How Inflationary Risk Could Corner the Fed

Published on
January 12th, 2021
Duration
34 minutes

Bitcoin’s Stumble and the Bond Market’s Moment of Truth


How Inflationary Risk Could Corner the Fed

Daily Briefing ·
Featuring Haley Draznin, Ed Harrison, and Peter Boockvar

Published on: January 12th, 2021 • Duration: 34 minutes

Peter Boockvar, CIO of Bleakley Advisory Group, joins Real Vision managing editor Ed Harrison to discuss how the full force of inflation that could emerge in 2021 could pose a significant risk to the Fed’s ability to execute. With Treasury yields rising, Boockvar anticipates the scrutiny of stocks with high price-to-earnings ratios to continue expanding, and once the distribution of the COVID-19 vaccine becomes more extensive in the coming months, he explains that the shift in spending toward services-oriented consumption could trigger a rise in nominal rates, but not necessarily in real rates. With the potential risk of inflation accelerating in the coming months and a yield curve that could steepen too quickly, he argues that these circumstances will restrict the Fed’s ability to act in the case of a market event. In the intro, Real Vision’s Haley Draznin examines the continued rise in treasury yields and the macro economic impact of all the debt that has been printed by the U.S. government.

Comments

Transcript

  • JJ
    John J.
    14 January 2021 @ 23:44
    As usual, Max did a great job. He is by far the best interviewer/moderator of these programs.
  • JJ
    John J.
    14 January 2021 @ 20:25
    Fabulous discussion.
  • DS
    Dan S.
    14 January 2021 @ 16:50
    There is no free lunch. The Central banks have financed Zombie companies which is one of the main drivers of low productivity. In one sense this is deferred inflation until the governments, being morons, shower money from above.
  • JM
    Jonathan M.
    14 January 2021 @ 04:27
    I'm a little confused. I get the thought that rising rates have an impact on high PE stocks, but why bullish on gold and silver then? If inflation is rising, then precious metals shouldn't do as well.
  • CM
    Cory M.
    13 January 2021 @ 21:52
    Peter is my favorite RVDB guest; he did not disappoint.
  • JL
    J L.
    13 January 2021 @ 04:56
    A few of the most important questions in markets right now are: 1) How quickly will global reserve managers diversify away from dollar-denominated assets and central bank reserves in dollars at an unsustainably high +60% 2) How quickly will investors get out of U.S. treasuries as the "40" in a standard 60/40 portfolio becomes a money-losing liability due to negative real yields 3) If the UST divestment happens too fast, threatening to cause a spike in rates, how quickly will the Fed apply yield curve control and how much faster will the dollar fall if they do so 4) If the dollar maintains a strong downtrend due to a reserve currency paradigm shift (e.g. 60% reserves down to 30%) plus more Fed purchases of USTs (with dollars) that others didn't want to buy, what impact will persistent dollar devaluation have on paper assets (it could push the valuation of FANGs upward for example) 5) If investors are bailing out of USTs, will they put the money in big tech because TINA (there is no alternative) or will they go for hard assets and EM instead and let wildly inflated tech valuations revert in the face of rising nominal rates 6) To what degree will surplus fiscal stimulus that goes into the pockets of households that don't need it (e.g. top 30% of economy) wind up back in the stock market, further supporting speculative asset valuations 7) To what degree will long-term deflationary pressures put a natural cap on inflation, allowing for greater debt-to-GDP expansion because debt service costs remain low The takeaway for me is that, more than ever, saying "this is what's going to happen" is kind of a pipedream. There are scenarios that could justify, say, 100% price appreciation in the FANGs from here (think extreme dollar devaluation scenario). There are also scenarios where all of the FANGs get cut in half. So much of it depends on timing and sequencing, along with unanswerable questions in regard to magnitude, you can draw up scenarios for way higher, way lower, or flat in six months' time and all have them have entirely valid pathways based on plausible configurations of variable inputs that nobody can nail down. Complex adaptive systems under dynamic stress just don't lend themselves to single path predictions. We only like to pretend they do because it's easier than charting iterative Bayesian adjustments and shifts in the probability distribution in real time as new information comes in.
    • VN
      Vitali N.
      13 January 2021 @ 11:03
      to your #2, Target Date Funds (a must-go-to default in every 401K) has over 1T in AUM and rising at the fastest clip. I would not expect any changes till there's some crash/crisis that will force employees, providers, regulators to rethink this "new paradigm" of solving the retirement challenge. Recognizing this set-up provides critical context to several other points.
    • JL
      J L.
      13 January 2021 @ 15:29
      @ Vitali N. That is an intriguing point. One could then also ask, to what degree do passive flows blindly support government borrowing (thus further enabling open-ended debt-to-GDP expansion). The Reinhart-Rogoff thesis already had major holes in it. That could be another big one.
    • sj
      sara j.
      13 January 2021 @ 17:33
      JL, what your view on Emerging markets as a opposite to the FAANG play? FAANG(deflationary), EM(inflationary) barbell.
    • JL
      J L.
      13 January 2021 @ 19:33
      Emerging markets look highly attractive on multiple fronts. EEM is near a life time high, even as emerging market valuations remain far more reasonable than big tech, and there are multiple tailwinds in favor. Then, too, a forecast for a historic global rebalancing away from dollar-denominated assets (central bank reserves going from +60% USD to something much lower) is bullish for commodities, and bullish for EM countries whose revenues and profits are commodity oriented, with all three working together in a kind of self-reinforcing feedback loop (weaker dollar makes commodity prices look better, which increases EM revenues and profits, which increases domestic consumer spending and capex in EM countries, which causes more investor capital to flow out of US assets and into growing EM assets, which weakens the dollar further, which boosts commodities some more, and so on).
  • VP
    Vincent P.
    13 January 2021 @ 16:21
    Hard pass on the "pent up" demand for services theory. I'm not going to the movies 7 days a week and I'm not getting a haircut every other day.
  • DA
    David A.
    13 January 2021 @ 00:03
    If you want persuasive arguments that inflation is finally upon us and you should buy real assets and emerging markets, listen to Peter Boockvar. If you want to be convinced that that is too simplistic and that demographics and passive flows will dominate, listen to Roger Hirst and Mike Green. These are some of the best people on Real Vision. It's just a shame (at least to this confused investor) that they don't agree.
    • DS
      David S.
      13 January 2021 @ 00:17
      That is why you are a portfolio. No one can know the future. Good luck. DLS
    • JL
      J L.
      13 January 2021 @ 15:26
      Perhaps it is like the blind men and the elephant. They are describing different aspects of the same beast. But to make sense of the full picture, you have to see the whole system -- trunk and ears, sides and feet and all... It's also notable Green left room for the passive flows aspect to turn bearish. (Once the car with no brakes hits the top of the hill and so on.)
  • DW
    Dean W.
    13 January 2021 @ 14:21
    One of the best daily briefings I’ve seen in a long time.
  • MK
    Michael K.
    13 January 2021 @ 12:30
    Haley’s comments are very well prepared and presented. Well done.
  • JL
    Jason L.
    13 January 2021 @ 03:05
    Haley is spot on: US rates can’t get too high because too much debt was printed last year. The US can’t afford to pay the interest on the debt, let alone the $7T+ debt itself, so rates will have to be capped for a long time to come. This is a case where the emperor has no clothes. But if the US is exposed as unable to repay its debt, what does that mean for the rest of the world? Who’s debt would you rather own? ...buy Bitcoin...!
    • JL
      J L.
      13 January 2021 @ 05:46
      The US will never be "exposed as unable to pay its debt." The only way the US could ever default on its debt would be if congress chose to do so voluntarily, which would make no sense. Can the US experience painful inflation? In theory, yes. But the demographics thesis and the tech deflation thesis both argue strongly against this. All those guys who argue deflation will be persistent and powerful are also arguing by implication that debt service costs will stay low (because inflation won't take hold). Can the US dollar see a loss of faith causing to rapid depreciation? Absolutely, it is certainly possible. But the United States is also home to the most dynamic technology and biotech and pharma companies in the world. If you want to own shares in any of the tech juggernauts, you have to do so with dollars. The inherent dynamism of the US economy (and various forms of highly desirable US assets, from world-beating companies to real estate) thus acts as a kind of arbitrage floor on the value of the currency. There are plenty of reasons to be bullish on Bitcoin. But the arguments for dollar implosion (versus a sizable but orderly downward adjustment) and / or US debt default (not possible) are by and large contradictory. The US has the most valuable tech sector in the world and a deflationary capper (demographics, tech productivity) on inflation trends. You have to put these together to see where a lot of people's models go wrong.
    • JC
      John C.
      13 January 2021 @ 09:46
      Although I agree with everything JL said below, that doesn't mean that US Tech and Biotech are impregnable and intense competion is not coming. Look at China's Big Tech champions. Also, givne the censorship that US tech practices I think many countries will begin to ban or limit their footprints, slowing their growth. I would be wary of FAANG here.....they do not look right in many charts and if we see a continued pivot from growth to value they will get hammered.
    • JL
      J L.
      13 January 2021 @ 10:51
      @ John C Re getting hammered, that could absolutely happen. The FANGs are so richly valued they could lose 50% of market cap and still be in reasonable territory. (They could also go much higher from here, depending on external factors.) My points were more in respect to a longer run floor for the USD based on the positive side of the US economy's balance sheet, and the idea that a sharp retracement, or even a 30-50% multi-year downtrend, is not the same as a path to oblivion.
  • DD
    David D.
    13 January 2021 @ 08:36
    good guest
  • DD
    David D.
    13 January 2021 @ 08:36
    good guest
  • AK
    ASHAY K.
    13 January 2021 @ 03:38
    The important take away is that an ever accomdative Fed is pretty much assumed in financial markets and well baked in curremt asset prices. It certainly is consensus view and no one wants to fight the Fed. When everyone is on one side of the trade, the risk always remains a trigger that causes people to reevaluate their assumption. Given where asset prices are and the amount of leverage, even small doubts about the activation of the Fed out can trigger a massive sell off in risk assets. Higher inflation would be that trigger and is worth watching for. It may not happen immediately, but trending inflation and change in consumer perception of inflation expectations (inflation and inflation expectations tend to be sticky over long periods of time) can really put the Fed in a bind. At the end of the day, even with their average inflation targeting, the market will have to start pricing in a less accomdative Fed.
    • JL
      J L.
      13 January 2021 @ 05:35
      I would argue Fed domination of markets is an old paradigm that has been replaced by a new one. To see Powell as the axe is to fight the last war. Yellen and congress, and the path of the recovery, more the variables to watch now. The fiscal side, and the forex side as a transmission mechanism for debt and growth adjustments as interest rates stay relatively low, are more important than what the Fed does, with the Fed becoming a significant variable mainly if it screws up by deciding to tighten prematurely (which isn't likely as Powell learned that lesson in 2018), otherwise being more of a neutral-to-dovish background constant relative to other, larger inputs (except to the extent Powell helps implement backdoor fiscal policy, in which case he will more or less be Yellen's beard).
  • MC
    Mark C.
    13 January 2021 @ 02:48
    Always lots to unpack when Peter is on... did this one at my desk so I can take notes. Thanks!
  • DR
    Danilo R.
    13 January 2021 @ 01:31
    I think most RV subs know how to invest rising rates/real inflation. I think we disagree on timing. I see more lockdowns for a longer time that makes the pick up in spending and demise of FAANGM premature. Sure it’s trendy but if you think we can sustain real growth with the majority of the wealthy in developed world’s consuming less and looking to retire, but look at bank rates. Trendy but it won’t sustain. Macro 101, demographics always wins, credit markets are the smart money, and the stock market is always premature and bubbly.
  • TC
    Tim C.
    13 January 2021 @ 01:26
    I enjoy listening to Peter and I agree with his general data on conditions, but I often disagree with some of his conclusions. A few random thoughts. So FAANG stocks aren't going to do well with "rising" 10yr. Who gives a F about rising 10y? You care about real rates. If real rates are falling, these companies are not going to want to sit on cash. They will buy back stock. How those two forces offset, who knows. Over 1/2 of the TSY issuance is 3yr maturity or less (maturity at issuance). Distribution is relevant, as is debt to GDP and Fed holdings. As far as steepening YC helping banks, yes, but that doesn't account for second order effects. A "steep" YC helps banks. That said, in today's environment a steepening 10y will drive up mortgage rates which impacts housing. There were over $4T in mortgage originations yoy to 3Q2020. Those folks aren't going to be rushing to refinance at higher rates. The Fed is helping to suppress rates through MBS purchases which will give some relief to banks on the retail end (Fed holding down wholesale market), but the higher the 10y goes, the more squeeze you get. Not a big Fed fan, but they at least have good data - link below. https://www.stlouisfed.org/publications/housing-market-perspectives/2020/why-havent-mortgage-rates-fallen-further
  • KP
    Kaushal P.
    13 January 2021 @ 00:37
    Didn’t the fed already preemp this with average inflation targeting? Even if inflation runs 4-5% in 2021, the fed can easily say they will pin the long end too since we can’t afford tightening financial conditions. I see no way fed lets the bond market and credit markets crash regardless of the inflation number this year.
  • MC
    Michael C.
    13 January 2021 @ 00:23
    Guys, guys, guys....lol So much left out. Question is whether inflation is demand or supply driven. In the case of physical goods as was pointed out, it has been demand driven in the ST. As Peter pointed out, how many cars/kitchens/laptops/suburb houses are consumed/demanded repeatedly. The demand signal, incorrectly IMO, is causing the suppliers to try to ramp up to meet demand that was pulled forward. Services are trickier. When conditions improve that people want to go out and consume services and will they have the financial wherewithal to do it? And will there be willing suppliers of those non essential services? IDK...lot of moving parts and pieces. There was a big emotional hit taken by restaurants and bars who came back after the March lockdown and then told to restrict capacity which is a basic death sentence for most. Then the Fed mandate...full employment and stable prices (and the third unspoken leg...a thriving stock market...lol). I agree with Peter that the Fed is in a box but it's going to be squeezed from 2 sides. How is the Fed going to achieve anything resembling full employment? If one looks at M2 supply and M2 velocity, the Fed has worn the pump out on M2 supply but the banks aren't lending, M2 velocity is 1.2 (see FRED stats for verification). If rates go up as Peter postulated, the debt service is going to be increasingly difficult to service. And on the other side, the debt is a drag on the economy, crowding out private borrowers but ineffective allocation to zombie companies. Debt service vs inflation...devil and the deep, blue sea. Then toss In Raoul's Pension Crisis...how many times have I read retirees saying they have no choice but to overallocate to equities since bonds pay so little? Debt/demographics/deflation. Another Minsky moment coming up perhaps? Thanks gents!