There are good arguments for the hypothesis that the currently high level of CPI inflation is indeed transitory. Longer-term, the case for real assets, including cryptocurrencies, remains strong.
The huge surprises in May’s payrolls and CPI inflation confirmed what we’ve known all along about the shape of the post pandemic recovery: that we don’t know much.
Why should we? As a downturn which was centrally imposed, the recession was highly atypical. As a coordinated monetary and fiscal stimulus which dwarfed all priors, in both size and scope, the policy response was also highly atypical. So why should anything about our recovery be typical?
As we exit the recession, inflation rates are higher than they were when we were entering it. We think this is the first time this happened since the 1970s. We’re seeing surging demand for labour but no obvious labour response, suggesting the labour market is failing to clear. And we’re seeing financial market froth more characteristic of the cycle’s end, not its beginning.
Things aren’t triangulating.
Nevertheless, we’ll try to make sense of it all as best we can. Though we’re groping around in the dark as much as anyone else, our best guess remains that the current CPI surge will be transitory, that emergency stimulus measures will be allowed to run off, and that the Fed’s over-stimulation will ultimately serve to further inflate asset prices and primarily real asset prices (with CCC spreads close to all time tights, it’s hard to see much upside in vanilla nominal fixed income credit, see Chart 1).
Maybe more interesting though, is what happens if all that is wrong, and we’re entering into a regime change.
We have thoughts on this too, which we share below.
We’ll start slightly outside of our comfort zone with a brief look at some monthly macroeconomic data, because even we found the gap between job openings and changes in payrolls to be glaring (Chart 2).
The US Chambers of Commerce were clear as to what they thought the problem was, calling for an end to the $300/week pandemic related supplement to Federal unemployment insurance. Though originally scheduled to expire mid-March, it was extended by Biden’s American Rescue Plan to mid-September, and the Chambers of Commerce argue that the effective $7.50 per hour wage supplement is impeding efforts by small businesses to hire.
It’s easy to see the narrative here. The emergency program has already been extended to September, why won’t it continue to be extended beyond then? (Milton Friedman: «There’s nothing so permanent as a temporary government program.»)
Relatedly, the stimulus checks are becoming bigger and bigger: $600 in 2008, $1800 in total in 2020, $1400 in 2021 so far, with talk of a coming fourth round of stimulus checks. There is loud and vocal pressure from within the Democratic Party for Biden to include recurring stimulus checks in the infrastructure plan he’s currently trying to pass. Indeed, California has already launched a fourth stimulus check plan ($1200 for those earning less than $75k, supplemented by a further $600 for anyone earning less than $30k).
Narratives, though, can be deceptive, and it’s not clear to us that this particular one is correct. For example, a closer look at Chart 2 above shows not only that changes in job openings are more volatile than changes in payroll employment, but that there are lags between the two.
Is the US employment data really conclusive that the labour market is stuck? Isn’t it plausible that payrolls might yet surge in the coming months? Elsewhere in the labour data, wage growth isn’t picking up, which we’d expect it to in a world of widespread labour shortage.
The conclusion we draw, therefore, is that the jury is still out.
Also, we think it’s likely that the temporary stimulus programs will stay temporary, notwithstanding Friedman’s quip. The labour market will likely clear. During his ongoing negotiations with the Republicans to pass his infrastructure bill, Biden has already reduced the size of the stimulus from $2.25 trillion to $1.7 tn, which suggests the recurring $2,000 checks to households demanded by some Democrats would be a nonstarter. Moreover, while California is being Californian, many mainly Republican controlled states – sixteen at the last count, we think – are opting out of the $300/week extension.
We found the response of risk assets to the data to be revealing. Although there was a wobble in the broad equity indices following the upside surprise in the CPI report in May, the market largely shrugged it off, probably because the market-based inflation expectations shrugged it off.
Chart 3 below shows that the spread between 30-year and 5-year inflation breakeven rates remains at historically elevated levels of inversion, suggesting the inflation markets remain sanguine about long term inflation prospects.
Meanwhile, within the equity market, leadership seems to have transitioned. Chart 4 shows that the Nasdaq has underperformed the S&P 500 year to date, while high profile go-go names like Tesla, Ark and Bitcoin have fallen heavily from their peaks earlier this year (Chart 5).
The crypto crash in particular was noteworthy. Triggered by Elon Musk ceasing to accept payment in Bitcoin for Tesla cars and compounded by a Chinese financial oversight committee signalling a crackdown on Bitcoin mining and trading, the >40% decline in less than a week was brutal even by crypto’s standards.
From what we can glean from our friends in China, its motivation was partly related to the roll-out of its own digital currency. Beijing wants to ensure that growing familiarity with digital currency among its population doesn’t translate into growing use of digital currencies to evade China’s capital controls. But China is also concerned that Bitcoin mining in the country is coal intensive and that is complicating efforts to reduce pollution (China represents around 65% of the global hashrate).
And there’s certainly a logic to being bearish Bitcoin on environmental grounds. Musk cited it when announcing Tesla would no longer accept Bitcoin as payment, and Greenpeace made a similar announcement with a similar rationale shortly afterwards.
What makes less sense is that Ether (ETH) was hit even harder, because ETH is expected to move to an alternative consensus algorithm later this year, which works on proof of stake (which doesn’t require gargantuan amounts of compute power, and therefore electricity), rather than proof of work (which does).
As can be seen in Chart 7, ETH is a more volatile «higher beta» coin than Bitcoin, so maybe the bigger drop was to be expected. However, its beta to Bitcoin increased during the rout (Chart 8) which is (weakly) consistent with the idea that the selling was indiscriminate, and effectively a massive if reasonably normal margin-induced puke.
Readers might be interested to know that unlike some of our smarter subscribers, we didn’t sell any of our personal holdings during the March and April price spike. They might therefore be excused for not being so interested in our current views of the crypto space. We’ll relay them here anyway.
Despite the savageness of the one week move we've seen, the actual drawdown from peak is quite routine as things stand, so far at least. The really big buying opportunities have been in the teeth of drawdowns which have exceeded 80%, which would translate into a Bitcoin price of around $12,700.
That’s not a forecast. It’s just an observation. So while we (annoyingly) didn’t sell any coins before the crash, neither are we in any rush to go out now and fill our boots today because there’s still potentially a long way down. Buying isn’t necessarily the worst idea as it feels unlikely that we will hit the $12,700 level again, however given our long position we aren’t in a hurry.
It’s also worth mentioning in passing that even though there have been several 80%+ drawdowns, acceptance and understanding of crypto currencies continued to flourish. We think this will continue to be the case from here. We don’t think the China news is ultimately material to the reasons we’re bullish, and we remain excited about developments in the space, even if we have paid for that with a few bruises in recent weeks.
The supply of Bitcoin (and soon Ether) is finite, and therefore such crypto currencies are real assets. We started out by thinking about inflation and concluded that we were relaxed (ish) that the near-term CPI surge was likely to be transitory and so the large dosage of stimulus still in the system would be likely to fuel asset inflation, and the bubbles we’ve written about in the past.
But what if CPI inflation isn’t transitory though? What then of our bubble thesis?
Last month we wrote that if CPI prints suggested inflation might become runaway inflation, the Fed would be forced to tighten aggressively, causing a recession and so depressing risk assets.
On reflection, we think that’s wrong and so we’ve changed our minds. We now think that in such an environment, central banks would accommodate the inflation, lacking the will or stomach to tame what they had unleashed.
In such a scenario, we feel that real assets would continue to do well, and Chart 10 helps to visualize why. It plots the breakdown of 10-year US Treasury yields into their real and inflation components and shows how mechanically real yields and inflation breakevens are connected to the nominal yield.
The point is that while the central banks can (and ultimately, we think, will) control nominal yields, they can’t control the composition of those yields. Inflation expectations will be set by the market and real yields will be set as the residual.
Thus, if inflation expectations suddenly spiked, putting upward pressure on nominal yields, we’d ultimately expect the Fed to move in to push those nominal yields back down, under the guise of fostering «financial stability».
But pushing nominal yields back down wouldn’t quell the rise in inflation expectations, because these are determined entirely by the expected trajectory of the CPI, not that of interest rates. With nominal yields fixed by the central bank, and inflation expectations ripping, breakeven inflation rates would necessarily go higher forcing real yields to go lower (potentially even more negative than they are today).
In effect, yield curve control in a world of rising inflation expectations makes real TIPS more expensive, and that consequently makes equivalent pricing of real duration in other markets (i.e. equities) more expensive. This would ultimately be supportive/bullish for equities, which would become similarly (and even more) expensive. We think it would also be bullish for real assets more generally.
While this isn’t ultimately the reason to continue to own crypto currency, it is a reason. For vanilla investors, it is a reason to continue to own gold, certain resources, and quality equity.