A few years ago, some smart observers popularized the phrase “the everything bubble” to describe the behavior of the financial markets.
Years of zero interest rates and bank reserve expansion through the Federal Reserve’s policy of Quantitative Easing set off a wave of asset price inflation. Fiscal policy (Federal spending) was aggressive as well. Oddly, consumer price inflation remained subdued. Governments and economists became confident that inflation was not a problem, but that deflation was a problem.
While it seems like yesterday, under the final year of the Trump Administration, the Consumer Price Index was climbing around 1.5% per year. This was largely because the CPI does not track asset price inflation well and undercounts the influence of housing costs by using a rental imputation number rather than actual housing costs.
You might recall, that the FED complained about disinflation and stated its goal was to take inflation above the 2% level. Looking back, it seems foolish that they got what they were asking for and more. Further, when it became evident something was going wrong, both the politicians and the FED argued that inflation was “transitory.”
Ultra-low interest rates promoted the use of borrowing by consumer for goods like autos, housing, and financial speculation. Conventional margin debt soared, and a host of new speculative products emerged: leveraged ETFs, SPACS, cryptocurrencies, and NFTs. Brokerage houses promoted asset-backed lending such as borrowing on your stock account to buy real estate or other assets.
Then along came lockdown. The policy of lockdown, an ill-considered reaction to the Wuhan virus, then set into motion a number of conflicting trends. Perhaps the most important was the direct injection of money into the hands of the public and the same time shutting down production by the closure of business and the quarantining of the healthy workforce. This injection of money created out of thin air was felt necessary to offset the negative effects of the government-mandated lockdown.
One good disaster deserves another.
Since this was fiscal stimulus transmitted directly into the bloodstream of the economy, rather than the earlier expansion of bank reserves through QE that largely remained in the banking system, the money supply boomed. At the same time, supply was constrained as both US production and most of the foreign products that we import, were shut down.
The result was too much demand was created and too little supply was permitted. The result now has been double-digit inflation caused by both monetary expansion and supply constraints.
Even as late as last year, equity prices soared 28% and gold prices tested their all-time highs, and went to new highs in many foreign currencies. Commodities soared and “the everything bubble” got larger and larger.
The government has continued the supply constraints, even beyond the lifting of lockdown. This has come primarily from the attempt to alter the climate of the earth over the next one hundred years. The result has been to restrict the production of cheap reliable energy sources in favor of untested and uneconomic alternatives of wind and solar, and the attempt to mandate a revolutionary change in transportation by forcing both through law and incentives, the adoption of electric vehicles.
This has driven up the price of fuel, the cost of farming (fuel and fertilizer), the cost of everything made from petroleum (over 6,000 products ranging from plastic pipe to adhesives), and the cost to transport everything that needs transporting to grocery store shelves and warehouses.
In short, the supply constraint on energy is a supply constraint on many other things.
Lockdown thoroughly screwed up the labor markets. Millions of workers left and never came back. Wage levels thus moved sharply higher and labor shortages are reported in many sectors of both production and services.
The result has been both asset price inflation and consumer goods inflation.
Reacting to the inflation they unleashed, the FED belatedly increased interest rates and started QT, or Quantitative Tapering, the selling of central bank reserve assets. The rate of change in the growth of the money supply is coming down rather quickly.
As a result of the new monetary dynamics, portions of the everything bubble are now starting to break and go in the other direction.
Beneficiaries of the cheap money regime have become victims of its removal. The benefit of financial leverage (the use of borrowed money to control more assets than you could afford to buy with cash), is now starting to work in reverse. We are now leveraging the downside losses.
Stock prices have declined into bear markets, bonds have had the worst year since 1788, and many commodity prices, that were soaring just months ago, are coming off their peaks pretty violently. Cryptocurrencies have dropped 70-80%, which are losses equal to or greater than some of the great bear markets in equities. Precious metals have fallen as well.
Commodity prices directly connected to economic activity are now dropping sharply.
Copper prices, you would think would be a direct beneficiary of the government-forced technology changes for transportation. But copper has dropped almost 40% from its recent peak just since March. Lumber prices, directly related to the housing boom, have fallen 55% from their peak in January. Shipping costs, once soaring, have reversed and are falling rapidly. The Baltic Dry freight index is down 65% from its recent peak. Container rates for the traffic between US West Coast ports and China are down nearly 50%.
Housing prices are now beginning to wobble and we have covered this development extensively in The Prickly Pear, largely through our friend Wolf Richter and his columns.
In short, many key commodity prices are now taking some serious hits and housing is likely to follow stocks, bonds, and commodity prices to lower levels. Housing is highly leveraged with the typical 3% down mortgage more leveraged than commodity futures. This has the capacity to throw our banking system into turmoil.
This is already evident in China, whose housing bubble is collapsing and bank runs are publicly evident.
As the everything bubble implodes, it is hard to know which sector will go next. The biggest danger is likely the real estate markets because so much of consumer wealth is tied up there and “feelings of consumer wealth and prosperity” are tied to housing. This could cause stress in the banking system, but also cause the feeling of “wealth loss” to cause consumers to pull in spending. Consumer spending is 70% of GDP.
All of this combined creates a real risk of slipping into recession, or worse.
What a problem now for the FED! If they stay the course to crush inflation, they may become a pro-cyclical force. In short, they will make the coming recession that much worse. This is called a policy error, which seems too mild of a term.
If they reverse course and take a monetary U-turn before inflation is vanquished, they run a risk not only to their credibility but risk high inflation in the midst of contraction; call it stagflation on steroids.
Meanwhile, the supply constraints on energy continue with a religious fanaticism by Progressives that rivals the Medieval church.
We even see signs of an inquisition of sorts, that is the punishing of heretics that don’t believe the global warming story.
It seems Wall Street is betting on a soft landing or a U-turn in policy. Stock prices are starting to stabilize a bit and bond prices have actually bounced.
A soft landing would be a nice outcome, but the sharp break in commodity prices suggests it will be a harder landing than expected.
The problem is we rely on the same geniuses who thought inflation at 1.5% was unacceptable, who thought huge deficits didn’t matter, and who think environmental fanaticism will have no consequences.
Good luck with that.