The Market Got It Wrong In 2008. Are We Making The Opposite Mistake In 2020?

[Editor’s note: As many readers are likely aware, fan-favorite Kevin Muir — formerly head of equity derivatives at RBC Dominion and better known for his exploits as “The Macro Tourist” —  recently transitioned his daily letter to a subscriber-only format. On Friday, I asked permission to republish his latest, which he granted on a one-off basis. The following is available exclusively to his subscribers and mine.]

I would like you to remember back to 2008 when Ben Bernanke cut rates to zero and instituted quantitative easing.

Remember all the worries about “hyper-inflation?”

In trying to find an article that captured the zeitgeist of the moment, I stumbled on this John Williams June 2008 article titled, “Hyper Inflation Special Report”:

Before you send me a note about how John Williams has extreme opinions, don’t bother. I get it. I know that not everyone believed the US would descend into a “hyper-inflationary great depression.”

However, at the same time, there can be no denying that many market participants were worried about increased inflation from Bernanke’s novel policies.

In November 2010, serious folk, including Cliff Asness and Jim Chanos, felt strongly enough that they penned an open letter to Ben Bernanke in the Wall Street Journal warning of the potential of “currency debasement and inflation.”

The reason I bring this up? I am trying to highlight how inflation was a main topic of concern for market participants in the wake of the 2008/9 Great Financial Crisis. Yet, to the surprise of many, the ensuing economic upswing brought subdued inflation, and these concerns proved for naught.

Let’s contrast that with the market’s current take on Jerome Powell’s response to the corona crisis.

There are few worries about inflation. In fact, until recently, the principal concern was deflation. The most popular “bear market narrative” was a collapse due to a shortage of US dollars which would necessitate negative interest rates.

It’s almost the exact opposite response than the 2008/9 consensus view!

Back then, the Fed was engaging in policies that would usher in hyper-inflation. Today, no matter what the Fed does, there is no way they can avoid the coming deflation.

If you don’t believe me that these contrasting views dominate the financial landscape, all we need to do is look at the yield curve. On December 16th, 2008, Ben Bernanke and the Federal Reserve lowered rates basically to zero. On March 15th, 2020, Jay Powell’s Fed did the same.

Let’s have a look at the yield curve on those two dates (blue line is the first day of zero rates during the GFC and the orange line is that same day for the corona crisis):

The curve was over 150 basis points steeper at both the 10 and 30-year tenor!

We are now three months from the period when Powell lowered rates to zero, so if we fast forward both curves appropriately, we notice that although we have steepened, during the GFC the curve steepened even more!

The equivalent period during the GFC was over 200 basis points steeper!

Fading consensus

One needs to be careful not to simply be contrarian for contrarian’s sake, but there is something to be said for not chasing the latest “hedge fund fad.”

Maybe the market has figured out that extreme monetary policy does not create the hyper-inflation they fretted about. Maybe today’s muted worries about inflation is a proper understanding of how monetary policy works.

And I would agree with the market if (and this is a big if) fiscal policy was the same. However, the two situations are night and day.

Long time readers of the ‘Tourist are probably tired of seeing this next chart, but it deserves another reprint.

This is the discretionary US Federal budget change on year-over-year basis for the past half century. After the GFC, we had five years of contractionary fiscal policy.

Let’s contrast that to today. Back in 2008 we had cash-for-clunkers and a couple of other smaller fiscal stimulus programs that were quickly withdrawn. Today, we have TRILLIONS of direct fiscal stimulus pouring into the economy, with no signs of that stimulus stopping anytime soon.

The market misjudged what creates inflation in 2008/9 and is now convinced that no matter what happens, governments cannot create rising prices. Once again the market is making a colossal mistake. The government can create inflation through aggressive fiscal stimulus (which monetary policy then accommodates).

How can one play it? Well, buying curve steepeners is one way. Going long inflation breakevens is another. Or simply, own precious metals.

I love trades where everyone is convinced something cannot happen, but I understand why the opposite might occur.


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