Abstract: We provide a follow on to our March 2020 piece, Inflation Is Coming. Inflation has now reached the highest levels since the early 1980s and the Fed will and must tighten liquidity conditions in response. Despite what some think, we believe this inevitable tightening of liquidity conditions will have a significant impact on consumer prices and the inflation rate will decline. However, in the long term, we still think inflation will emerge as the final victor and the intervening period may have volatile inflationary conditions, which could be incredibly difficult to navigate.
Inflation is here
Whatever weight you allocate to the various potential contributing factors behind the current elevated inflation rate, be it a set of specific supply chain issues in the wake of Covid-19 or the monetary and fiscal response to Covid-19, we are where we are. Inflation is now here, officially at the highest level since the early 1980s. The Fed is now required to respond and will do so.
US CPI
Source: Bureau of Labour Statistics
Rate hikes will have a significant impact
Having predicted the arrival of inflation in March 2020, some readers are asking for an update. Our view is that the Fed will respond, the Fed will taper quantitative easing and raise interest rates. And yes, we do think this shift will have a significant impact on financial conditions. Inflation is therefore likely to decline in 2022, in our view. This is not necessarily a consensus view, at least not among Bitcoiners, gold bugs and those who anticipated inflation in 2020.
Take Peter Schiff for example, perhaps the most enthusiastic and prolific predictor of higher inflation in the world. He questions the impact rate hikes to 2.5% may have on the economy and inflation.
The highest estimate I have seen for rate hikes is ten….. Ten rate hikes is nothing! Assuming all ten of these hikes are 25bps, after ten of them, rates will be 2.5%. Big deal! Inflation is 7.5%….. Even if the Fed raises rates to 2.5%, you have 5% negative real interest rates. You are not going to fight inflation, with 5% negative rates. There is no history that shows this, it is impossible and contradicts any type of economic school of thought. If the Federal reserve raises rates ten times and each one of those hikes is 25bps, by the time they get to 2.5%, real yields will be a lot lower than minus 5%, because by the time the Fed gets rates to 2.5%, CPI will be at least 10%, maybe more!
Source: Peter Schiff – 19 February 2022
Peter’s view above is not one we agree with. A 250bps hike, from 0% to 2.5% will bite, even if real yields are still negative.
Financial intolerance
Investors and the financial system have become used to declining rates for decades. The prevailing narrative in some quarters was of lower rates forever. Investors reacted to this environment, piling into equities and equity products, often using leverage. In addition to this a rate rate increase from 0bps to 250bps is not the same thing as a rate increase from 250bps to 500bps. Investor behaviour is convex. The shift from 0bps to 250bps is likely to have a far greater impact on investor asset allocation and investment flow, than a hike from 250bps to 500bps. Investors think in nominal terms, not using real interest rates. Markets are structurally intolerant to nominally higher rates, regardless of what economic theory teaches one about the inflationary impact of negative real rates.
Therefore, we expect the rising rates to have a significant impact on investor demand for financial assets, namely equities and crypto. And in an environment where investor flow is king, rather than fundamentals or valuation ratios, the impact could be significant. At the same time the so-called real economy has already largely disintegrated. Artificially low rates have taken the economic fuel away from real, sustainable, profitable and humble companies. Instead, we are left with loss making tech startups, master of the universe VC funds, meme stocks, CryptoPunks and a Metaverse real estate bonanza. This represents an extreme level of financialisation in the economy. These highly financialised sectors and any businesses depending on them could be hit hard by tightening financial conditions. The interrelationship between these sectors and the political economy is stronger than many analysts predict. This is what we have left and these areas are extremely sensitive to financial flows and liquidity conditions. The tightening will have an impact and we predict it will result in a lower official inflation rate for consumers.
Policy response
Of course, the authorities will react to the economic downturn and we will eventually correct course back to the inflationary regime. However, this may not be as straightforward as some expect. After raising rates they may be reluctant to simply lower them again this time. A widespread loosening of monterey conditions could be less politically palatable. Instead the response could be a more targeted and coordinated monetary and fiscal stimulus. The result here could be that the next wave of inflation is experienced first in consumer prices, rather than financial assets. But there will be significant lags and volatility.
How to position yourself
The temptation is to say just wait it out. There will only be one winner in the end of this, inflation. Just sit it out with your inflation hedges. Your portfolio of Bitcoin, Ethereum, gold, gold miners and index linked bonds, after all, they will win in the end. At this point however, this is not an investment strategy we would recommend. This game could take five or ten years to play out. In the intervening period inflation is likely to be volatile. This means the CPI is likely to decline in some periods. Very few investors will have the patience and resilience to stick to this thesis as inflation declines.
Trying to be tactical and time markets is widely regarded as a fool’s errand. This is now the prevailing narrative, with passive funds and automated algorithmic strategies leaving active fund managers and stock pickers in the dust. It is time to turn off the machines and sell the index trackers, you will have no choice. Buy Bitcoin at $20,000. Play the game!