and 2021, there was a lot of base money creation combined with a large fiscal transmission mechanism to transfer it to the broad money supply. The fiscal deficit was far larger than total loan losses, and the net result was greatly inflationary for both money supply and, with a lag, broad consumer prices.
Many analysts at the time took the alternative view, and made the case that what was happening in 2020 and 2021 was not real money creation, that it was more akin to 2008 and 2009, and that structural inflation would not follow.
Among the most influential writers on this topic were Lacy Hunt and Jeff Snider, who took the more deflationary position and made the case that it wasn’t true money-printing.
In particular, I received a lot of emails from people who had read or listened to Jeff Snider’s articulate and prolific work and had questions about how it contrasted with my analysis. That was helpful, because it led me to write a lot of long-form pieces in rebuttal that went into detail on how it was indeed money-printing.
At 13,000 words, my November 2020 article “Banks, QE, and Money-Printing” was the most comprehensive. Here’s an excerpt:
This following chart shows the year-over-year change (in billions of dollars) of total U.S. commercial bank deposits in blue, government transfer payments in green, and the Fed’s balance sheet in red:
That chart is critical to see why 2020 and 2008 were quite different, and why the policy response acted so much quicker and more powerfully on financial markets and personal income this time. Personal income and net worth on a nationwide scale went up, rather than down, in 2020 so far.
In 2008-2014, there was a lot of QE (red line going up), but those dollars didn’t get out into public bank deposits (which is what mostly makes up the broad money supply). This was because there was little or no fiscal transmission mechanism; the government wasn’t sending huge checks to people. So, the green line (year-over-year change in government transfer payments) and blue line (year-over-year change in bank deposits) remained low. The QE process in 2008 mostly just recapitalized banks.
However, 2020 was a very different story. The government sent out tons of money directly into the economy, and financed it by issuing Treasury bonds that the Federal Reserve created new bank reserves to buy. For legal reasons, the Fed buys those securities on the secondary market, but that doesn’t make much of a difference in practice; it’s where they end up and remain that matters. The banks that buy them from the Treasury and sell them to the Fed just act as pass-through entities in this case.
So, the blue, green, and red lines all went vertical in 2020, unlike the 2008-2014 period. The government sent money to people and businesses (green line), that money showed up in their bank deposits (blue line) and thus in the broad money supply, and the Fed created new bank reserves to buy a lot of the Treasury securities issued to fund that program (red line).
Or, put simply, the broad money supply went up a lot in 2020, but didn’t budge nearly as much in 2008/2009 (in either absolute or percent terms), because QE alone to recapitalize banks, and QE-financed fiscal stimulus into the real economy, are two very different situations:
Many people who saw the inflationary non-event from 2008-2014, are suggesting that QE is inherently deflationary, and that it won’t cause inflation this time either.
I’m glad many people feel that way, because I’m happy to buy their gold from them on dips. I bought plenty of precious metals back in 2018 and have cooled my purchases since then due to the notable uptick in price, but am still happy to dollar-cost average into them at these prices, or buy on dips. I also like cheap natural resources more broadly, as well as high-quality equities, real estate, Bitcoin, and other scarce assets for a diverse mix, with a long-term view.
In my view, the “QE is deflationary; it only increases bank reserves!” position is from not taking into account the fiscal element; the transmission mechanism that gets QE into the hands of the public rather than stuck in the banking system. QE alone is not inflationary and mostly stays in bank reserves, but QE combined with massive fiscal deficits, is inflationary, and gets the funds out into the broad money supply, out into commercial bank deposits of the public.
Basically, massive fiscal spending combined with the central bank buying lots of sovereign bonds to fund it, is a modern monetary theory “MMT” program in practice, for the first time since the 1940’s when the equivalent of “wartime MMT” was used.
Now, bear in mind that this is still up against large deflationary forces: technology, demographics, debt, and shifting consumer behavior around the pandemic. So, even a one-time pro-inflationary $3 trillion injection into the real economy is merely enough to cause a quick rebound in inflation and a sharp recovery in asset prices, as we saw in 2020 from the March lows. Combined with certain supply limitations, it also helped cause non-discretionary prices to rise: grocery price inflation in particular was rather significant this year.
However, a one-time $3 trillion injection is not enough to cause a persistent trend change in inflation. Those deflationary forces outweigh it. There is not yet a situation of too much money chasing too few goods and services, except in niche areas. The stimulus delayed an insolvency crisis for several months and got consumers through the worst 3-4 month period of the economic shutdowns.
If we look over the past century, we can see that the two inflationary decades (the 1940’s and 1970’s) occurred when broad money rose rapidly. This chart shows the 5-year rolling cumulative percent increase in the consumer price index and in broad money supply per capita:
Therefore, the big question for investors in multiple asset classes, is whether the fiscal authorities will keep repeating that on a notable scale, or whether they will cool off. Without the massive fiscal+QE “MMT” combo, the economy remains in the grip of structural disinflation, and a renewed cyclical disinflationary trend. However, with another round of massive fiscal+QE “MMT” combo, the outcome would likely be more of what we saw in spring/summer of 2020: rebounding inflation and asset prices, and likely eventually pushing too far.
Ultimately, with so much debt in the system and the weight of private debt, policymakers are likely to be forced to do more rounds of fiscal stimulus (either from civil unrest or political donors), but the timing for that is something that investors need to work around when it comes to assessing the inflationary or disinflationary outlook for the next couple quarters ahead.
Right now, with money velocity so low and the pandemic still raging, and plenty of commodity oversupply particularly in regards to oil, it may seem like there is a limitless sink for broad money creation without leading to sustained consumer price inflation. However, that can change a couple years down the line, as the world fully emerges from pandemic effects, after years of not putting much capital into resource development.
It’s also worth noting that “fiscal stimulus” in this sense refers to both spending and taxation. In other words, federal deficits. A fiscal stimulus could include giving everyone a $1,200 check, or could include giving everyone a $1,200 payroll tax cut, for example. The differences between those two mechanisms matter around the margins (particularly for the unemployed, who wouldn’t benefit from a payroll tax cut), but for large chunks of the 150 million working population, a stimulus check and a payroll tax cut are functionally similar throughout the course of a year, and result in more cash in the hands of most people. These policies increase the amount of broad money, not just bank reserves.
When it comes to fiscal stimulus, regardless of whether it takes the form of taxation or spending changes, its stimulatory impact and inflation outcomes are mostly a question of magnitude, as well as who it primarily targets (unemployed, working class, middle class, wealthy, or rich). It’s inflationary, against the deflationary backdrop, and so whether the outcome shifts to inflation or remains disinflationary becomes a question of scale and persistence, and whether it increases productive capacity or not.
-November 2020 Article, “Banks, QE and Money-Printing”
-The December 3, 2020 episode of Macro Voices with Jeff Snider was called “QE Still Isn’t Money Printing, and the USD Still Isn’t Crashing.”
-The April 21, 2021 episode of Macro Voices with Jeff Snider was called “Why Deflation is the Story, Not Inflation.”
-The November 18, 2021 episode with Jeff Snider was called (with intentional humor), “I Agree With Janet Yellen and Jerome Powell“.
That last one stuck out in my memory because the host, Erik Townsend, brought me on in the very next episode to provide a reaction to it. There were these two dueling narratives in macroeconomic analyst circles at the time of inflation vs deflation, money-printing vs not money-printing. In that episode, Jeff Snider argued that while CPI was now rising and we might get a temporary energy shock, that it wasn’t true inflation because there was no true and persistent expansion of the money supply. Any price shocks would be transitory due to supply issues, because without money printing there isn’t really inflation. And more specifically, he pointed to the bond market as the key source of information.
I’ll quote a key part of it, not to highlight any issues with Jeff Snider who is articulate in this interview as always, but rather to highlight the problem with the bond market. I’ve gotten plenty of stuff wrong in any given year, so it’s not about right vs wrong by any individual analyst, but rather it’s about the headline topic of this piece regarding whether the bond market has any idea what it’s doing.
Jeff: Again, what are long-term bond yields all about? As Irving Fisher said more than a century ago, long-term bond yields are growth and inflation expectations. So even if there’s a secular non-economic reason behind consumer prices, the long-term bond yield would see that somehow as, “Okay that’s something I’ve got to factor.” If I’m owning a 10-year Treasury, and I expect non-economic consumer prices to be accelerated in some secular trend to continue for ten years, then I’ve got to factor that into how I’m viewing my holdings of U.S. Treasuries.
So if the Treasury market says, “Whatever’s going on in the CPI is not going to affect the long run”, then the bond market is essentially discounting these different factors, which lead to this ability to sort out different CPIs from one another. Is it monetary? Is it actual inflation? Or is it something else that isn’t going to last, that isn’t going to impact the long run?
I think people can probably understand where we’re going with this. If we fast-forward to slide nine, we’re getting into the 21st century, and again, the bond market has done a very good if not perfect job, of sorting out which CPIs represent monetary inflation, and which are just transitory supply shocks, or transitory shocks from other factors.
Erik: Okay Jeff, I just want to get this straight. Because it sounds to me, if I plan to have you back on this program one year from today, like we’ve kind of got a setup where I might say, “Jeff, you said there was going to be no inflation, but now gas prices are $7.23 a gallon.” And you might say, “Yeah, but that wasn’t inflation.” I mean, is that where we’re headed?
Jeff: And it sounds like a cop-out doesn’t it? But yeah you’re right. What we’re saying is, the bond market has looked at the 2021 CPI spike and says “This is not money-printing. This is not inflation. This is something else.” And you’re saying- you’re agreeing with me right Erik? You’re saying, “I agree. This is not money-printing.”
Erik: I agree this is not strict monetary inflation. But I still think that an energy-led price shock is coming, which is going to dramatically increase first energy prices, and then almost everything else has energy as an input cost and so the price of almost everything else goes up. That results in even more unhappiness with lower-income consumers particularly, and it leads I think at that point to money-printing, to real monetary inflation as a government response. The way they respond to when people can’t afford that seven-dollar gasoline is they print up a bunch of money and give it out as hand-outs or transfer payments of some kind to support the economy. And if you listen to what Joe Biden said about inflation, he said, “Listen, don’t worry about it. Because we’re going to pump so much money into this economy that it’s not going to matter.” And everybody who understands inflation rolled their eyes and said, “Oh my god I can’t believe he said that.”
Jeff: Well they don’t understand inflation. That’s the point!
Erik: Take him at face value. What he’s saying they’re going to do in response to inflation, excuse me, what they’re going to do in response to consumer price increases, particularly around energy, is they’re going to generate real inflation. They’re going to print up a whole bunch of money, and you’re going to get the inflation that you’re saying is not coming.
Jeff: The bond market says it’s not happening. In fact, the bond market is unequivocal about how such a low probability that is, that it’s not even worth paying much attention to. Look, I mean, I just went through more than 75 years of history, and it goes back further. We’ve got over a century of history where the bond market has been spot-on time and again sorting out long-run consumer price changes, what is inflation, what is not inflation, what are the non-economic factors we need to pay attention to over the intermediate to long run, and which ones we don’t. And right now, the bond market is unequivocal saying, “Yeah, Biden may say these things, but it’s not going to happen.” And there’s a very specific reason it’s not going to happen.
If we go to slide ten, as Milton Friedman said in 1963 as he was touring India, “Inflation is always and everywhere a monetary phenomenon.” Now he didn’t just make the statement as sort of, “I’m just conjecturing here, or this is a theory I had bouncing around in my head.” He made the statement- he just wrote A Monetary History, he made the statement as an acknowledgment of empirical fact in reality. So, as inflation is everywhere a monetary phenomenon, nearly 60 years since he said that, everything has only validated what he was saying, especially the later 60s and 70s of the Great Inflation.
Look, we know what inflation is. Inflation is money, and inflation means long-run problems. And if it’s a long-run problem, the bond market is going to find out about it and it’s going to trade upon it. And if the bond market says, “There is no long run inflation here, there is no money-printing”, then that’s a pretty good historically-validated gauge that says no matter what’s going on in the short run, we’re going to shrug our shoulders and ignore it because there are other problems that supersede what’s going to- and as I said before, yes we could have gasoline prices become extraordinarily expensive and painful. But all that’s going to do in the absence of money-printing and currency devaluation, all it’s going to do is create other economic problems in other parts of the economy that are going to balance it out, so that these so-called secular trends never become secular in the first place.
Again, this is the judgment of the bond market. It’s not me saying this. I’m just telling you what bond yields are saying. And again, this has been a reliable, historically-validated, empirically-established indicator which right now is saying, “Yeah, we hear all of the stuff of what you’re talking about. We see oil prices going up. We see the CPI at 6.2% and used car prices being 1/8th of the increase in the October CPI. But that’s not inflation. And inflation is what we have to look at over the long run, not the short run.
Erik: Okay Jeff, so we’re still in agreement that there is a good chance that energy prices in particular go to the moon from here, but it’s not inflation. And then that gets transmitted into the rest of consumer prices going up dramatically, but it’s not inflation.
Jeff: No, that’s not what I’m saying at all.
Erik: Well, wait a minute. It sounds like that’s what you’re saying. And-
Jeff: No.
Erik: And then what I’m saying in reaction to that is, that the President of the United States went on television and already announced his intention for how he’s going to respond to inflation is by throwing money at it. So that says to me that they’re going to print money.
Jeff: No, they’re not going to print money. They don’t know how. And again, we’ve heard all this stuff before, it’s just that the numbers have gotten bigger. I mean, we’re having the same arguments we had in 2009 and 2010. It’s really just the same thing and the reason for the bond market skepticism is because it’s been empirically validated time and time again. Yeah, who cares what Joe Biden has to say? He doesn’t control money. That’s really the whole point here, that inflation is all about money.
And I’m not saying energy prices are going to the moon. I’m saying energy prices can be temporarily elevated in extremely painful ways, but that pain that consumers will feel because of rising gasoline prices will rob other parts of the economy of vitality and economic activity such that you’ll have one sector of the economy that’s nominally growing massively because of inflation and prices, because prices are going up, but that is going to depress other parts of the economy over time. Neither the energy trend nor the economic trend can survive that kind of split personality. You can’t have rising energy prices and have economic growth continue for very long because, again, history has shown that what happens in those situations is you have the really nasty economic contraction within a short order, and that necessary economic contraction, as nasty as it gets, re-establishes a very different consumer price environment which is not inflationary.
In fact, it ends up being deflationary. Consumer prices, including those of energy and gasoline, will fall very quickly when we get into that sort of a situation. So if energy prices continue to go as they are now, absent the money-printing which is not there, I don’t care what Joe Biden has to say, the market says unequivocally the guy has no clue. Just like Jay Powell has no clue, and just like economists don’t have any idea what goes on in the monetary system. The bond market is telling you, unequivocally, no matter how high energy prices get in the short run, it’s not going to stick around in the long run because it just cannot. It’s not actual inflation. It’s a temporary trend that’s based upon as you said supply factors and supply shock factors alone. And because of that, it’s not an economy-wide- it’s not a global situation that’s going to last for very long because it can’t. Without the money printing you can’t get it.
Again, Milton Friedman 1963, this was not, you know, conjecture. This was empirically-based. And the best way we have of telling us what is going on in the monetary system, what is going on in the real economy, not just today but what is the best type of information or best real-time argument that we can make about what the future is likely to look like. When the 10-year U.S. Treasury is now, what, 1.6%? Even though it’s up over the last couple weeks. I mean, that is an incredibly low rate. And I haven’t even gotten to real yields yet which are unbelievably ugly. So what the bond market is saying, this is not me this is the bond market saying. And the bond market by the way, that’s the people who actually do the money in the global eurodollar system. So they’re already telling you the money’s not there, the money’s not going to be there at any real probability for the future, and so this isn’t inflation.
-November 18, 2021 Macro Voices
Erik brought me on the next episode to specifically present the opposing view, not just on inflation but more specifically on the predictive power of the bond market.
So I gave my repeated spiel about the sources of money printing that I had been writing and talking about for a year and a half at that point, how this was indeed money-printing due to a combination of large-scale fiscal spending and debt monetization, and why the bond market was out to lunch.
Erik: Lyn, I have really been looking forward to getting you on the show, because frankly one of the biggest names that’s come up in response to Jeff Snider’s interview last week was yours. And a lot of people saying, “Hey, wait a minute. Jeff is really telling us a story that banks heavily on the idea that the bond market is a really solid source of information.” And of course, a lot of people are saying, “Wait a minute. If the Fed owns 30% of the 30-year Treasury issuance or whatever the statistic is, I’ve lost track of it, um, it’s kind of hard to believe that there could really be efficient price discovery in that market.” So, what did you think of Jeff’s interview overall and in general this discussion about secular inflation? Which side of the debate are you on? And particularly, what do you think of the value of the bond market as a predictive signal?
Lyn: Well, thanks for having me on Erik, always happy to be here. Big fan of your podcast. And when it comes to Jeff’s work I have a lot of respect for areas that he covers. And one of the things we agreed to touch on was some of the things I view differently than his discussion on your podcast. So, the areas I would view differently is that I am more in the inflationist camp and have been for the past couple years. And I don’t view bond markets as being a particularly reliable signal about forward inflation expectations overall. And I think history bears that out. So I’m happy to go over a couple of the slides that I’ve brought here to kind of cover those points.
-November 24, 2021 Macro Voices
What ensued after that was the worst bond market sell-off of the past century as yields soared to about 5% in 2023.
The bond market, even by late 2021, indeed had no ability to properly price what was already happening, let alone what was coming. By that time in November 2021, the major fiscal injections were already complete, and the bond market still hadn’t reacted.
I was writing and talking about fiscal-driven inflation initially during the fourth year of the Trump Administration in 2020, and then continuing with that theme under the first year of the Biden Administration in 2021, because it was ultimately a numbers thing, and those are the two years where the bulk of the fiscal injections occurred.
There was indeed a brief energy shock later in 2022, although there wasn’t much fiscal stimulus in response to it. The bulk of the money was already printed by that point back in 2020 and 2021, through a combination of major QE and major fiscal deficit transfer payments. The year 2022 was the worst-ever for long-duration U.S. Treasury bonds after that money worked its way through the system, and here in 2024 they still haven’t recovered.
And the reality is even worse than that, because bonds went down while almost everything else went up. Asset prices and consumer prices for most things went up. The opportunity cost of owning bonds in 2020 or 2021 was catastrophic.
Looking back from years later, prices and wages rose across the board for almost every category, and in aggregate stayed high and continue to grind higher. There’s permanently more money in the system (both base money and broad money), and aggregate prices are permanently higher. The growth rate of prices is still above the Fed’s official target, let alone how much cumulative price increases have occurred.
Bondholders from 2021 have much less purchasing power today than they did back then, because the bond market had no predictive power and was a managed market. Even if yields eventually come back down, bondholders from that era won’t be getting their lost purchasing power back.
Imagine a wise old sensei, long known for his excellent judgement and skill, but growing very old in years. His student sees a fire starting to light in the dojo, and asks the sensei if it’s a problem. The sensei seems serene, unconcerned. The student assumes it must be fine then. After all, the sensei has long been known for his discernment, and is showing no concern. But it turns out the sensei is actually senile and asleep, and thus not really himself anymore. And the fire in the dojo is indeed a problem.
That’s what happens to a sovereign bond market when debt/GDP ratios get to around 100%+ and the central bank becomes a large re-occurring participant in it.
While bonds will have good years or bad years like they always have, the main takeaway from this piece is that the informational value from the bond market is now diluted. It’s not the bond market of the 1980s or 1990s or even the 2000s anymore. It’s a big, bloated bond market that requires constant intervention by fiscal policymakers and monetary policymakers. There are pockets of information and pockets of opportunity here and there, but the overall market itself is not what it used to be.
Inflation manifested in recent years without the bond market anticipating it at all, and it can certainly happen again in the future. The same is true for periods of disinflation or economic deceleration. And the bond market can’t really front-run the sheer supply of Treasuries that will be coming to the market over the upcoming years; for the most part it can only respond in real time from the flows.
Portfolio Updates
I have several investment accounts, and I provide updates on my asset allocation and investment selections for some of the portfolios in each newsletter issue every six weeks.
These portfolios include the model portfolio account specifically for this newsletter and my relatively passive indexed retirement account. Members of my premium research service also have access to three additional model portfolios and my other holdings, with more frequent updates.
M1 Finance Newsletter Portfolio
I started this account in September 2018 with $10k of new capital, and I dollar-cost average in over time.
It’s one of my smallest accounts, but the goal is for the portfolio to be accessible and to show newsletter readers my best representation of where I think value is in the market. It’s a low-turnover multi-asset globally diversified portfolio that focuses on liquid investments and is scalable to virtually any size.
And here’s the breakdown of the holdings in those slices:
Changes since the previous issue:
- Replaced TFC and BNS with OZK, CIB, and ITUB.
Bitcoin Note:
I use allocations to bitcoin price proxies such as MSTR and spot bitcoin ETFs in some of my brokerage portfolios for lack of the ability to directly buy bitcoin in a brokerage environment, but compared to those types of securities, the real thing is ideal.
I recommend holding actual bitcoin for those that want exposure to it, and learning how to self-custody it. I buy mine through Swan.com.
I don’t have a firm view on the bitcoin price over the next few months, but I am bullish with a 2-year view and beyond.
Other Model Portfolios and Accounts
I have three other real-money model portfolios that I share within my premium research service, including:
- Fortress Income Portfolio
- ETF-Only Portfolio
- No Limits Portfolio
Plus, I have personal accounts at Fidelity and Schwab, and I share those within the service as well.
Final Thoughts: Watching Gold
Gold broke out to fresh all-time highs early this year, and has continued to move higher since then:
While I have temporary concerns whenever it reaches overbought conditions, I continue to be structurally bullish on the asset.
The U.S. bond market entered its good years of high positive inflation-adjusted interest rates in the 1980s, and foreign central banks began to steadily sell gold in favor of U.S. Treasuries in the 1990s. They continued to decrease their total tonnage of gold for nearly two decades until 2009 during the global financial crisis.
Since 2009, foreign central banks have been steadily accumulating gold tonnage again, and have been benefitting from the price increases as well. Meanwhile, they have been mostly avoiding U.S. Treasuries. Foreign central banks currently have less dollar-value of Treasuries than they had a decade ago.
Best regards,
