The Great Reflation 2021
Markets have rushed to price in higher inflation during the first quarter of 2021, in expectation of supercharged economic growth. To support this, they point to central bank and government largesse, as well as rising commodity prices and market expectations of inflation. But do market prices really support this narrative?
What Is Inflation Exactly? When Is It Good?
Inflation is a much used word that somehow evades all attempts at precise definition.
A commonly used one is provided by Milton Friedman, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output”.
Which is just a long way of saying that inflation is always caused by an increase in the supply of money.
But is it?
Inflation comes in many forms, not least of which are food, asset price, currency value, and goods & services inflation.
Asset inflation is when demand for assets is high, causing people to bid up asset prices.
Currency inflation is when a currency falls in value, causing asset values to rise proportionally.
And finally, goods and services inflation is when demand for goods/services drives up their prices.
Asset price inflation is closely tied to currency value inflation, since asset values are expressed in terms of the domestic currency.
This means that when asset prices increase, they do so relative to the domestic currency. A good example of asset inflation would be the large rise in residential property prices in the US housing market going into 2008.
This appreciation can broadly be attributed to two factors:
1) Asset Price Inflation: The US housing market was in a generational bull market with strong demand for houses for dwelling, investment, and speculative purposes.
2) Currency Value Inflation: The USD was in a bear market going into 2008, with investors preferring to swap their dollars for higher yielding assets; no one really wanted to hold on to dollars. The weak USD meant that assets, when priced in dollars, had higher nominal prices.
Monetary policy has the potential to affect asset and currency inflation, because modern central banks execute their policies by influencing interest rates. This may affect the cost of financing for assets, and thus their prices, while simultaneously changing the yield on holding the domestic currency, hence demand for it.
Goods & Services Inflation works like asset price inflation, except that it pertains to goods and services that are not seen as investments in the way “assets” are.
This is important because if goods and services inflation is broad based and present in both essential and non-essential goods/services, this could* be a result of an economy that is growing robustly.
This is what economists call rising aggregate demand, and is a result of the type of economic growth that central banks are trying to engender through their monetary policies.
It leads to higher disposable income, then higher consumer spending which feeds back into corporate profits and expansion, bringing more people into the labor force in a virtuous cycle.
All of which ultimately shows up as the “good kind” of demand inflation.
“Good” because the virtuous cycle mentioned above is a rising tide that lifts all boats. Incomes across the general population increase, labor force participation is high and unemployment low, and general living standards improve.
In other words, it’s the kind of economy that we all want.
Every instance of “non-standard” monetary policy implemented by central banks over the last decade (last two decades for the Bank of Japan), has been in pursuit of the “good kind” of inflation. Unfortunately, all it has brought so far is asset and currency inflation, with little in the way of healthy goods and services inflation.
*A collapse in the domestic currency’s value would cause the same kind of broad based inflation, but be really bad for the economy – think Venezuela.
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Is Dr Copper Making A Fool Out Of Us?
A favorite trick of global macro commentators, and some traders, is to look at short term price action in a particular market and from there extrapolate broader economic conditions, which they then use to make other forecasts.
Copper is a perfect example of this.
Dubbed “Dr. Copper” (the PhD kind) by market folk, copper prices are seen as a leading indicator of the global economy’s health because of how widely it is used across industrial economies; power generation, construction, electronics, and telecommunications, to name a few.
The logic runs that higher prices for copper = higher demand from across industrial economies, therefore massive economic growth. BUY BUY BUY!
While copper’s cyclical price moves are correlated with global growth over the long term, such linear, reductive thinking does not really work well when it comes to short term market movements.
Copper is no exception, and its price is much more than a function of demand driven by global economic growth.
For example, what about supply?
Demand cannot be considered in isolation, it must be seen relative to supply. In the case of copper, supply in 2020 was affected pretty adversely by the spread of Covid simply due to two countries accounting for 40% of global production.
Chile and Peru, the first and second producers respectively, both had a very difficult time dealing with both the first and second waves of Covid in 2020, with lockdowns and concerns about the health of miners curtailing production.
As such, it isn’t surprising that forecasts for 2020 production stand at around -1.5% according to the International Copper Study Group.
Which brings us to the economic situation post April 2020.
As lockdowns rolled across the globe in the first quarter of last year, global economies shut down, leading to that now forgotten sharp and vicious move lower across global financial markets.
With immediate threats to employee health, frantic government actions to control the spread of Covid, and an extremely uncertain outlook for the future, miner’s cut their production.
Then Western governments decided to open their countries and economies again as spring turned to summer, and demand came rushing back.
However, demand didn’t rush back due to a rosy and robust global economy, but instead from the reopening of economies and the restart of previously mothballed industrial activity.
This left the copper market with producers seriously struggling, while demand rebounded like a coiled spring being released.
As an example of how dire the supply situation was at the peak of last year’s supply shock, Peru’s production dropped 38% over April and May 2020.
There simply was no way producers could keep up with rebounding demand from the world’s reopening.
In other words, one hell of a short squeeze.
Markets and economies are extremely complex – do not conflate the short term price moves of an asset with the general state of the broader economy!
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Markets ≠ The Economy: Oil
Crude oil is another commodity that market participants like to look at in order to gauge the overall health of the global economy. The logic here is the same as with copper, since oil is what the modern industrialized economy runs on, a higher price per barrel must mean strong global growth… right?
Alas, as mentioned before, and will most probably have to be mentioned over and over again, it never is so simple.
Again, like copper in Covid 2020, do not forget what producers are (or aren’t) doing. For oil this is doubly important because of the outsized influence Saudi Arabia (OPEC), Russia, and American shale producers have on the market.
The confluence of every negative factor possible caused chaos in the ranks of American shale producers, leading to many filing for bankruptcy protection. The aggregate debt of these producers was approximately $50 billion, close to 2016’s record of ~$57 billion, and 2016 was a horrible year, where WTI bottomed out at ~$30 a barrel after selling off from highs of ~$100+ a barrel in 2014.
Needless to say, supply in the American shale patch was very badly affected, with oil and gas extraction dropping sharply, while drilling of new wells fell below 2016’s low. Note that both index values have not recovered to their pre-pandemic levels.
Obviously, everyone else was suffering as well, and Saudi Arabia with its OPEC allies came together with Russia to jointly cut their production in order to force prices higher.
As with copper, these supply cuts and bankruptcies coincided with global reopenings and the massive rebound in demand that comes with industries bringing back production capacity, with exactly the same result – an upward surge in prices.
It cannot be overemphasized how important it is to gain an understanding of both supply and demand before coming to some kind of conclusion about what commodity prices represent. Jumping to the conclusion that higher commodity prices, especially energy, are due to a robustly growing economy is a very linear and reductive way of thinking about a very complex global system.
Avoid reductive thinking as much as you can.
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Can Money Run? Introducing Monetary Goldilocks
How fast can money run? Fast enough to destroy an economy. Paradoxically, also slow enough to destroy an economy.
But what exactly is money velocity?
There’s nothing complicated to the fancy term actually, it is simply how quickly money changes hands in an economy.
Here’s a simple illustration:
Imagine that you’re a dollar in the system. Someone takes you out of their pocket to pay for a can of coke, you end up in someone else’s pocket. This new person takes you out to pay for some bread, again you change hands, but this time you end up spending the night in a piggy bank.
You (or rather, the dollar), changed hands twice in one day.
Next consider a scenario where the dollar changes hands five times a day. This could be as it was used by different people for breakfast, lunch, coffee, dinner, then a beer at a bar. The dollar definitely worked harder here, but it still seems like a pretty manageable day.
Now imagine the dollar changes hands 100 times in the same day.
In terms of our hypothetical scenario that’s a lot of people buying a lot of meals, all in 24 hours!
This scenario is what happens in hyperinflation, and is a result of incredible fear that the value of the dollar would depreciate by the hour. Anecdotes from the Weimar hyperinflation about bread prices skyrocketing within the span of a single day are a good example of this.
So if someone ever riddles you with, “When is it cheaper to board the bus in the morning than at night?” The answer is: When money velocity is way too high!
Finally, consider a scenario where the dollar only changes hands once a day. Someone takes it out of their pocket to pay for breakfast, after which the dollar sits in a cash register for the rest of the day.
Obviously things aren’t going well here either, because people are not spending.
This scenario is called deflation, where people simply refuse to spend.
Deflation is a very different beast compared to hyperinflation, and is often caused by multiple factors.
These could include economic shocks due to internal or external factors, a currency that is too strong relative to its peers, a currency that is pegged to a currency that is too strong, and/or a lack of meaningful money supply growth.
In general however, deflation can be attributed to a lack of confidence in future economic prospects.
When people are not confident in their ability to find consistent work (as opposed to hourly contractual work), work with meaningful compensation, or for that matter any kind of work, their natural reaction is to slash their spending. Money then begins to flow through the economy at a slower pace, and prices for various goods and services fall in response to the drop in consumer demand.
If this carries on for long enough, producers can no longer supply their goods/services at a profit and begin to shut up shop, which can perpetuate the deflationary cycle, wreaking economic havoc.
Turns out that money velocity is one of those Goldilocks things; too hot and it burns, too cold and it turns.
It has to be just right.
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Breaking Down Breakeven Rates Part 1
Breakeven rates are all the rage these days. The chart below has been posted (and printed) all over the place showing the huge rally in breakeven rates since the lows of March 2020. People are looking at this rally and using it as evidence that the US economy (and by extension the world’s) is on the verge of “boom times!”
Their thinking runs along the lines of: breakeven rates represent market expectations for future inflation, hence higher breakevens = higher inflation. Higher inflation means that the Fed’s (together with, at this point, almost every other major central bank on the planet) QE is working! Add into this talks of a massive fiscal stimulus package from the Biden administration and all of a sudden what had been talk of reflation becomes turbocharged into “boom times”.
Are things really as simple as looking at the yields of some fixed income products and saying that everything is peachy? Of course not, because the global financial system and economy are anything but simple.
Proponents of the “boom times” narrative are conflating two distinct scenarios, inflation and growth, into a single, hyper bullish outcome. But not all inflation is of the kind that indicates robust economic growth. Which begs the question, what kind of inflation is currently being “priced into” breakeven rates?
Let us first begin by understanding what breakeven rates are, how they are calculated, and what they represent. Breakeven rates are the difference between nominal Treasury yields and yields on Treasury Inflation Protected Securities (TIPS), for example:
5 year Breakeven Rate = 5 year Treasury Yield – 5 year TIPS Yield
It is useful to think of this equation as representing the calculation of real interest rates in the economy, real in this case simply meaning adjusted for inflation:
Real Interest Rates = Nominal Interest Rates – Inflation
With a little readjustment, we get:
Inflation = Nominal Interest Rates – Real Interest Rates
When arranged in this way, it is quite easy to see that the breakeven rate is “supposed” to represent the level of inflation; US Treasury yields, nominal interest rates; and US TIPS, real interest rates. Because the breakeven rate is derived from market prices of US Treasuries and US TIPS, it is often thought of as representing market expectations of future inflation.
All in all, the breakeven rate and what it represents is quite easy to understand on an intuitive level, except that all too often people take this intuitive understanding and extrapolate linearly from there, the “boom times” narrative being a good example.
To be continued…
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