Generally speaking, the market doesn’t have much faith in the reflation narrative and hasn’t for quite some time.
Indeed, the long, slow grind lower in bond yields and attendant curve flattening betray a deeply-ingrained skepticism around the notion that developed economies will ever manage to engineer robust growth and/or achieve “healthy” inflation outcomes.
The “duration infatuation” in rates is evident in equities, where secular growth, quality, min. vol., and a variety of bond proxies have exhibited a tendency to outperform. Over time, this has led to crowding as some tech names have become synonymous with multiple styles and factors.
All of that works to the detriment of cyclicals, value, small-caps, and anything that would benefit from a steeper curve and a high-growth, “running-it-hot” world.
The pandemic obviously accelerated those trends. It was, first and foremost, a deflationary supernova.
That said, there are myriad ways in which COVID-19 could prove inflationary over the longer-run, something I’ve discussed in these pages at length. Some of those potentially inflationary dynamics are captured in responses to a special question in BofA’s Global Fund Manager survey (below).
Re-shoring and rising protectionism are generally inflationary, and there are palpable concerns in some corners that “extreme” debt financing (i.e., overt fiscal-monetary partnerships) will be inflationary by definition.
At the same time, some have suggested that once a vaccine is found (assuming a vaccine is found), re-openings and accelerated economic activity will collide with the trillions already spent into the system (so to speak) to trigger an overheat.
In a Wednesday note, Nomura’s Charlie McElligott touches on these points before presenting an alternative view on the recent surge in monetary aggregates.
“Longer-term/structurally, the market continues to pivot from the prior ‘outright cynicism’ towards the potential for an inflationary impulse into something that is upgraded to somewhere in the area of ‘non-zero'”, he writes, employing his trademark cadence.
This “upgrade” to a non-zero chance of a reflationary outcome is predicated on two beliefs, McElligott says. They are:
- Gradual economic reopening (especially off the “base effect”) in conjunction with;
- The unprecedented full-force of coordinated fiscal stimulus and monetary policy being unleashed could spill-over into an overshoot, especially as the market now builds a Fed “inflation targeting” expectation into the base-case for September
He goes on to say that “much has been made of the impulse higher in monetary aggregates like US M2 as a representation of the central bank-enabled ‘liquidity cannon’ that could in theory ‘release the kraken’ of inflation”.
To that, he adds a caveat. It’s possible, McElligott writes, that some market participants are misinterpreting “the lunge higher” in US M2. He elaborates as follows:
This contrarian view is that the Fed hasn’t been the largest driver of the growth in broad money supply–because if that were the case, we would have seen a similar spike in M2 over the period immediately during / after the GFC and the Fed’s foray into QE, large-scale asset purchases and emergency lending programs–but that did not occur. Instead, the belief is that M2 this time is surging because of 1) US corporates drawing down on their lines of credit / take new loans from commercial banks, which have then been placed into deposits / put into money market funds, on account of risk aversion. The second input for the spike in M2 is due to 2) the US CARES Act, which has put stimulus money directly into households, paying bills and for “staples”, but also much of which has actually been behind the spike in personal savings rates.
You can visualize this if you like. The figure (below) illustrates all the points from the excerpted passage from McElligott.
One possible read-through, Charlie says, is that “the monster jump in M2 money aggregates is potentially being misinterpreted as an inflation catalyst, instead of actual saving and risk aversion, which many would argue are ‘disinflationary’ as money velocity is shocked lower”.
Apparently, this has been discussed at length in a series of tweets by multiple accounts, among them are “Dave” (@djr8519) and former US Treasury economist David Beckworth.
If this is the correct way to conceptualize the situation, then one takeaway would be that we need to see M2 fall in order to get the inflationary impulse that so many insist is inherent in its rise.
That’s because, to quote Charlie one more time, a decline in M2 would mean “money is put back to work on the corporate [and] individual levels [as] risk aversion and focus on savings turns into a more opportunistic outlook” once the economy is deemed “healthy enough to see loans and lines of credit paid back”.
Good article here on the relationship between the Fed’s printing press and market dips.
https://www.bloomberg.com/opinion/articles/2020-08-04/fed-props-up-falling-stocks-doesn-t-try-to-prick-bubbles
Elmer- thank you for linking this article. Does not bode well for fundamental based investors for the foreseeable future.
Velocity- it sounds so sterile. Yes but what high velocity really means is that the banking system is out to lend money- and borrowers want to borrow to expand- in other words money circulates and is relent. Does this sound like what is going on in the real world now? Nope. Bnaks are raising lending standards based on a recent Fed loan officers survey. The money supply geeks/many monetarists never connect the dots. It is a failing for many of them. Parroting that money supply is growing fast so that we will have inflation has proven time after time to be an error. Remember duing the financial crisis that ad that many financial luminaries signed on to telling Bernanke that his policies would unleash inflation? I do and it was dead wrong. And most/all of those guys never put another ad out saying how wrong they were. Believe me the Fed would get down on its hands and knees and kiss the ground if they were lucky enough now to have an inflation problem. The output gap right now is way too large for that. Could it change? Perhaps. But not in the next 2-3 years. We will be digging out of this problem for years…
PS- I think McElliot is correct but I do not think it is so contrarian.
Roger that!
The gold rally concerns me, because I don’t own it.
Copper and other commodities have shown some uptick, but not so much as gold.
It appears that the possibility of inflation, seems to be driving gold, more so than the reality of inflation.
Look at the DBC ETF on the 5-year chart. Presently trading around 13 and moving in the direction of 14 to 15, it’s longer term average.
Does this mean the nascent reflation trader is dead on arrival next time it shows up (September)? Damn, I guess I should pile on my tech…
The velocity of the money is key.
I recall the same issue was raised back in 2009. The right-wingers were screaming about growth in the money supply, in the context of “the debasement of the currency” mantra. Someone rebuked that beautifully when he noted that you can print a billion dollars but it won’t have any impact on the economy if it is left locked up in a room. That money had no velocity.
we are on the same page
Yep. I had typed that before I read your post.
No velocity in the economy, but plenty in the financial markets.
As usual, asset inflation side by side with economic softening. Something’s gotta give, but what and when? It took six years for the ammonium nitrate in Beirut to develop to the point of exploding, so don’t get all excited just yet. My problem is I can’t figure out how to position myself away from the inevitable event. Dying before it happens looks like the only possible out. I’m certainly old enough for that to be the case, but what does government and the central banks have in mind for the young?
Coronavirus federal $1200 payments, unemployment benefits of approximately $1k/week, moratorium on rent evictions (therefore, many are not paying rent- effectively borrowing from landlord and hoping for forgiveness), banks offering “extend and pretend” (as in “pretend the LTV still makes sense and the lender will eventually get repaid”), and significantly reduced opportunities to spend money on travel, entertainment, eating out etc. are all generating savings levels in excess of the pre-covid level.
IMHO, this is simple math: people spending less than income and/or transfer payments received – not analytical concerns over whether or not the future will be inflationary. Once covid is mostly in rear view, most of this savings will likely be spent on past due bills.
I was led to believe that the velocity of money is reflective of all economic activity. Banks play an outsized role.
Charlie does make the case that for now, it ain’t inflation if it is all under the mattress.
This also validates MMT in some respects. But the Gold market screams inflation……
Gold could also be screaming anxiety. China, inflation/deflation, Biden/Trump, will he stay or will he go? Many opportunities for something to go bigly wrong. I
Doctor PJS nailed it.
Our Dear Leader has done us all a great service showing us how the FANGs check so many factor boxes.
As PJS points out, gold does the same for many people.
Ditto…………….
Slowcoaches. There is $15,000,000,000,000.00 trillion dollars in non-M1 components (including large CDs), that is un-used and un-spent, lost to both consumption and investment, indeed to any type of payment or expenditure in the U.S. payment’s system. That is the cause of Alvin Hansen’s 1938 secular stagnation thesis since 1981.
Banks don’t loan out deposits. Banks create deposits. The only way to activate monetary savings (and all monetary savings originate within the payment’s system), is for the saver-holder, deposit owners, to spend/invest either directly or indirectly, e.g., via a nonbank financial intermediary. Everything was predicted in 1961.
Savings flowing through the nonbanks never leaves the payment’s system. Savers never transfer their funds outside of the banks unless they hoard currency or convert to other National currencies, e.g., FDI. There is just an exchange in the ownership of pre-existing deposit liabilities in the banking system, a velocity relationship. Where do you think velocity has gone since 1981? Savings have become increasingly impounded and ensconced in the payment’s system (due to the complete deregulation of interest rates for the stupid banksters).
Dr. Philip George’s equation proves Dr. Leland James Prichard’s theory, Ph.D. Economics Chicago 1933, M.S. Statistics, Syracuse ( the ratio of M1 to the sum of 12 months savings ). Link “The Riddle of Money Finally Solved”. As Dr. Philip George points out:
(1) “Holding interest rates down does nothing to boost investment because the problem is falling consumption.”
(2) “When interest rates go up, flows into savings and time deposits increase.”