Signs of financial instability: How inflation and rising bond yields affects fiat currencies and what this means for financial markets.

Finance & Fury Podcast

Welcome to Finance and Fury. Today, signs of financial instability that are emerging in markets – why are inflation and rising bond yields affecting fiat currencies – and what this means for markets – modern economy is interconnected and complex – so do my best to break these all down

1. There is a growing recognition that price inflation has the potential to increase significantly in the near future
   1. It has already increased significantly in certain areas – timber/wood, food, and petrol especially in the US with the hacking of colonial pipeline
   2. The official estimates state that this inflation will be a temporary phenomenon – with it reverting back to limited to an average of 2% p.a.
   3. But the markets are more worried about the fact that this may not be a transitional phase in the short term, but that inflation is going to linger for years – hence there is increasing speculation about the need for interest rates to rise – creating further uncertainty in markets and sectors starting to de-risk from growth shares
2. For those who are familiar with monetary policy – if inflation is above the mandate of CBs policy, increases of interest rates are the typical response
   1. It is something that hasn’t really been seen since the 80s – but markets could panic that this is going to occur and with this – the growth companies that are relying on the lack of discounting of their cashflows in propping up their valuations could come crashing back to earth – specifically the tech sector of the market
3. Where the probability of interest rates being increased is being reflected in the bond yield – in the US – the yield on 10-year Treasuries has more than doubled over the last year, Australia and most of the world is seeing the same phenomenon – all of this is occurring whilst QE is occurring to held artificially lower yields through buying up the additional supply of government bonds on the secondary market –
   1. who knows how high the yields would have spiked without QE
4. Historically – and working in a world where fundamentals matter - equity markets have continued to rise during an initial increase in bond yields
   1. But Financial markets have become dislocated from fundamental realities – they are now more vulnerable to a change in sentiment – driven from central bank policy – this all requires a revision to fundamental theory – with an updated view to look at what the driving factors are of markets at this stage of the economic cycle
5. Yields rising, or inflation peaking technically should have no effect on equity markets – but it is what economic responses that they point towards that do – in the modern era – CB policy and investor behaviour in response
   1. If a central bank changes their mind on interest rate policies – or how much to expand their balance sheet by through QE purchases – markets will react more than they would have historically to something like inflation kicking in – they are reacting to what a central bank will do in response to inflation – not the inflation
      1. This is because equity markets are purely driven more by money flows– i.e. money flowing in or out of share – buying and selling – which is the demand of the share market – if it is demanded, then people will buy more, money will flow into the markets, pushing up prices – the reverse is true
      2. Money flows can occur in a few forms – in response to the perception about the economy
         1. CBs - from policy like QE who are worried about rising yields on government debt
         2. Inflation rates and employment concerns – leading to changes in Interest rates -
         3. The perceived economic prospects – will GDP be strong, will companies have good profits
      3. When looking at some of the current economic prospects - commodity prices are soaring, and supply chains remain disrupted – both of these can lead to supply issues and inflation in prices of goods and services
         1. Commodities – inputs to goods and services – when their prices go up, it is passed on to consumers – Supply chains – when they are disrupted it lowers the supply of goods, and if demand stays the same then prices go up
            1. Even directly for consumers - oil prices go to petrol – coal, gas – go to power bills
         2. These factors on top of the expansions of money supply – which is expected to continue in the future – inflation rates have the potential to spike – if these are not simply transitionary through one or two quarters - higher interest rates may be brought in – which with the amount of debt and additional money supply – threaten to destabilise both financial markets and fiat currencies.
            1. For financial markets - The reality is – if interest rates rise – the money flows into assets can reduce – creating a limited price growth and if anything – a price decline
            2. For Fiat currencies – all currencies are debt – every dollar is an IOU to a central bank – with inflation, the value of these fiat currencies declines for the person holding it – so inflation for savers in a world where interest rates are zero
               1. People are converting their money for dogecoin – this says a lot about the state of the current fiat markets
            3. The concerns are that the money flows will cease – CBs will stop printing as much as a response to increase interest rates –
               1. So in effect - an interest rate rises will lead to less money supply flowing into assets such as shares and affect existing borrowers
                  1. This would have dramatic effects on the property markets
               2. The interesting thing with markets is what is known or predicted is typically priced in – if an increase in interest rates is known before it takes effect – markets would have already priced this in
                  1. This being said – what is not expected is what shocks markets – What shocks markets can be in the form of changes in expectations – for instance, inflation is expected – but CBs have said that interest rates will be on hold –
                  2. Markets are hedging their bets – investors are starting to sell off some of the overpriced growth companies in the market – companies like TSLA – slowly being sold down
                  3. But Public participation in equity markets is at an all-time high, not just through direct holdings but through passive index tracking funds and the like
                  4. So the real risks to the markets at this stage of the cycle is that money flows will dry up thanks to responses to monetary policy – this will then spook investors –
                  5. There will be an inevitable cyclical switch from greed for profits to fear of loss that defines the divide between bull and bear markets
               3. The bond market is pointing towards a bear market -
                  1. considering the effect on market relationships as over many investing cycles it has been observed that bond prices conventionally top out before equities – it is a very reliable warning sign
                  2. But today we see that there is a relationship between declining bond prices and rising equities
               4. The increase in bond yields will affect the cycle of money flow –
                  1. Looking back – one of the largest debt markets - the 10-year US Treasury bond – saw its yield fall to 0.48% in March 2020 – this is when deflationary fears were around – then the S&P 500 index fell by 32% and commodity prices were collapsing due to demand fears
                  2. The Fed and global CBs then did what they have always does in these conditions - cut interest rates to the minimum possible (zero this time) and it flooded markets with money ($120bn in QE every month in the US)
                  3. Over the past year - equity markets recovered fully and have gone on to new highs and commodity prices are now rising strongly
                  4. But the money supply isn’t being reduce in response – it has continued and is likely to continue - the expansion of base money by central banks is huge - From the beginning of March 2020 base money in the US, the world currency reserve has grown by 69% - this is an incredibility large increase – and it has been rapid – 12 months - likely behind rising commodity prices in part as the purchasing power of the dollar in international markets is falling – as most commodities are based on the global reserve – the USD
                  5. When the outlook for the purchasing power of a fiat currency falls, all holders expect compensation in the form of higher interest rates or prices – this is inflation after all – the real value of $1 is less when there are now almost 70% more USD – due to time preferences – the expectation is that the currency will buy less tomorrow than it does today.
                     2. When looking at CPI and bond yields – if we look at the official targets of inflation, at 2.5% - the dollar’s purchasing power should sink to 97.5 cents on the dollar in 12 months if it is accurate – so the yield on the ten-year UST should be at least 2.56% to compensate this - otherwise new buyers face immediate losses – but it isn’t which shows a concern for markets as if inflation is going to go up, investors in debt markets will lose out – which is why QE is needed –
                  6. You will never hear a CB, like the Fed admit the erosion of the currency they manage – but it is happening
                     1. It is only a matter of time before holders of all fiat currencies slowly realise these issues one at a time – further eroding the confidence in the dollar and other fiat currencies – this can fuel further money flow out of the dollar – into assets
                     2. And as has been seen - commodities have soared in price along with other inflation hedges, such as cryptocurrencies, equities and residential property. Other than the purchasing power of currencies, prices of fixed interest bonds have fallen, which is why their yields have risen.

What risks are there to markets with a collapse of the value of Fiat

1. For several decades successive – going back to the times of Alan Greenspan – Cb officials have admitted that a rising share market is central to monetary policy – they believe that it creates the wealth effect and economic confidence
   1. This has been evident from CB policy – especially last year – but these policies to prop up equity and property markets is always going to address any financial or economic collapse by inflationary means – through the money flow – coming from an increase in the money supply
2. But this in turn creates a real devaluation of the dollar through inflation - the valuation basis for equity markets will shift - undermining prices based around low to no inflation expectation
   1. Even if the Fed tries to offset a decline in prices as markets start to price in inflation –
      1. Creating higher yields for bonds and greater preference for present values in cashflows today rather than in the future for equities – if the solution is to increase QE to feed more cash into bonds and equities – they are chasing their own tail and at some point, it will be impossible to offset the valuation effect
   2. Equities will almost certainly succumb to an interest rate shock at some point. At the same time, the increase in bond yields will undermine government finances.
3. In these conditions the Fed will be trapped - it cannot let bond and equity prices slide - investment sentiment would turn deeply negative creating further sell offs and further price declines- but nor can it stand back and let markets sort themselves out, because of the record levels of corporate and other debt which would become impossible to refinance
   1. But nor can it just print money in order to rescue everything, because the dollar will be further undermined and start to become even more worthless - That leaves it with only one alternative left to pursue, albeit with the greatest reluctance. And that is to raise interest rates — substantially
4. From this earlier precedent – the central banks have made the choice to increase interest rates over printing more money – but only when confidence in the dollar is low – you don’t want to lose all confidence in the dollar – or your currency – get a hyperinflation event – so to save the currency at some point interest rate increases would be needed
5. But today – almost every economy is loaded up with debt, much of which is unproductive. A sharp rise in interest rates to contain price inflation would drive the world’s economy into a humungous debt-induced slump – also government borrowing is already out of control – especially in countries like Japan and the US
   1. Whilst it would create a massive downturn in prices – it may be what is needed.
6. We aren’t at this point just yet – but there are some consequences of rising bond yields – that is that they can bring a rapid shift from overtly bullish assumptions to a more considered bearish outlook
   1. Where instead of bad and inflationary policies being tolerated or even demanded by investors, their thinking turns on a dime to a fear of anything and everything
   2. Under these conditions - every turn of the central management of economic outcomes only makes things worse
   3. Such is the violence of market imbalances that plague the financial world with central banking environment – where under their control financial markets can face a rapid decline if major inflation spikes due to the artificial controls on money – through increasing the money supply and keeping interest rates near 0%
7. In this environment – alternative assets can do very well – commodities, physical previous metals – and beyond speculation – this may be why many crypto markets started to rise over the past 12 months – people are looking for anywhere to put their money beyond fiat currencies or debts denominated in those currencies

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