The Inflation Trade Starts to Unwind…
Wednesday, 24 March 2021
By Greg Canavan
[3 min read]
In Monday’s Insider, I argued that the constant talk and positioning for ‘the coming inflation’ might be a little overdone.
As I wrote, when ‘everyone’ thinks an outcome is likely, the market usually moves the other way. That’s because there is ‘no one’ else left to push prices higher.
Overnight, the market seemed to have second thoughts on the ‘inflation trade’. Of course, it first needed the world’s most important central banker to tell it what to think. From the Wall Street Journal:
‘WASHINGTON—Federal Reserve Chairman Jerome Powell told lawmakers Tuesday he doesn’t expect the $1.9 trillion stimulus package will lead to an undesirable increase in inflation, but he emphasized that the central bank has tools to deal with rising price pressures if necessary.
‘“Our best view is that the effect on inflation will be neither particularly large or persistent,” he said, reiterating comments he has made repeatedly since the measure was enacted earlier this month.’
Powell is right. A large government stimulus package will not create sustainable inflation. In fact, it’s more than likely to create disinflation/deflation. That’s because when the stimulus flows through the system, the economy is just left with more debt.
Unless government spending is invested wisely, there are virtually no productive benefits. And you know as well as I do, governments never spend wisely.
Especially in this day and age. The bar just keeps getting lower for the type of human that thrives in a political setting these days. Trump was no angel, and held dubious moral and ethical standards. But the reaction of the swamp to Trump’s attempts to drain it tell you all you need to know about the standard of politics in the US these days.
The sociopaths are back in charge. As they are in Australia and just about everywhere else in the world. Is this because of years of easy money? Does a broken monetary system filter through and corrupt our cultural and political institutions? I think it does.
Looking back, the Howard government was really the last one of principle and cohesion. He was voted out in 2007. The system broke soon after.
But I digress…
Where was I?
Yes, stimulus doesn’t create inflation. Especially when the private economy remains busted. The thing is, government spending is the only game in town.
Looking at bank credit creation in the US tells you that. (Despite what you hear about central banks printing money, private/commercial banks are the only entities that create the money that goes into the economy. Central banks create bank reserves.)
In February, total bank credit in the US expanded a robust 5.7%. But most of that was lending to the government. Year-on-year it was up 17.2%. Meanwhile, lending into the real economy remains very weak, up just 1.1% in the year to February.
For example, commercial and industrial loans increased 6.8%, but that was after contracting 22.4% in the fourth quarter of 2020 and 18.8% in January. And real estate loans fell 5.1% in the year to February.
If government spending were increasing at double-digit rates at the same time as robust credit growth in the real economy, then yes, you’d be worried about inflation.
But that’s not happening.
And this reality might be dawning on the market:
The Dow fell 1% overnight, the S&P 500 was down 0.75%, while the NASDAQ declined 1.1%. Gold fell around 0.65%, silver 2.65%, US oil prices tanked 6.5% (although Brent crude was only down 0.4%), while copper sank by 2.75%.
I should also add that bond yields declined too, with the 10-year Treasury falling from just over 1.7% to 1.62%. A key component of the inflation trade has been rising bond yields.
Oh, I almost forgot. The US dollar had a strong night too. Remember on Monday I said to watch the dollar?
Well, it closed above that support line I mentioned. Only just, but it’s probably enough to see the shorts cover and new longs come into the picture. It’s now very close to breaking above the recent high at 92.50. If it does that, it increases the probability that the worst of the US dollar sell-off is over, and a new upward trend might be in play.
As I said on Monday, watch the US dollar.
While it’s only one night’s price action, it’s been brewing for a while. All the evidence points to an unwinding of the inflation trade.
How big an unwinding?
Well, here’s where it gets interesting.
In my view, the unwinding will be just big enough to give governments and central banks more ammunition to experiment with even more extreme monetary and fiscal policy.
I could be wrong of course. This may be just a minor pause/correction in the trend. So if you take a longer-term view with your investments, it’s really nothing to be concerned about. But if you like to trade and be more nimble with your capital, you may want to consider the implications of a change in the inflation narrative over the next couple of months.
Before signing off today, I’ll leave you with one more thing to keep an eye on…the NASDAQ. There are indications we could be at a short-term top here. Momentum, as measured by the Relative Strength Index (RSI), peaked in December and began to diverge from the price index for the next few months.
That’s not necessarily a sign of a top. But it is a warning sign. If the NASDAQ turns down again and closes below the March low around 12,600 points, it suggests a trend change could be underway.
That and the US dollar…keep an eye on it.
Editor, The Insider