Inflation: The BIG Market Crash Risk?

Summary

• The money creation and monetary inflation advances made by the FED has reached its pinnacle where inflation and zero interest rates meet.
• Monetary inflation initiated in 1981 but significantly advanced since the 1987 market crash has created unsustainable economic and market dislocations now at crisis levels.
• A review of the 1929 and 2008 market crashes informs that a levelling off in monetary inflation will set in motion an unravelling of the dislocations.
• Economic and market fault lines are identified to inform best investment and trading positioning given the current economic and market risks.

Keystone/Hulton Archive via Getty Images

1929 Wall Street Crash

Seeking Alpha has rightly asked its contributors to address the inflation crises currently experienced in the global economy. The idea is to identify the most advantageous investments for such and environment. This essay, however, will not be offering any inflation hedging investment suggestions. Why not? Well, we need to first understand the nature of the inflation and then the possible scenarios going forward referencing “inflation”, for “inflation” is not always visible as the general rise in prices nor may it necessarily offer a good foundation for an investment thesis.

Digging for answers in economic history is appropriate for “inflation”, as a monetary inflation, is a feature in almost all market crashes even while “inflation” as a general increase in prices is not. Incidentally, that was the case in the most devastating crash of them all, the 1929 crash, followed by the deepest depression in modern human history. There was historically substantial monetary inflation during the 1920’s but stable prices so that “other inflation” was absent. What then was the role of “inflation” in the 1929 market crash and the depression thereafter?

We can build a roadmap, a frame of reference, from economic history to inform our understanding of the current developments in the macro-economy and the markets. Such a roadmap will then guide out trading and investing decisions but only if we can gain an understanding of the mega-drivers behind monetary inflations and its impact on both Consumer Price Inflation and Asset Inflation.

The 1929 Market Crash and Great Depression

The world experienced, in the period from 1920 to 1929 an economic advancement greater than anything in human history before. Productivity increases of around 5% annually across the economy compounded for most of the period and is unheard of in any other economic period. Annual average labor productivity was 5.44% in the period 1919 to 1929 while annual average capital productivity was 4.21%. The 1920’s saw the introduction of the motor car, and with-it tractors together with farm mechanizations, road freight, building of road infrastructure with bridges and all, filling stations where previously car owners bought jerry cans of fuel from the general store. We saw the deployment of electricity into houses and household appliances, dual breadwinners, electrification of factories with better lighting, aircon, electrical machinery of which electrical cranes seemed to have been a major breakthrough, mass newspapers and printing, a move from the telegraph to the telephone, the introduction of radio and mass communication, mass advertising and many more advances.

The vesting of the USA Federal Reserve, America’s venture into central banking, which was founded in 1913, gained full traction in the 1920’s. It expanded its footprint across the economy with its cadre of semi-autonomous regional central banks rolling out credit to government, banks, and the private sector alike. One of the reasons given for the crash of 1929 is these activities of the central banks, usually described as a “credit boom” gone wrong. Again, a less than satisfactory explanation as a “credit boom” cannot simply happen by itself. The “credit” must be sourced from somewhere and to “boom” it one has to see a similar “boom” in savings (attracting deposits at banks to on-lend to creditors) or the alternative a “boom” in money creation by Central Banks unveiled in US economy for the first time in the 1920’s.

All of the incredible economic advances catapulted productivity to the stratosphere and yet by 1929 in spite of the most spectacular economic advancement in human history the markets collapsed. The general picture of the 1920’s is one of excess, overvalued assets, unbridled speculation, yet the science papers could not find it. Asset prices in 1929 were mostly “fair value” by the accounting standards applied to the markets and shares even considered undervalued, volatility was not particularly excessive prior to the crash, margin trading often blamed was not excessive, interest rates were not too high nor too low and the period saw stable prices with little inflation, still the markets collapsed. It has the economic scientists perplexed, scratching their collective heads, and not offering any real explanation for the 1929 crash and depression. The only economic school which offers some resemblance of an explanation is the Austrian School of Economics, but they have been pushed out of mainstream economics. Their brand of free markets and Laissez-faire economic principles have been relegated to alternative economic science as the world have been on a relentless march towards interventionist economics and ever tightening economic control systems. Globally governments have taken almost total control over the banking and payments systems often under the guise of anti-money laundering or anti-terrorism or anti-organized crime legislation to the point where governments can trace virtually every material movement in money, leaving almost no economic activity “free” from their sphere of control.

Excessive Market Speculation in 1929

Monetary Inflation by its very nature will inflate the stock exchange. The macro-economic explanation for this phenomenon will be addressed further down. What is of interest in 1929 is that both the US government and the FED believed it to be a highly undesirable outcome of credit creation. The prevailing view was that credit creation must be deployed in "good" areas of building USA factories and financing agricultural production, but credit creation must not flow into the stock exchange for unsavory speculation or into real estate speculation, or into buying cars on installment credit, or into speculation on commodities, or into buying foreign assets, etc. Credit creation had to be bridled by the “morality” of the FED and government.

“It is its responsibility to regulate the flow of new and additional credit from its reservoirs in accordance with solid indications of the economic needs of trade and industry. When production, trade, and employment are in good volume and the credit resources of the commercial banks of the countay are approximately all employed and there are signs neither of speculative business expansion nor of business reaction, Federal reserve bank rates should be neither so low as to invite the use of credit for speculative purposes

nor so high as to discourage its use for meeting legitimate productive needs of the business community. It seems clear that if business is undergoing a rapid expansion and is in danger of developing an unhealthy or speculative boom, it should not be assisted by too easy credit conditions. In such circumstances the creation of additional credit by rediscounting at Federal reserve banks should be discouraged by increasing the cost of that credit—that is, by raising the discount rate.”

TENTH ANNUAL REPORT OP THE FEDERAL RESERVE BOARD COVERING OPERATIONS FOR THE YEAR 1923. St Louis FFED.

This is very relevant given that it is totally the opposite of the FED policy of today. The FED of 1929 believed that it could avoid stock market speculation and specifically stock market speculation on credit (margin trading, usually 10% down broker accounts) when it blatantly engaged in monetary inflation. Money is fungible and so is credit, it will find its way to where it is demanded, and so it did in the 1920’s. It annoyed the government and the FED endlessly, yet the FED did not really discourage the flow of credit to stock exchange margin accounts until late in 1928 (or attempted to unsuccessfully). The FED was also divided in the 1920’s, where the NY FED branch was a power and law unto itself, doing basically as it pleased. The FED of today, 2022, follows the NY FED playbook.

“The late Benjamin Strong had always held that it was impossible to earmark bank loans, and that the problem was quantitative and not qualitative. The New York Bank continued to stress this view, and refused to follow the FRB directive, repeating that it should not concern

itself with bank loans, but rather with bank reserves and deposits.”

America's Great Depression, Murray N. Rothbard.

The then President of the United States, Herbert Hoover lamented this irresponsibility of the FED.

“One of these clouds was an American wave of optimism, born of continued progress over the decade, which the Federal Reserve Board transformed into the stock-exchange Mississippi Bubble”

The Memoirs of Herbert Hoover - The Great Depression, 1929-1941, By Herbert Hoover

It is fascinating to read how the banks gamed the credit system already in 1929. The FED became concerned about the stock market exuberance in late 1927 and attempted to limit credit creation at the banks by increasing the reserves that banks had to hold at the FED. This was usually a cash reserve and by increasing the reserve requirement, money would flow out of the banks and be parked at the FED which would then restrain credit creation. The reserve requirement would be calculated as a percentage of the on-demand deposits held by the bank. The banks gamed the system when the FED increased the reserving percentage of demand deposits by asking all their customers to move their money from demand deposits to “time” deposits which were subject to a much lower reserving requirement and ended up increasing credit creation rather than decreasing it. It was a nudge-nudge, wink-wink arrangement where the banks never imposed the time limit of deposits and simply paid them out on demand should a customer so desired.

“Alarmed at the burgeoning boom, and at the stock prices that rose about 20 percent in the latter half of 1927, the Fed reversed its policy in the spring of 1928, and tried to halt the boom. From the end of December 1927, to the end of July 1928, the Reserve reduced total reserves by $261 million. Through the end of June, total demand deposits of all banks fell by $471 million. However, the banks managed to shift to time deposits and even to overcompensate, raising time deposits by $1.15 billion. As a result, the money supply still rose by $1.51 billion in the first half of 1928, but this was a relatively moderate rise.”

America's Great Depression, Murray N. Rothbard

It was not speculation on credit per se which inflated the stock market it was the monetary inflation created during the 1920’s within the “stable prices” policy which drove the process.

The Hidden Role of “Stable Prices”

The 1929 - 1933 economic history is surprising in how fragile the system actually was and how easily everything collapsed. There was no price inflation yet monetary inflation (the best historical example is from 2008 to the present, 2022, most visible in the growth in the assets held by the Federal Reserve – see below) was so extreme that it consumed all of the productivity advances. This is easily verified as the economic advances of the 1920’s should have seen prices decline similarly to the declining prices in computer hardware since its introduction in the 1980’s, yet prices generally remained stable. The monetary inflation hides in the averaging of the prices. Something or someone consumed the advances, and it can be found in the monetary inflations during the 1920’s. The monetary (money creation) inflation was curtailed once the productivity advances waned, and it collapsed the economy first and then thereafter the markets collapsed. This is generally the Austrian School of Economics explanation and seems to be only viable explanation. People often think the markets crashed and then there was a depression, not so, the economy tanked first. The method of consuming the economic progression is wrapped in the policy of “maintaining a stable price level” as is the primary objective of the FED and most modern central banks to this day.

“The Federal Reserve works to promote a strong U.S. economy. Specifically, the Congress has assigned the Fed to conduct the nation’s monetary policy to support the goals of maximum employment, stable prices, and moderate long-term interest rates. When prices are stable, long-term interest rates remain at moderate levels, so the goals of price stability and moderate long-term interest rates go together. As a result, the goals of maximum employment and stable prices are often referred to as the Fed’s “dual mandate.””

Presently in 2022, we have a far more overt monetary inflation, much more robust and persistent interventionist policies, and the 2008 experience which "cured" a monetary inflation crash and looming depression by deploying massive additional monetary inflation without price inflation. The lesson from the 1920's is that it is entirely possible for the Central Bank and government to consume all economic advancement with a policy of "maintaining a stable price level" without causing price inflation. It can be run as hot as needed for as long as there is sufficient economic advancement to consume. It can feed extreme growth in both government and the Central Bank. It is an opium for government spending which governments will fight tooth and nail to keep. The pinnacle of this economic consumption of human economic advancement is when the Central Bank buys the debt issuances of government or government institutions (usually government creations to cater for banking vested interests around mortgages, bad and doubtful debts, too big to fail entities and protected industries) and holds it on its balance sheet.

Let’s pause for a moment on this principle of consuming the economic advances. Humanity introduced fantastic innovations in the 1920’s, it is in reality one of the enduring characteristics of humanity throughout history. Look at the example of the Model T Ford in the development years from 1910 to 2016. It is before the 1920’s but it is the principle of advancement which we are discussing. Ford developed the assembly line for mass production and built a new factory. Moving production from the old Ford Piquette Avenue Plant to the new Highland Park complex saw Ford cars produced in 93 minutes per vehicle from the previous 12.5 hours per vehicle, by 1914, while using less labor. The Ford T Runabout was selling for $900 in 1910 and due to the innovative advances in production the price was reduced to $345 by 1916 (a drop of 62% in price) where after the price increased to $500. This is the usual outcome of economic advances, higher productivity, cost savings and lower prices. The economic consequence of such advances widespread across every economy globally and persisting for almost a decade implies falling prices not price stability. Monetary inflation and the policy of “price stability” mopped up the productivity advances and price declines and the price advantages of deflation was never passed on to the population while the narrative of the evils of deflation was preached. By what standard would one call the example of Ford’s manufacturing ingenuity, “evil”, in using innovative manufacturing to create a 62% price deflation?

A policy of “stable prices” is fundamentally flawed as it sets the monetary inflation supply at the maximum level just before consumer price inflation takes hold and ignores the impact of monetary inflation on asset price inflation. Gaming the system by the central bank with targeted channeling of monetary inflation into asset inflation will further maximize monetary inflation and central bank money creation but it will create a massive structural disconnect between the economy and asset prices.

This is what it will look like.

The Monetary Inflation Gauge (Sarel Oberholster)

Consumer price inflation is held comfortably at the “stable prices” level, but asset price inflation is running at the burnout level.

The COVID pandemic came at a very inconvenient time for monetary inflation. Scope to increase monetary inflation to “combat” COVID without triggering consumer price inflation did not exist so monetary inflations were pushed into the red. The Ukrainian war now adds just another very serious complication to an already very vulnerable situation.

The Monetary Inflation Gauge 2020 COVID (Sarel Oberholster)

“Stable prices” was abandoned and consumer price inflation is already at 8.5%, while asset price inflation was pushed even beyond the danger zone.

Excessive Market Speculation in 1929

The money created under monetary inflation has a number of inevitable outcomes and causes a number of systemic dislocations. It is distributed via securities purchases by the Central Bank. Those securities can be public sector or private sector securities. All newly created money, when used to acquire public sector securities, for whatever public interest purpose, will inflate government. All newly created money, which is used to acquire private sector securities inflate the “corporate sector” in the private sector for that is the origin of private sector securities (it naturally includes the banking sector).

The buying of securities with newly created money to be held on the FED balance sheet is the act of monetary inflation. Temporary trading in securities when central banks act as liquidity provider to the banking sector in its role of “lender in last resort” is not inflationary unless it gains a long-term holding structure on balance sheet.

These twin inflations of government and the corporate sector must by its very nature inflate the prices of government assets and inflate the prices of corporate assets. The inflation of government assets manifests as declining securities yield (or declining bond yields) which stand in an inverse relationship to the price of those securities, hence the result is an inflation of the value of government securities. Complete the circle and it is obvious that government growth is greatly enhanced by the lower yield and the higher price of government securities. Government can exponentially increase its debt growth rather than having to use taxes to fund that growth. This is a highly desirable outcome from the government’s point of view.

The Central Bank facilitates this “tax-free” government growth which also serves the Central Bank very well. Its assets held increases automatically to the extent that it engages in money creation. Central Banks have no income per se, they live off the income received on the assets which they purchase through money creation. The more money creation, the greater the Central Bank income, that is provided interest rates do not fall to zero or beyond as we see with the negative European interest rates. A surplus income after all the needs of the Central Bank is met will be paid to government (a small portion may go to “shareholders”, there to provide optics that the Central Bank is independent). The consequence is that there is a systemic higher government growth dislocation built into the process. That systemic dislocation also becomes more excessive as more inflationary money creation takes place and the longer it is maintained.

Corporate assets are inflated when the Central Bank engages in buying private sector, corporate sector securities. The growth principle is the same. The corporate sector growth is artificially stimulated by the cheap money and as a spin-off, artificially enhanced profitability. Stimulating growth and profitability via monetary inflation will cause the share prices of companies in the “corporate sector” to artificially increase. The outcome is the same as with government inflation, the systemic dislocation also becomes more excessive as more inflationary money creation takes place and the longer the money creation is maintained, inflating corporate debt and share prices alike.

None of these dislocations can be sustained without ever increasing monetary inflation.

Monetary Inflation Causes Systemic Downwards Dislocation of Interest Rates

The inflationary money creation must inevitably suppress interest rates. The inflationary money creation is deployed throughout the economy as an increase in the supply of credit. Interest rates are the price of credit and adding newly created money from an external source will artificially add more credit supply which will then push the price of credit down, i.e. interest rates are artificially lowered.

In modern monetary management that supply of credit is channeled with an objective to minimize the impact on consumer prices while actively targeting asset price inflation. The extreme money creation of 2008 was deliberately channeled into reflating asset prices as well as providing easy liquidity for government bond issuances. The FED and all other Central Banks digitally created money out of thin air and bought government securities and corporate securities while also channeling liquidity to the banking sector to keep it afloat secured often by assets of dubious quality.

The supply of fresh digitally created credit originating from the Central Bank then increases the available supply of credit which suppresses the price of credit, i.e. interest rates. It is the same money expansion process going back to the very beginning of the history of the use of money even though the methods differed relative to the money used. The money created always ended up in the hands of governments to spend or distribute. The digital money creation flowed to government when the FED bought government securities with it, similar to when the Roman Empire increased coins in its treasury holdings through debasement, melting gold coins down and mixing it with copper. Modern Central Banks have a much easier process of just creating it with a keyboard.

The axes of control in managing monetary inflations is the Central Bank, the government and the primary dealer banks. That was the case in 1929 and it still is the case today. The reality of the present money creation expansions can thus be traced to the interest rate cycles since (surprisingly) July 1981.

Effective FED Funds Rate (St Louis Fed)

Federal Funds Effective Rate – St Louis FED

The first down cycle sees the fed funds rate drop from July 1981 to Feb 1983 by 10.89% from 19.4% in July 1981 to 8.51% in Feb 1983. The next drop is from 11.64% in August 1984 to 2.96% in Dec 1993. Each phase pushed the cost of credit ever lower, then slightly increased credit costs with raising interest rates once the “other inflation”, the one which generates a general increase in prices, started to emerge. The objective is to tap all economic advancement but without causing any increase in the general level of prices for the longer the inflation of a general increase in prices persist the longer interest rates must remain elevated. Higher interest rates reduce the budgets and spending powers of governments, and it is something extremely disliked by politicians.

So, it is clear how the economic advancements have been harvested since 1981 and how each subsequent monetary inflation eventually required increased interest rates to contain general price level inflationary increases, yet even with the occasional small increases, interest rates continued to trend lower thanks to humanity’s incredible propensity for innovation and progress. This period advances trace back to the development of computers, the internet, international standardization, micro chips and miniaturization of computer technologies and others, sustainable energy, globalization of manufacturing and supply channels, globalized specialization, and many more in an almost endless list. The deflationary economic benefits of all those advances are stripped away with a policy of “stable prices” and monetary inflation and redistributed to governments first, then to the other issuers of securities bought with the monetary inflations.

The next down cycle in Dec 2000 took the rate down from 6.51% to 1% until May 2004. The 2^nd last down cycle was to drop the rate from 5.25% in July 2007 all the way to the zero bound and then holding it around 0.1% until 2015. The final down cycle saw the rate cut right down to zero where it has been languishing since the start of the COVID crisis in early 2020. We’ll return to it but first let’s look at the policy of encouraging asset inflation using the S&P500 as the proxy.

sp-500-historical-chart-data-2022-04-30-macrotrends (Macrotrends)

S&P 500 Index - 90 Year Historical Chart

Channeling monetary inflation into asset price advances was initiated by Alan Greenspan in 1987 after the 1987 crash. It’s that tiny little blip in the chart in 1987 but the asset inflation which followed was certainly not a blip. The first monetary asset inflation crash after 1987 happened in 2000 but was cured by dropping the interest rates and pumping a real estate bubble of epic proportions with ever expanding monetary inflation. Monetary inflation was channeled to banks who were encouraged to expand mortgage lending. Securitization of mortgage loans facilitated this process beautifully. Newly created money could be channeled into securitized mortgage securities, which in turn could be bought by the Central Bank and held on balance sheet, and initiate yet another dislocation. Home ownership was preached and combined with the advantages of lower mortgage rates and an almost infinite supply of newly created mortgage credit, it generated rising real estate prices and unbridled growth in real estate assets. Still it only managed to get the S&P500 back to the 2000 level.

The housing bubble started to unravel when interest rates were increased from 2004 to 2006 and soon the global economic crises of 2007/8 ensued. The dislocation in the real estate market assets was much more sensitive to interest rate increases and started to unwind as soon as the interest rates increased. Once again, the solution was to use, now bazooka class, monetary inflations combined with dropping interest rates to the zero bound. Treasury and the FED, as in 1929, worked the bazooka together and as in 1929 they also acted in concert with all the other major central banks globally.

“Paulson asked Congress for the right to use taxpayer funds to intervene - but hoped the pledge alone would be sufficient. "If you have a bazooka in your pocket and people know it, you probably won't have to use it,'' he said at a July 15 Senate Banking Committee hearing.

But now Paulson is readying the bazooka, because the markets didn't respond as hoped. Shares in the companies bounced back from multiyear lows in recent weeks, but bond markets have not regained confidence in Fannie and Freddie.”

Paulson readies the 'bazooka', CNN Money, By Colin Barr, senior writer, SEPTEMBER 7, 2008.

The Bazooka class monetary inflation together with the COVID class monetary inflation catapulted the S&P500 away from the 2000 level of around 1500 to around 4750 on an exponential trajectory but now it is running out of steam. What class of monetary stimulation will be required to stem the tide?

This monetary inflation and stable prices formula ideally requires a period of economic advancement, the larger the better, which will shield against general price increases and hide the inflation. The curse of this formula is the one way-ticket of this policy. Every cycle of monetary inflation drives the interest rates lower and totally perverts the pricing of credit and its distribution throughout the economy while governments as well as the asset markets become entirely dependent on the Central Bank liquidity provisions. The Central Bank balance sheet balloons and any attempt to wean governments off Central Bank liquidity requires that the securities bough by the Central Bank must be returned to the “market”. Someone else must buy and hold all those securities yet at zero interest rates who would want to in the absence of Central Bank buying which at least generated capital profits for holders of similar securities. The moment when the Central Bank steps aside and say that the market must now buy and hold those securities is the moment when the crash risk clock start ticking.

Interest rates start to increase, and losses start to accumulate on all those government debt securities issued at fixed yields. It’s now that the cycle flips into reverse. This is where nobody really wants the long-dated debt securities which fuels further increases in yield and more capital losses (long dated debt assets lose value when those interest rates increase). It then initiates a vicious negative cycle. Funding the debt needs of government becomes dependent upon convincing the “market” to buy and hold losing assets. That all happens before we get to the point where the Central Bank undertakes to actually reduce the size of its balance sheet (which is where we are about right now). Let’s take a look at the asset growth on that FED balance sheet.

Total Assets of the Federal Reserve (St Louis FED)

St Louis FED.

Looking for monetary inflation we start in 2008 with assets less than $1trillion. The initial bazooka push takes the assets to $2trillion and eventually peaks the monetary inflation at over $4trillion. Looking at the asset inflation above on the S&P500 chart, we see the effect of channeling the inflation into asset inflation in the financial/corporate sector of the economy rather than allowing it to spill over into consumption economy where it may generate the other undesirable inflation of a general increase in prices. Asset prices have been inflating at exponential rates. The most perplexing result of the 2008 monetary inflation is how the global economy escaped the other inflation, the general increase in prices, effect. Controlling where the monetary inflation was deployed explains it as well as driving interest rates to the zero bound.

The FED outcompeted with newly created money in hand in the market for government securities which obviously absorbed a good portion of the newly created money and made corporate debt more attractive, channeling money towards the corporate sector of the economy. Banks similarly opted for the least possible risk by deploying new FED credit to the corporate sector given that the banking sector very nearly had a 1933 meltdown in 2007/8.

FDI 2000 to 2020 (World Bank)

Foreign direct investment, net inflows (BoP, current US$), World Bank

The newly created money in 2008 was divvied up mostly between the governments and the corporate sectors, hence not spilling excessively into the consumption side of the economy where it may have caused price inflation. Here we can see from the World Bank data how Foreign Direct Investment (as a proxy for the deployment of corporate investments) increased sharply with the availability of monetary inflation but literally collapsed when the Central Banks just levelled off the monetary inflation from 2014 onwards, and completely collapsed when monetary inflation was mildly “tapered” by 2018.

Interest Rates are Eliminated from Return On Investment Decisions at Zero Interest Rates

The decision to make or not make an investment is fundamentally decided by the Return on Investment (ROI). Will the investment “return” a profit or not. The ROI in simplified terms means how much profit can be made by making the investment vis a vis the cost of funding that investment. For example, if I were to build a new mine at $1bn and it will return 20% per annum for 10 years then I’ll get my $1bn back in 5 years and another 1bn in profits over the remaining 5 years. That, however, ignores the cost of making the investment so the usual approach will be to say that I will borrow the $1bn and use the returns to repay the $1bn loan plus interest and what then remains is my profit. Keeping it simple, let’s say the bank charges me 5%pa interest, then my ROI will be 5%pa where the 1^st 10%pa of the 20%pa will repay the loan, the next 5%pa will pay the bank interest and the 5%pa which remains is my profit or my ROI. This accentuates the importance of interest rates in decision making about investments.

I’ll make the investment to build the mine if I’m content with a 5%pa ROI but if I believe the risk requires that I should at least get 8%pa ROI, will not build the mine. This is where these cycles of monetary inflation generated a similar effect as in 1929. Lowering the interest rates and generally providing easy access to credit, encourages increased investment as more and more projects become viable when the interest rates decline. The long-term decline in interest rates was initiated as far back as 1981 and was re-enforced every time with a new cycle to the point where virtually any project which could generate a positive ROI became viable. The constant expansion of investment in production feeds consumer products and services into the markets and in a virtuous cycle of abundance assist in keeping consumer price increases in check, restraining the “other inflation” of a general increase in prices.

This is what I mean by a one-way ticket. The monetary inflations can be staggered through a number of cycles each driving interest rates ever lower and yet not result in the inflation of a general increase in prices. The protective virtuous cycle ends when it reaches zero interest rates. There are no more abundance of viable projects which has not been invested in already as at zero interest rates, interest rates no longer has any impact on the ROI decision and the marginal utility of declining interest rates on ROI decisions diminishes in every downward cycle of the interest rates. Zero interest rates are the end of the line. We punched that ticket in 2008.

The tiny increase in interest rates from 2015 to 2020 had already been too much by 2019 and were once again in decline to sustain this increasingly unstable monetary inflation economic system. The market volatilities are but one example of its instability, with asset price movements increasing progressively every year, flash crashes and priced to perfection crashes where major companies can see their share price decline by anything from 15% to 50% in a single trading session even at only a hint of “bad news” are now regular occurrences. The Central Bank policy of stable prices certainly does not extend to asset prices where asset price inflation has been allowed to expand exponentially and bubbles are ostensibly unrecognizable until after the event. That is if one believes in the propaganda of Central Bankers. The central banks have certainly earned the label of “serial bubble blowers”.

The COVID pandemic landed in early 2020 and once again the answer was to use monetary inflation while “cancelling” interest rates to zero. But, this one-way ticket was punched already in 2008 so this time round that “other inflation” the one which is a general increase in prices arrived and it arrived with a vengeance.

CPI Inflation USA (TradeEconomics)

CPI Inflation USA, TradeEconomics

CPI Inflation EU (TradeEconomics)

CPI Inflation EU, TradeEconomics

The channeled monetary inflation, targeting government and corporate credit expansion initiated by Greenspan and bazooka-ed by Bernanke and Paulson has also reached the end of the line. The bond market is fully inflated at zero interest rates, the corporate investment opportunities are fully utilized at zero interest rates, the mortgage and real estate markets are fully inflated at zero interest rates and the stock markets are fully inflated at zero interest rates.

The COVID pandemic paused a general economic advancement through innovation while disrupting economic activity to the extent that global GDP growth as reported by the World Bank declined by 3.3% in 2020. The decline in growth after the 2000 technology crash and the decline in GDP growth after the 2007/8 Global Economic Crises are dwarfed by the COVID decline.

Global GDP Growth (World Bank)

Global GDP Growth, World Bank.

New monetary inflation during the COVID pandemic was not shielded by rapid economic advancement while the decline in GDP resulted in a very real decline in available produce. Thus, great care had to be taken not to channel monetary inflation during the COVID pandemic into the economy of goods and services preventing the newly created money from triggering the undesirable price inflation. That was an impossible ask. The massive fiscal stimulus during the pandemic was financed with the new monetary inflations and distributed through government spending. The government as a consumer of goods and services further channeled the COVID class stimulus into the consumer sector of the economy. The monetary inflation spilled over into the general economy and unleashed price inflation.

The Central Banks’ first narrative was to call the price inflation “transitory” yet most experienced market commentators did not buy into the transitory narrative. By late 2021 the FED abandoned the “transitory” message as price inflation had become entrenched. The current price inflation in the USA published in April 2022 at 8.5%, is the same as the price inflation of 1981. The relative context regarding interest rates is that the Federal Funds Effective Rate (see chart above) was over 19% in 1981 when consumer price inflation was 8.5%. The Federal Funds Effective Rate in April 2022 is still at zero % yet consumer price inflation is at the same 1981 level of 8.5%. This huge divergence is due to compounding the monetary inflations from 1987 to 2022 until the Federal Funds Effective Rate got stuck at zero %, the end of the line, and the unwillingness of central banks to adhere to the “stable prices” policy when it does not suit the circumstances.

Piling up the Dislocations

The policy of “stable prices” facilitates extended periods of monetary inflations but at the cost of structural economic dislocations. These dislocations will grow to the extent to which economic advancement facilitates monetary inflation without triggering price inflation and for as long as interest rates can be driven down. Remove any of those conditions and the monetary inflations must be paused which then automatically result in an economic crisis as the dislocations cannot be sustained without exponentially growing monetary inflation. It will set in motion a reversal of the dislocations and the economic crises which follows will be proportional to the extent to which monetary inflations were deployed in the dislocations as well as to the duration during which the monetary inflations were used to sustain the dislocation.

Identification of those dislocations will guide our market response to it.

1. Government size dislocation. The availability of newly created money facilitated government growth to beyond where it would have been, were it not for the new money financing government growth to a size which cannot be sustained by the economy without the monetary inflation.
2. Interest rates decline dislocation. The creation of new money is floated into the market through credit creation channels which force interest rates lower than it would have been without the new money.
3. Credit growth dislocation. Credit growth both public and private credit are expanded by the new money to levels much higher than what it would have been without the presence of the new money and cannot be sustained by the savings in the economy.
4. Goods and services production growth dislocation. Investment in production of goods and services is stimulated by the cheap interest rates and abundant availability of credit as a result of the newly created money to much higher levels than would otherwise have prevailed without the monetary inflation. This may seem like a “good” outcome but was one of the major reasons for the extended duration of the 1930’s depression.
5. Asset price inflation dislocation. Its best to identify the three most relevant asset classes. The prices of government securities including government bonds are overinflated and dislocated (yielding too low interest rates) due to the newly created money being used to buy-and-hold these assets on the balance sheet of the Central Bank. Corporate debt securities including all debt securities issued or collateralized by banks are overinflated and dislocated (yielding too low interest rates) due to the newly created money being used to buy-and-hold these assets on the balance sheet of the central bank. Share prices of beneficiaries of cheap credit are overinflated and dislocated due to the monetary inflations. Real estate prices are similarly overinflated by the money creation, abundant credit and low interest rates.

Identifying the dislocations allows us to pinpoint the fault lines in the economy and will shape our market response to it. The scenarios which need testing are what will happen if any or all of these dislocations reverse. Timing the potential reversal of a dislocation, its likelihood, and the consequences of the reversal will empower or trading strategies.

It’s the Money not the Interest Rates

The starting point must be to ask, will the monetary inflation continue or not, or even be reversed? The driver of these dislocations is not the interest rate it is the actual money creation. Interest rate movements are a causal consequence of the money creation. The “stable prices” policy is facilitated by deflationary innovative economic advancement and scope to stimulate investment via interest rate reductions to enhance ROI. Ideally, the monetary inflation should not spill over into the consumption of goods and services economy. These are the effects under review.

The recent spill-over of monetary inflation into the consumption economy was probably a temporary effect due to the crisis created by the COVID pandemic and cannot be assumed to continue or be repeated at the same pace.

The decline in GDP growth is not that easily dismissed as the experience of the 1920’s and 1930 depression advises. This is where the economic theory of the Austrian School of economics is useful. The Austrian economists hold that the newly created money stimulated “malinvestment” (not “overinvestment”), undesirable harmful investment during an inflationary boom. Those investments must be liquidated (destroyed or repurposed), at the end of the inflationary boom. The inflationary boom misleads entrepreneurs to invest in unsustainable projects not aligned with the desires, needs or interests of consumers.

The dislocation in investment is not so discerning or discriminatory and the Austrian Economists would like to believe. All investments which seem profitable with a suitable ROI and generous credit availability will be undertaken to create overinvestment and malinvestment alike, both unsustainable without the continued presence of monetary inflation in ever increasing quantities.

Any decline in the positive growth trajectory of the monetary inflation is already enough to initiate the unraveling of the dislocations. Pausing the monetary inflation accelerates the unraveling of the dislocations and reduction of previous monetary inflations or “tapering” certainly reverse the dislocations. None of this happens as isolated and absolute events. It happens within a controlled environment where the central bank will manage the process with great care as they are aware of the dangers of the unraveling.

The limitation imposed by a zero-interest rate is permanent but not fatal to the monetary inflation process as was demonstrated since 2008 with negative interest rates. The monetary inflation and its consequences can be managed, assisted by deflationary innovative economic advancement and continued corporate investment even at zero interest rates.

Formulating an Investment Strategy

The decline in the growth of monetary inflation as is demonstrated by the visible flattening of the asset growth in the FED balance sheet (see chart above), the declines in GDP growth (USA Q1 GDP growth came in unexpectedly at minus 1.4% when plus 1% was expected) and declining corporate investment as well as the presence of consumer price inflation, have triggered the reversal of dislocations. We each must now rank the risks associated with each of these dislocations to formulate our own investment strategies. I will rank the risk as follows with 1 the highest risk and the most likely outcome:

1. Corporate asset prices risk. Risk of a severe market correction without ruling out a significant general market crash (prices of the best companies in 1929 dropped by more than 90% - see the links above). Zero interest rates (or very near zero, and some even negative) will encourage investment when it is reached for the first time, but investment opportunity will wane as time passes. Accumulation of malinvestment and overinvestment will peak if the zero interest rates are maintained for extended periods. Any reduction in monetary inflation (flattening of the asset curve on central bank balance sheets) will reduce credit available for speculation as well as negatively impact inflationary asset growth of corporate assets. Any increase in interest rates will exacerbate the negative feedback loop. Asset prices dependent upon the cashflow stream of both the availability of cheap credit for speculation as well as dependent upon the asset inflation generated by monetary inflation channeled into corporate assets will suffer cash withdrawal symptoms to add to the negative feedback loop. This risk indicates a strategy of identifying overvalued corporate assets, credit securities as well as shares, to be sold short. Any corporate asset which will be vulnerable to a reduction in cheap credit due to leverage or due to risks to profitability must also be targeted for short selling. The prevalence of a high risk of a general fall in corporate asset prices and securities also accommodates strategies of selective shorting of indexes or buying short-aligned ETF’s. Examples of inverse stock ETF’s to consider are NASDAQ:SQQQ, ProShares UltraPro Short QQQ with a 3x leverage short trade on the Nasdaq and NYSEARCA:SDS, ProShares UltraShort S&P500 with a 2x leveraged short trade on the S&P500. There are a wide range of short-aligned ETF’s listed at the link provided and each trader/investor must familiarize themselves with the risks of each and decide if these ETF’s fit their risk profiles. The extreme volatility in the markets and inherent in these leveraged short ETF’s requires that one must time your entry points and exit points efficiently. Rather stay away from the leveraged short ETF’s if you do not have the skills or tools to effectively manage such trades. Trading short in any asset is a specialized skill and should not be undertaken by novices.
2. Government bond market price risk particularly longer dated bonds. The dilemma for bonds is twofold. The emergence of price inflation introduces the risk that interest rates will increase. The inflation may not last and the need or willingness of the central banks to increase interest rates may not match the ferocity of the present inflation numbers but what is more important is that the central banks can no longer act as a sponge to absorb almost limitless government bond issues. More bonds must now be sold into the markets, and it may have to take place while the central bank is also offloading bonds on its balance sheet into the market. The risk is therefore that bond yields may spike higher than what is expected and generate a longer-term aversion to bonds which will facilitate a negative feedback loop on bond pricing. The dislocation on government growth is the most severe dislocation in this cycle of monetary inflation dating as far back as 1987. A negative feedback loop in unwinding this dislocation will pose an equally severe risk of yield increases and price falls in this market. A significant rise in the yields of the assets held by central banks will make them technically insolvent. They will then either monetize the losses (simply write it off against future incomes from assets held on balance sheet) or hold the highest loss risk assets and sell the shorter duration assets first. One can short specific bonds, say the US 20year bond with a variety of derivative instruments and it is usually a professional skill and requiring access to such instruments. Inverse bond ETF’s are easier to trade but still do not attempt these, particularly the leveraged ETF’s, unless you have the skills and understand the risks. The bond ETF’s can be found on the same link as in 1 above with examples being TBT, ProShares UltraShort 20+ Year Treasury, a 2x leveraged short sale simulation of 20year plus bonds or TBF, ProShares Short 20+ Year Treasury, unleveraged exposure to the Barclays Capital 20 year+ US treasury index. Please be aware that the ETF is already a short or inverse ETF and buying units achieves a short position.
3. Commodities price risk. Commodities were favored for special pain after the 1929 stock market crash. The deflationary depression and the malinvestment into commodity production created severe price risks which, particularly in agricultural commodities, attracted equally aggressive government interventions to maintain prices at levels where the markets could not clear. The risk today will be that the economic contraction and higher interest rates would negatively impact consumer and investment demand for commodities, driving down prices. It is not expected that governments would unduly interfere with the repricing of commodities presently in 2022, as was the case in the 1930’s. Here I would view crude oil (remaining cognizant of the risks of the Ukrainian war) as well as industrial commodities to be at risk. Any of these commodities can be shorted with relative ease with derivative instruments but once again do not enter into a short position on any commodity unless you have done the necessary research to validate such a short position as each commodity will have its own dynamics and price risks. Here I would follow a very specific sniper strategy (commodity specific) and not a shotgun strategy (collective or indexed risk) as discussed in 1 & 2 above.
4. Banking risk. Banks are at the center of the monetary inflation process and crumbles easily when the dislocations reverse. Bad and doubtful debts are usually the first sign of trouble, then liquidity. The extent of banking failures in the 1920’s and 1930’s was almost unreal where banks were smaller independent community and regional banks. The banking meltdown of 1933 stands out. Here is a sample of how it started in Detroit.

“THE DETROIT EPISODE

What proved to be the straw that broke the camel's back occurred in Detroit, Michigan. Sometime in 1930 a drain approaching the proportions of a run began on the large banks in Detroit. In a period of about two and one-half years prior to February 11, 1933, about $250,000,000 was withdrawn from the First National Bank of Detroit, and large sums were also withdrawn from the Union Guardian Trust Company and the Guardian National Bank of Commerce. In order to meet these withdrawals, the First National Bank was compelled to liquidate practically all of its liquid and unpledged assets, and the Union Guardian Trust Company was compelled to borrow from the Reconstruction Finance Corporation and from the Ford interests. Mr. Edsel Ford was Chairman of the Board of the Union Guardian Group. In January 1933, the run was continuing without abatement, and the Detroit banks were losing from $2,500,000 to $3,000,000 each week. The banks could not continue to pay out money at this rate without further borrowing.”

Recollections of the Banking Crisis in 1933, By Francis Gloyd Awalt, 1895-1966

ACTING COMPTROLLER OF THE CURRENCY, U.S. TREASURY DEPARTMENT, 1932-1933

Nobody wanted to believe that another similar banking crises could happen in modern times, yet the banking dominos fell when Lehman Brothers collapsed.

“Lehman Brothers began in the mid-19th century – 1844, to be precise – as a general store. Henry Lehman was responsible for the first incarnation of the business; his brothers (Mayer and Emanuel) joined the business in 1850, laying the groundwork for what would become a financial industry powerhouse.

The 1990s were a time of great power and financial success for Lehman Brothers; the repeal of the Glass-Steagall Act allowed the company to engage in both commercial and investment banking services, a move that would ultimately lead to its downfall.

Lehman’s ultimate end came as a result of being utterly overwhelmed by mortgage-backed securities (MBS) that were mostly backed with subprime loans, many of which went into default.

The End of Lehman Brothers

Lehman’s stock plummeted some 77% in the first seven days of September 2008. Richard Fuld – the CEO at the time – attempted to save face in front of investors and keep the doors open by using multiple tactics, including a spin-off of the company’s commercial real estate assets.

Investors saw Lehman for what it was: a sinking ship. The clear signal that investors were running came with the swelling of credit default swaps on Lehman’s debt, as well as with the backtracking of major hedge fund investors.

The final straw dropped by September 15 when, after attempted buyout rescue deals by both Bank of America and Barclays fell through. Lehman Brothers was forced to file for bankruptcy, an act that sent the company’s stock plummeting a final 93%. When it was all over, Lehman Brothers – with its $619 billion in debts – was the largest corporate bankruptcy filing in U.S. history.”

Lehman Brothers, The rise and fall of the US investment bank

Lehman Brothers embraced the securitization of mortgage loans as facilitated by the Greenspan FED with monetary inflation and paid the ultimate price for swimming in the money creation pool. The risk usually pops out unexpectedly when banks realize one of their own have high default risk assets in its lending portfolio. Other banks then cut off interbank funding to the wounded bank forcing it into a spiral of asset liquidations which more often than not leads to bankruptcy. This is how “banking-runs” take place presently, not people queueing at the bank for withdrawals but other banks cutting off liquidity in the interbank market. It was no different for Lehman Brothers and it is a high risk that another Lehman Brothers may emerge from the reversal of displacements created by an extended period of monetary inflation. The strategy which I favor here is to rather wait until it becomes apparent that a bank is in trouble then short the stock but get out before the collapse as exiting a short position after the collapse may often no longer be possible. Know the rules of your platform with regards to suspended shares and be aware that the FED and the government takes a dim view on shorting banking shares especially when they are in trouble and may intervene to your detriment.

5. Real estate assets repricing risks. All real estate asset values are closely tied to interest rates. Reduce interest rates and prices increase, increase interest rates and prices fall. This was one of the 2008 crash catalysts and is once again a significant risk given that interest rates have been driven to the zero bound this time. Ranking this risk at number 5 indicates that I expect the stock market risk and the bond market risk as greater catalyst risks in 2022. I will leave the identification of suitable trading strategies on real estate assets in a severe bear market to some other Seeking Alpha authors at this article is already far longer than the average Seeking Alpha article.

Before dealing with the strategic risks of the general investment thesis of this article I would like to pause at the principle of short selling. It is often viewed with disgust and horror. Short selling was directly blamed for the 1929 stock market crash and for the depression calling it a practice to profit from the misery of others. Shorting, unless deliberately structured as a malicious bear raid on an asset, is not the cause of the vulnerability of the asset to a price change. It is no different in morality from a long or bullish trade. It is simply an expression of an investment or trading point of view. Bullish: I believe this asset will appreciate in price and will therefore buy and hold it with the expectation of making a profit should it increase in price. I’ll make a loss should the asset price fall but ultimately, I would want to have a buyer to sell to when I want to exit the asset. The same applies to short sale. Crashes are really nasty for exiting any asset. Nobody buys while the price just keeps falling. Everybody will experience this phenomenon sooner or later in the markets. It is often only the short sellers closing their short positions which allows bullish traders to exit in an orderly fashion. Markets are made up of buyers and sellers and hating bears is simply an expression of one’s bullish bias. The, I only want buyers on this asset then the price will not fall fallacy, it never works that way. Short selling is vital to the orderly functioning of the markets. Predatory short selling is not. The investment thesis of this article does not propose any form of predatory short selling.

Risks to the investment thesis of a monetary inflation unravelling.

• Monetizing Losses. Do not think even for a moment that the FED and the government will sit by idly while the stock market or bond market crashes. Both will actively and aggressively intervene, especially since there exists a general perception that a stock market crash may cause a depression. The FED is very skittish about a stock market decline and will reverse its monetary tapering or interest rate increases without hesitation at the threat of a stock market collapse. That is why I have taken care to provide an extensive frame of reference for the distortion of a monetary inflation. Interventions by the Fed and the government will always remain the supply of credit. They only have this hammer, and they smack everything with it. So, the interventions will be to create more credit and fight the stock market decline and all other economic consequences with it. A bank looks like it may fail, and it will get a credit bailout. Same with a “too big to fail” company or any economic participant which the FED and government deems important to the “public interest”. The structure most often used is to create a Bailout Corporation which will be guaranteed by government and funded by the FED through monetary inflations (buying its bonds). The government burdens the taxpayer with any losses and the FED just monetize any losses (write off the loss in income, which is its usual position in this scheme, against future incomes from monetary inflations). This strategy worked spectacularly well in 2008 as there was ample room to grow the balance sheet of the FED and there was room for another drop in interest rates to zero. There also was no “other inflation” of a general raise in prices. Now, in 2022, the FED balance sheet is seriously bloated with assets, interest rates are at zero and CPI, Consumer Price Inflation, is running very hot at 8,5%. The most likely outcome of interventions under the current conditions will be to run inflation hot and to issue additional government debt while bailing out problem assets. Governments can also be expected to use fiscal measures to ward off a recession or depression. The room to maneuver is almost nonexistent so a choice to grow the FED balance sheet even more while running inflation hot will shift the risk to bond interest rates, increasing the debt securities market risk. A recession or depression will reduce the debt securities market risk but increase the stock market risk. The attempts to re-stimulate everything after 1929 all failed, and the interventions were substantial and aggressive. The book by Rothbard quoted and linked above tells the whole story.
• The Plunge Protection Team. Yes, it is real and was created by US President Ronald Reagan after the 1987 crash to protect the markets against a crash with a “whatever it takes” mandate, full access to the FED money creation machinery and any required concerted actions with private sector entities.

“The President's Working Group on Financial Markets, known colloquially as the Plunge Protection Team, or (PPT) was created by Executive Order 12631,[1] signed on March 18, 1988, by United States President Ronald Reagan.

As established by the executive order, the Working Group has three purposes and functions:

(A) Recognizing the goals of enhancing the integrity, efficiency, orderliness, and competitiveness of our Nation's financial markets and maintaining investor confidence, the Working Group shall identify and consider:

(1) the major issues raised by the numerous studies on the events in the financial markets surrounding October 19, 1987, and any of those recommendations that have the potential to achieve the goals noted above; and

(2) the actions, including governmental actions under existing laws and regulations (such as policy coordination and contingency planning), that are appropriate to carry out these recommendations.

(B) The Working Group shall consult, as appropriate, with representatives of the various exchanges, clearinghouses, self-regulatory bodies, and with major market participants to determine private sector solutions wherever possible.

(C) The Working Group shall report to the President initially within 60 days (and periodically thereafter) on its progress and, if appropriate, its views on any recommended legislative changes."[1]”

Working Group on Financial Markets, Wikipedia.

The short explanation is that the PPT has access to unlimited FED money creation to support markets which it can use to interfere in the markets as it deems necessary only reporting to the USA president. It is what it is, but beware the PPT will not be aligned with the trading strategies of this article and interventions from the PPT may hurt short position on any asset. Learn to watch for unusual activity on index trading and index ETF’s as those are the areas generally viewed as fair game for intervention by the PPT.

• Macro-economic scenario. This article describes a macro-economic scenario within a specific monetary inflation frame of reference. Predictive macro-economic scenarios are a high-risk venture, and many variables are in play at any given time which may not interact as expected or new events may emerge to alter the scenario. I have constructed this scenario with an extended frame of reference and expects it to play out within that frame of reference, but it is still a dynamic changing environment to which investors and traders must adjust in real time. For the record, I am not predicting a crash even though there is a high crash risk, and the trading/investing strategies are not dependent upon a market crash.

Conclusion

The use of monetary inflation has reached the end of the line exposing the stock markets, the bond markets, and the global economy to material readjustment risk. The systemic displacements created by monetary inflations over a period of 25 years since 1987 now press up against a wall of zero interest rates, consumer price inflation and an overinflated FED balance sheet. Correcting the dislocations is creating high risk of systemic events in the stock market and bond markets. Targeted short positions via inverse or short aligned ETF’s are expected to be the best trading strategy until such time as the displacement stress in the economy has abated.

Analyst’s Disclosure: I/we have a beneficial long position in the shares of TBF either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.