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America: One Nation Under Stagflation

With the Federal Reserve launching QE-Infinity, an old group of individuals have resurfaced that we haven't heard from in some time-- the hyper-inflationists. There is nothing wrong about being incorrect about any position or idea, whether in the market or in real life, but it does become a problem when one remains wrong and doubles-down on said conclusions. In this particular case, the hyper-inflationists believe that Quantitative Easing (QE) will cause hyperinflation, which is when the value of a currency declines exponentially and eventually becomes worthless.

The Federal Reserve initially launched QE in November 2008 as a response to the financial crisis. This program continued in various forms, basically until October 2014, so for almost 6 years. Anyone that was on the internet with an interest in finance at the time can probably tell you that there was no shortage of fear-mongering in terms of an imminent collapse in the U.S. Dollar due to these measures. So, how did those predictions play out? Let's take a look at a chart of the U.S. Dollar, seen here below:

As you can see, QE had an overall net effect of doing nothing to the U.S. Dollar between 2008-2014. Sure, there were gyrations in the value of the dollar during this time, but all markets can move a lot in a span of 6 years.

So the question worth asking to the hyper-inflationists, "Is it really different this time?"

Here are a few things the hyper-inflationists got wrong, and continue to get wrong:

1. They accept Quantity Theory of Money: It just simply is untrue in the real world.

2. Money supply is not the same as monetary base. If the banks, which are members of the Federal Reserve system, are not actually lending money to customers, there can be no inflation, as the money is never actually circulated in the economy.

3. Floating-exchange rates: Other developed nations pursued and continue to use the same monetary policies. In places like the EU and Japan, they were even more aggressive than the United States. So, if investors were to flee the dollar, where would they go?

4. The United States has the largest, and most liquid (by far) capital market, or bond market, in the entire world. Institutional investors from overseas have no other option than to park their money in the U.S. if they want to receive some sort of fixed return.

The last point is actually an excellent segue to the more likely scenario that we are forecasting at the moment, which is stagflation.

Stagflation is characterized by a few themes:

1. High unemployment

2. High inflation (not the same as hyper-inflation)

3. Low consumer demand/Low economic growth

The last time the United States suffered stagflation was in the 1970s. We know that history doesn't repeat exactly, but it does rhyme. The main difference between now and then is that the Federal Reserve is much more aggressive at trying to keep interest rates low on both the short and long-end of the yield curve. But a couple things of note have occurred in the last few weeks that suggest inflationary pressures are increasing, even though the Fed continues to fight against it.

The chart above shows the spread between highly-rated, investment grade corporate bonds and U.S. Treasuries. The "spread" is the interest rate differential between these two types of bonds. Normally, we look at the yields themselves, but for all intents and purposes, price works fine too. When the line on the chart goes up, it means spreads are tightening, which is a sign of economic confidence from credit markets. When the line on the chart goes down, it means spreads are widening, and it's a signal that credit markets are showing distress.

What we've seen in recent weeks is interest rates on corporate debt skyrocket, while interest rates on Treasuries have remained subdued. Now, that trend could reverse, and spreads could tighten. It's started to, perhaps because the Federal Reserve is starting to buy corporate debt too. But the corporate debt market is worth about $10 trillion, so it's unlikely they'll buy it all. In any case, it looks like we could have a new trend within credit markets in the short-term-- that of widening spreads.

The next question is: Why have corporate bond rates gone up? Frequent readers know interest rates are a function of inflation, but there is another variable with respect to interest rates we must consider: risk premium. If investors think risks are rising, they will demand a higher interest rate to be compensated for their lending. It's not hard to conclude that near-nationwide business closures increases risks for lenders.

However, it's also the panic-buying we've seen from consumers that has helped spark higher corporate rates. This is because many corporations don't keep a lot of cash on hand, and instead opt for borrowing money to expand their business. So, if a corporation is desperate for money to accommodate short-term consumer demand, they too will show a high demand for borrowing from the capital market. High demand means a high price, and in this case, the price for money is the interest rate.

This is very much an ongoing, potential economic scenario that we will continue to monitor, so stay tuned. We know this post is longer than usual, but it's important to put this out there, because a lot of disinformation likes to circulate in times of crisis.

We will address this subject again in this weekend's publication of the Mercator Letter. In the meantime, stay safe. Hopefully, as the data starts to come in more, the virus isn't as bad as previously thought. Keep in mind, spring is here, and warm weather is around the corner, which tends to help fight disease too.

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