No Way Out: Breaking The Cycle Of Asset Price Inflation May Be Impossible

I don’t claim to know much with absolute certainty, but one thing I’m almost sure of is that the number of armchair economists, would-be libertarians, and “creative destruction” advocates far exceeds the number of people who would thrive in a Hobbesian state of nature.

This is a subject I revisit frequently, because talk of asset bubbles fueled by monetary policy very often strays into debates about the relative merits of a prospective “grand” reset, wherein all misallocated capital is “purged.” Once that happens, economies are imagined to be rebuilt from the ground up, constructed in the “correct” proportions atop the smoldering ashes of our bubble-laden past.

To put it bluntly: No educated person who is any semblance of rational takes this idea seriously in the 21st century. But you wouldn’t know that if you spent your days perusing finance-focused social media or the economics blogosphere, where unhinged, aggrieved netizens, often with loose connections to finance, economics, or government service seek vengeance upon an “establishment” they blame for some petty, decades-old personal failure. (That’s a generic origin story that applies to multiple popular websites and personalities.)

These discussions become more pressing and more relevant the further down the road to extreme monetary accommodation we go and the further away from market clearing prices we get.

Price discovery has been relegated to the dustbin of history for many assets, including, for example, periphery European government bonds. Some EU Debt Crisis pariahs now borrow for less than the US government.

It’s easy (and tempting) to decry this situation while it persists. The problem is that for the vast majority of critics, decrying the loss of price discovery entails implicitly (and very often explicitly) arguing that it should be restored. And the quicker the better.

That is a simplistic view that lacks nuance, and while it’s entirely fair to argue for the gradual normalization of markets, we should all be thankful that the “Band-Aid” approach is not taken seriously by policymakers. Because, as discussed at length in “Yen And The Art Of Bridge Maintenance,” allowing the market to clear all at once (a logistical impossibility considering the trillions of assets sequestered away on central bank balance sheets) would lead to catastrophe.

But, all of that said, it’s important to note that this is, in fact, a trap from which there is no obvious escape. And that’s a bad thing.

In other words: The criticism does have merit. It’s just that the critics aren’t usually serious people. In that respect, the situation is a lot like the Trump administration and China. It’s not that the administration is totally wrong. Rather, it’s that the credibility deficit is so large at 1600 Penn., that you can’t take anything that emanates from that address seriously even when you suspect it might have merit.

The current conjuncture is characterized by two traps, and they’re related. The first is illustrated in the figure (below) which regular readers have seen dozens of times (although it’s been so long that I can’t remember, I believe I adapted the chart from Citi’s Matt King at some point years ago).

As central banks push investors out the risk curve and down the quality ladder, excess capacity is allowed to stick around. It’s even encouraged. Producers (think of shale, for example) that would have otherwise gone out of business, keep producing. That’s conducive to disinflation, which leads to even lower yields, and more herding into even riskier assets, which depresses default rates even further, and around we go.

Of course, that trip out the risk curve and down the quality ladder entails (by definition) the bidding up of financial assets. Because those assets are primarily (but not totally) concentrated in the hands of the wealthy, the whole endeavor serves to exacerbate inequality.

All of that sounds bad, so why not intentionally short-circuit the whole thing? Well, simple: Because we’re so far afield that a controlled demolition would be anything but “controlled.” This is the second trap.

Indeed, merely raising US real yields to ~1% in 2018 triggered a bear market. I’ll use my good friend Kevin Muir’s annotated visual (below) as it saves me the trouble of having to recreate it.

BBG, Macro Tourist

“It’s hard to argue that the lack of inflation means the US or global economies are in equilibrium, in a wider sense,” SocGen’s Kit Juckes wrote, in a Monday note, adding that “a decade of interest rates far below the growth of nominal GDP and far below the return on capital, has sent asset prices into orbit.”

As I wrote earlier this month, those assets may be overwhelming owned by the wealthy, but allowing stocks to collapse necessarily means tanking retirement portfolios for some everyday people. More than that, though, rising equity prices have contributed to the easiest financial conditions in history.

If you “let” stocks (and other risk assets) careen lower, you’re unlikely to be able to contain the fallout in rates and FX. Just ask March of 2020.

When equities, credit, and risk assets in general go into free fall, everyone scrambles for USD cash. At the same time, the deflationary read-through of a sudden spiral can push down breakevens and drive up real yields. All of that serves to rapidly tighten financial conditions, which in turn has the potential to flatline the economy, especially if you start seeing funding markets freeze up and other signs that the proverbial “plumbing” is impaired.

In the same Monday note cited above, SocGen’s Juckes wrote that asset prices “in orbit” are “lovely for those who own assets,” but the perpetual froth “increases inequality [and] fuels political division between asset-rich and asset-poor.”

That’s familiar territory. However, Juckes also touched on the “damned if they do, damned if they don’t” dynamic. The Fed, he wrote, is “hostage to equity markets because they can’t afford to trigger a correction in indices that would send the US economy back into recession.”

And therein lies the quandary. A recession disproportionately affects the same people who are on the wrong side of the inequality equation. While I’ve variously argued that the Fed might be able to engineer a correction in stocks that wouldn’t necessarily do too much damage to lower-income households (which are unlikely to own equities in the first place), Juckes’s remarks underscore the extent to which that is very difficult to pull off.

The unfortunate reality is that while the adage that says “the stock market isn’t the economy” is true on the way up for equities, it’s arguably less true on the way down, depending on how deep the correction turns out to be. In other words: There may indeed be such a thing as a “healthy bear market,” but there is no such thing as a “healthy collapse.”

All of this “gives markets far too much power over policy,” Juckes went on to say. And he was right. He was also right when he said, on Monday, that,

when the next rate hiking cycle starts, the peak in rates will be even lower than the last cycle, because equity valuations will make it so. Debt levels will remain (too) high and asset valuations relative to the underlying economy likewise.

The ultimate question for which nobody has a good answer is how to break this chain. Juckes harmlessly suggests “us[ing]the good times… to start building more resilience into the global economy.”

With all due respect to Kit and while acknowledging that he wasn’t attempting to offer a sweeping set of prescriptions in what, ultimately, was just a short piece, we’re going to need a more specific set of remedies.

Because, coming full circle, “creative destruction” isn’t an option — no matter how many bloggers and Twitter personalities suggest otherwise.

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34 thoughts on “No Way Out: Breaking The Cycle Of Asset Price Inflation May Be Impossible

  1. Breaking the cycle is impossible in that the political dynamics in this country make it impossible. It’d be doable if we had a functioning government that was willing to implement a massive safety net and policies to redistribute wealth through higher taxes on capital.

  2. I was a perma-bear who no longer believes a sustained correction will do anybody much good. Dustbinned my old way of thinking in April. Debt, inflation, the whole Macro dynamics have to be viewed differently than 2 decades ago.
    Philosophically many finance /political people are unwittingly Nihilists. They think they talk stability. Russian roulette.

    1. Hilarious! I too was in the perma-bear camp, sitting on a large cash position for a long time.

      I, too, changed my thinking in the March/April timeframe.

      100% agree that the whole macro dynamic has to be viewed differently than 10 or 20 years ago. My old biases stuck with me longer than I expected they would.

      1. April 8th and studying 4-8 hours a day since. I did become very fearful June 10th, but gaining a peace of mind about a world I do not care for. If things were different they would be different. We are transitioning from gold to Fiat and a ways to go yet.

        1. Love you, JoeSail, but… Fiat is a concept, just like gold. Only as good as the full faith and credit of..whatever. If we don’t repair that, fiat isn’t worth the paper it’s printed on.

  3. I wonder about the intersection of inflationary fiscal policy and gradual normalization of monetary policy. Is there a possibility to kill two birds with one stone here, in a world where execution was perfect?

    (P.S. today, for the first time ever, I am checking the two unlabeled checkboxes near the “Post” button before submitting my comment. What wonders await? Time to find out…)

  4. Great piece, this is something I have been pondering recently, can we break the cycle? Does it end in calamity eventually and the Fed is simply delaying the inevitable? We don’t really experience normal bull and bear markets anymore, since 2016 we either rip higher or collapse, hence policy response is hostage to market reaction. Perhaps there is an answer is the world of MMT and yield curve control.

  5. ” … allowing stocks to collapse necessarily means tanking retirement portfolios for some everyday people.” I’d say nearly all everyday people invested in a retirement account. 401(k)s, are especially nasty because so many employers restrict participants from making moves to protect their investments. My daughter and son-in-law are just now coming back from 2008 because they were forced to stay in the junk their employers poked into their piles. Perhaps we do need a correction, but there will be much blood in the streets.

  6. Awfully well written irregardless of what a readers ideology … Reminded me of…….’the World has changed , I can feel it in the water , I can feel it in the land I can smell it in the air’ (credits Lord of the Rings opening scene ) This is the early glimpse of a new world order to come..

  7. Canuck wrote “I honestly think your pieces are getting better. This is to good to be a small niche of the internet.”
    I think the observations that H makes should be shared much more widely but I wonder if they would lose value if they left the “small niche” they occupy. (I have been trying to get my siblings to subscribe but no luck yet.) I also am not completely sold on MMT. As long as we follow/use MMT without acknowledging it, everything should work fine and the deficit would not matter but I think the forex market would react volatilely if the Fed/Treasury explicitly adopted MMT.

  8. Thank you going back to this topic. “Creative destruction” and “healthy collapse” and “Hobbesian state of nature” are not places that any of us want to be. March 2020 is as close as we ever come to collapse, I hope.

    We are at the end of the WWII era, both in our leadership and the policy tools we use. The old ways, e.g., Tobin tax, or capital gains on the exceptionally wealthy, etc., aren’t ideas any longer that are worth relying on to solve our problems. We need new leadership and solutions that we haven’t thought of yet.

    There is zero inkling so far of who or what these might be. (Let’s hope there is no war involved.)

    Maybe it’s not just the Japanese who come out one day and hold a ceremony April 2nd on the grounds of the Imperial Palace where CB-held JGBs are “forgiven.” Maybe it’s coordinated across the three main blocs, where the CBs coordinate forgiveness of CB-held sovereign debt all at the same time. I want this to be years away still so as to give the US the chance to spend trillions on infrastructure, AI, robotics, etc.

    In the meantime, we need to ensure that the financial economy does not collapse.

  9. The trap is like a black hole. I believe the change function will be a social-political crisis, the consequences of which are totally unpredictable. But we need only look to the horrors of the twentieth century to realize how bad such outcomes can be. There is the idea that volatility cannot be destroyed, and that it will eventually be transmuted into a different form. There just are no pressure release valves anywhere right now, and political systems are far too rigid to diffuse tensions and renew themselves along with the dramatically different circumstances. Stability, conceptually, cannot be reduced to a neoliberal theory of tranquil asset bubbles. Destroying capitalism will have a cost. The Soviets in the early 80’s probably felt as confident in their stability as we do right now, or the CCP does right now.

  10. There is no substitute for smart forward thinking federal leadership. To break out of the trap we need a federal government capable of rebuilding our infrastructure and improving our society’s safety net that works in the modern world. It is past time to stop screaming socialism etc. everytime someone has an idea for the government to supplement or regulate an inefficient market. The academic research has been out there for some time- at least long enough to start trying different solutions on a smaller scale. If they work, try to roll them out for the entire country. Let the states experiment if necessary. Health care is but one market- there are many others. I can never understand the worshipping of the market to always find the most optimal solution. It borders on a cult or religion. Sometimes it works, and that is great. But other times it gives a suboptimal result…. we need to be smart enough to recognize when it works and when it does not. And smart enough to figure out a better approach by looking at what went wrong and fixing it in a practical way.

    1. Good point.
      BTW there was an excellent article on the equivalency of religion and the libertarian believe in free markets as a panacea in “notesfromdisgraceland”, also published on this site. It’s called “The Rise Of The Primitive Society Of The Future”.
      Should be required reading for all undergrad econ students.

  11. The only viable option i see to quickly and seriously address inequality is a significant wealth tax combined with increased fiscal spending. Given that’s extremely unlikely (for now anyway), significantly increased fiscal spending on productive public assets (i.e. infrastructure) should slowly start to address inequality via job creation, increased capacity, etc. That could kick off inflation in a controlled way with higher wages and greater distribution of wealth. If fiscal spending is high enough, the economy would become less dependent on the stock market, allowing the Fed the increase yields and keep equity valuations in check. In any case, it’s a complex situation with a lot of variables/things to go wrong, with unclear global knock-on effects. It is pretty clear though that the current system is not eternally sustainable. I bet the powers that be would regret their pro-gun policies if half the population is rioting due to poverty.

    1. This was a phenomenal article! On the plus side, blowing massive duration bubbles makes it really easy to raise capital. And with capital so easy to obtain, one of the only real risks left to discount is regulatory, making socially responsible endeavors and long shot innovative plays really attractive, which will eventually benefit even those living in poverty.

  12. “allowing the market to clear all at once.”.. the operative word here is “allowing”… somehow this struck me as akin to “this time is different” or something… I wonder if the catalyst will be such a surprise and so sudden we are all taken completely unaware?

  13. Everyone…just keep in mind that we are no longer #1 in the world. We are sliding down a hill of ice into the #2 slot against a #1 that has more money, more highly educated workers to choose from and a growing edge in science and engineering. That new world in the morning ain’t goina look like you think it’s supposed to.

    1. Yes, China is leapfrogging the U.S. in many areas of science, engineering, and education. But it is severly constrained by geography and demographics. Those are both huge and not to be overlooked.

      1. Bingo, China will never rival the US because it will never (in this lifetime) be capable of securing global trade. India has a stronger regional position all things considered. China has real risks of famine which would quickly collapse any central government. The US is likely to cede global hegemony but not to another but rather to regional powers and partnerships.

  14. well they are just kicking the can down the road, there is no beautiful unwind out of this mess… we will get to Zombie Land status (aka Japan) shortly.

    And whilst I understand why this is being done (buy time) I would also be careful with what you wish for…

    We could be sleep walking to a world where people will distrust money that is a very dangerous place to be in

    with “stonks only go up” mentality and creating conditions where retail believes this is the way, will only accelerate the disorderly and uncontrollable unwind.

    Crashes can be healthy they wipe out the frauds and the weakest companies and let the fitter companies grow stronger. Yes it may take time, and people will suffer, but the other way out from this utopia maybe something like war (civil or world). I’m not sure I would want to find out. We need to let some steam out… otherwise the unwind will come faster and the damage likely irreparable.

    All of this brought to you by:
    Short term incentivised central bankers (playing hot potato) and 4 year fiscal planning designed to secure the next 4 years and everyone wanting immediate results.

    I am more scared of the unknown of where we are heading than the big crash this might cause.

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