In our view, inflation will make a true comeback in the second half of 2021. Not weak inflation either, but the real stuff. It could be the kind of inflation we haven’t seen in years. Rising wage levels for the average worker could materialize too, providing the fuel source for a sustainable, multi-year inflation trend.
If it happens, there will be good consequences and bad ones. For TradeSmith Decoder subscribers, there will be exciting trading opportunities, on both the long side and the short side of markets. For all its wildness and with no shortage of awfulness, 2020 has been a stellar year for Decoder — hello Bitcoin — and 2021 could turn out even better.
If inflation returns, markets will respond with powerful trend movements, both bullish and bearish. In a development that investors aren’t used to, whole sectors and industries could become bearish shorting targets as inflation fears trigger capital flight. (Utilities and consumer staples, look out below.)
For the U.S. economy, it could be a mixed bag. On the positive side, new jobs are likely to be created — many of them via government programs — and the average worker could be in line for a pay hike (or even an ongoing series of them). We saw early hints of after Election Day, when Florida became the first Southern state to pass a $15 minimum wage law.
On the negative side of the ledger, many more trillions are likely to be spent, and the U.S. national debt total will rocket higher with worrisome long-term effects. A return of robust inflation that feels like a boon, at first, could later feel like a return to the 1970s. Meanwhile, for investors, the long bull market in stocks will finally end. But we don’t expect that to happen right away.
In the aftermath of the 2020 election, the U.S. dollar has been profoundly weak. This was confusing at first because the election delivered a “Biden gridlock” result, in which, barring a surprise run-off result in Georgia on Jan. 5, a Democrat White House faces off against a Republican Senate.
That is a recipe for reduced stimulus, or even no stimulus at all. Consider this Nov. 16 excerpt from Bloomberg, which gives the flavor:
President-Elect Joe Biden’s call for Congress to pass a larger-scale stimulus package ran into swift headwinds, with downbeat comments from a senior Republican senator…
“Right now Congress should come together and pass a COVID relief package like the Heroes Act,” Biden said Monday in Wilmington, Delaware.
Senate Appropriations Committee Chairman Richard Shelby made clear that’s not coming soon. “We’re not going to pass a gigantic measure right now – and the question is will we pass it later? Doubtful,” he said, hours after Biden spoke.
Against a backdrop like that, with the COVID-19 vaccine cavalry on the way, one would expect the U.S. dollar to be stronger, as the U.S. muscles through a pandemic recovery with less spending than expected and a White House that finds its priorities largely blocked.
And yet, the U.S. dollar has weakened substantially since the election, and this may be the message: Government spending in 2021 will not necessarily be blocked by a GOP Senate.
Even if Mitch McConnell takes a sacred vow to kill every bill, the Biden administration may have the means to spend trillions anyway and the technocratic knowledge to make an end-run around the Senate.
Jerome Powell, the Chairman of the U.S. Federal Reserve, has learned a lot over the course of the pandemic. One of the things he learned is that, if the Federal Reserve packages its actions in the right way, it can break the rules and hardly anyone will care.
Billionaire bond-fund manager Jeff Gundlach, and others, have accused the Fed of violating the terms of the Federal Reserve Act with its unorthodox pandemic programs — some done in coordination with the U.S. Treasury — and its willingness to openly buy corporate bonds, including high-yield junk bonds.
This is where the spending back door comes into play.
The Federal Reserve and the U.S. Treasury can team up in creative and unorthodox ways, and pull off technocratic maneuvers that a majority of observers don’t understand. If the Fed and Treasury are also willing to bend the traditional rules, or even break them a little bit, there is a whole lot they can do.
Powell, as head of the Fed, has gone on record repeatedly expressing his opinion that the U.S. government should do more to help the recovery.
Powell’s view, more or less, is that monetary policy (lending programs and credit) has been stretched to its limit, and fiscal policy (direct government spending) needs to kick in to help the U.S. economy make it through.
For the Federal Reserve and the U.S. Treasury to truly team up, and bypass the spending authorization of the U.S. Senate, Powell needs a U.S. Treasury secretary with the same mindset — and preferably one who supports the tenets of Modern Monetary Theory (MMT).
MMT is not a crackpot theory. Advocates believe some questionable things, but the underlying logic is sound, at least from a plumbing perspective.
The core of MMT, more or less, is the belief that a sovereign government in control of its own currency and debt markets has no spending constraint other than inflation. As long as the economy is not seeing an unhealthy level of inflation, MMT proponents believe a government can spend as much as it wants.
MMT theorists also tend to be sophisticated and technocratic, meaning, they have numerous ideas as to how to run the financial system, and how to dampen or block inflation even with government spending on the rise.
For example, one MMT policy prescription is linking mortgage loans to a price-to-rent ratio, so the size of the loan is capped by an index of average rents in a given area. If you wanted to buy a house at a price that is greatly inflated relative to the price-to-rent ratio, you could do so, but the financial system would not support your decision with lending leverage. This would reduce home price inflation by keeping prices more tethered to a realistic measure (local rent averages).
So an MMT theorist with policy knowledge and technical skills would seek to spend government money on new job programs, or community funding for government-approved initiatives, while simultaneously using various financial tools (like capping mortgage size based on price-to-rent ratios) to keep inflation pressures down.
This is how the next U.S. Treasury Secretary will think. In our view, the incoming U.S. Treasury Secretary will almost certainly be pro-MMT, even if they never say “Modern Monetary Theory” out loud.
If you put together a Fed Chairman who is pro-fiscal (Powell) with a U.S. Treasury Secretary who is pro-MMT, and mix in a willingness to bend or break rules, you can get trillions into the hands of consumers and communities in ways that Mitch McConnell can’t stop.
Here is a hypothetical example:
- The Federal Reserve and Treasury combine forces to create a municipal lending program that is tied to “green jobs” at the state or county level.
- Low-interest-rate loans — think borrowing rates so low the cost is close to zero — are packaged for state and local entities with the stipulation that the money is spent on green jobs in a local area (solar installers, wind farm technicians, ethanol plant workers, and so on).
- States and counties borrow trillions by way of the Fed-Treasury joint program. The loans are long-dated and low-cost so there is low risk of default, and no performance reckoning for many years out.
- Meanwhile, hundreds of billions or even trillions in credit are distributed (in loan form) to the states, with the stipulation that the money is spent on jobs or infrastructure-type improvements immediately.
There are a great many technical details left out in the above example.
But the basic idea is that, in a modern financial system, credit and money are the same thing. When banks extend credit, they are, in effect, creating money, because the entity that draws on the credit line, or takes the loan, has newly created funds as a result.
It is normally the case (again, in a modern financial system) that banks create most of the money in circulation, rather than the Fed or Treasury. The banks do this by extending credit, and creating loans with their reserves, in such a manner that every dollar of reserves is multiplied throughout the system.
Our main point here is that, with a little creativity and some artful rule-breaking, the Federal Reserve and Treasury can do this too, either in partnership with banks or bypassing them altogether.
But to make this happen, you need both the Federal Reserve Chairman and the new U.S. Treasury Secretary to play ball, and to have the same pro-fiscal, MMT-style goals in mind for stimulating the economy.
Here is the New York Times from the morning of Nov. 20:
President-elect Joseph R. Biden Jr. said on Thursday that he had chosen his nominee for Treasury secretary and that he would announce the pick in the near future.
Mr. Biden, at a news conference following a meeting with U.S. governors, said he believed the selection would be accepted by “all elements of the Democratic Party.” He said the choice would be unveiled just before or just after Thanksgiving.
Mr. Biden has been widely expected to choose a Treasury secretary that would make history. The job has only been held by white men in its 231-year history.
Those believed to be on the shortlist include Lael Brainard, a Federal Reserve governor; Janet L. Yellen, the former Fed chair; and Roger W. Ferguson Jr., a former Fed governor and business executive…
The shortlist candidates all have a few things in common. First, they are either progressive in their political views or sympathetic to progressive ideas. Second, they are highly intelligent and highly technocratic, meaning they know the financial system inside-out — with direct knowledge of how the Federal Reserve works — and how to work the hidden levers of the system. And third, they will all be pro-MMT, in word and deed if not public allegiance.
The Fed and Treasury won’t need McConnell’s Senate. They’ll get the trillions through, for good or ill, and the MMT experiment, started in March 2020 with the initial emergency response to the pandemic, will continue one way or another.
Whether you like this news or hate it, it means a roster of excellent investing and trading opportunities in 2021 — as we see progressive technocrats with inside knowledge of the system figure out how to unleash inflation, for good or ill, in a manner the U.S. economy has not experienced in decades.