Inflation Or Deflation?

The Iran War is causing energy prices to spike world-wide.  Energy is the most important cost element in consumer price inflation, since it effects everything from transportation, heating/cooling, fertilizers, food, chemicals, to building materials and pharmaceuticals. 

Therefore, cost driven CPI will inevitably go higher if things do not normalize in the Persian Gulf in the immediate future.

• Inflation for Goods: A spike is to be expected in consumer good prices, particularly for staple necessities such as fuels, natural gas, food and housing costs.  Let's call these "inelastic" expenses, although consumer behavior may shift after a few months of prolonged high prices (this may happen faster than before because in the US, particularly, a very large portion of households live hand to mouth and will have to cut spending even for necessities (the K-economy).

But what about assets such as equities, real estate, private credit and equity, junk bonds, precious metals, cryptos, collectibles?  Prices for these depend on spending and saving patterns by the top 10% of US households who control 80% of wealth.  How will they react to a war that drags on?  I make the following assumptions:

1. Risk premiums will re-adjust across all markets.
2. Short term interest rates may go higher, putting downward pressure on equity and precious metal valuations, on top of risk premium adjustment.
3. A squeeze in disposable income will lower discretionary spending for luxury goods and services, including travel, vacation homes, collectibles. Valuation for their respective assets will be marked down.

• Deflation for Assets: As risk appetite recedes, asset prices will be marked down.  Coming into an already highly elevated market for all risk assets, markdowns may be very substantial.  

Therefore, Inflation for consumer goods and Deflation for risk assets (if the Gulf War drags on).

One final possibility: the US may have to rework its tax policy in order to raise revenue to support the "bottom" 80% part of the K-society.  I will not be surprised to see President Trump announce a "temporary, wartime" wealth tax.  After all, the war is already costing around $1 billion per day and the tariff window has been firmly shut by the Supreme Court. Mr. Trump may, in fact, be the only President who could propose and pass such a tax (he is a populist, after all).

 The negative effect of a wealth tax on all risk assets is easy to predict, while long Treasury bonds and the FX value of the dollar may benefit.

The Danger Of “Passive Investing”

Warren Buffet is unquestionably the greatest value investor of all time. Yet, he may have unwittingly recommended the worst investment strategy to individual investors: buy and hold index funds.

It was done with the best intentions, of course, since most active money managers routinely underperform broad indexes and charge high fees. 

His advice, among others, led to a massive influx in index funds which now amount to $14 trillion in US equities alone (ETFs plus index mutual funds). That’s 25% of the market capitalization of S&P 500. 

Combine this with algo trading and we now live in a world of “passive investing” - an obvious oxymoron and the very antithesis of Mr. Buffett’s own strategy. 

Index investors trust that markets will always perform as usual. They are akin to warriors who use “fire and forget” weapons, sure that their missiles will find the target no matter what. That’s a grave mistake at a time of global fundamental changes:

1. Geopolitical power is shifting East.
2. Climate change.
3. Energy transitioning from fossil fuels to renewables challenges the dollar’s supremacy.
4. Consumer spending, and therefore GDP growth, is limited by the K-economy.
5. The US may finally deal with its fiscal problems and raise taxes, particularly by imposing a wealth tax plus a VAT-type consumption tax.

The Elephant In The Room

What made America truly great was that from its start it took tens of millions of poor, underprivileged immigrants and transformed them into a massive, vibrant and prosperous middle class which drove production and consumption to ever new highs. The Empire was built entirely upon its middle class foundation.

But starting in the 1980s ideologues took over and pushed a mantra of global free markets and, even worse, labor "deregulation" a.k.a. to destroy labor unions.  There were some positive results, to be sure.  But, in the long run production shifted to Asia, the well-paid middle class evaporated and Trump became President riding the MAGA wave - where the key word is "Again".  Judging from the explosive growth of the middle classes in China and India, "again" is just not going to happen.

Which leaves the door wide open to bitter political disappointment for the American middle class getting crushed in the K-economy.  How will they vote in the polls? And how will the current administration react to getting snubbed? 

So this is the elephant in the room, one which financial markets are not yet taking into consideration: for the first time ever there is real political risk in the USA.  It is certain that the Trump administration understands this very well.  In recent testimony to the Congressional Judiciary Committe, the Attorney General was asked a pointed question about the Epstein files.  Her immediate answer was: "you should ask about the Dow hitting 50.000 and the S&P 7.000".  In other words, everything depends on markets now. This is really scary.  

When the political agenda is guided by the gyration of indexes... watch out.

On The Risks Of Algo Trading

 Algorithmic trading now accounts for 60-80% of all equity volume in the US.  Astonishing.

I wonder... since algo trading is basically a trend following mechanism and has never been tested in a seminal bear market (algo trading accounted for a mere 10% of volume in the early 2000's and not much more during the GFC bear), what will happen if algo starts following a hypothetical down trend? 

How long will it take algo masters to throw the "off" switch during a sudden market break?  And will they then merely follow the bear all the way down, algorithmically speaking?

Mr. Warsh At The Fed

 Mr. Warsh has just been nominated as Fed Chairman by President Trump.  If he acts on his old convictions, he will be an excellent choice, in my opinion.

He was, and apparently still is, against Quantitative Easing and expanding the Fed's role in the broader economy, ie against capital misallocation to support financial markets and to raise asset prices at the expense of productive investments.  As I understand it, he is for lower interest rates AND reducing the Fed's balance sheet.  I strongly support such actions, particularly the latter.

The Fed is now sitting on $6.5 trillion of assets consisting of Treasury bonds and mortgage securities.  While significantly down from $9 trillion at the peak, it is still 600% more than 17 years ago (see chart below).

Federal Reserve Balance Sheet Assets

Some claim that such large holdings are justified because the economy has grown as a whole - but this is only partly true. As we can see from the next chart, assets are now at 21% of nominal GDP, up from 6%.  

Assets As Percentage of Nominal GDP

But even this chart is parially wrong: nominal GDP has grown significantly due to inflation, particularly in recent years.  So, a better picture can be obtained by looking at the Fed's assets as a percentage of Real GDP, adjusted for inflation (see chart below).

 

Assets As Percentage of Real GDP

Clearly, the Fed has been adding huge amounts of liquidity into the overall economy.  Some of it may be going into productive investments, but judging from the record price levels of risk assets - equities, metals, cryptos, junk bonds and spec real estate - most of it is going into pumping up their prices via easy and plentiful leverage money. Some of it is also directed to more arcane places requiring huge liquidity (eg the Treasury basis trade).  In two words: capital misallocation. If Mr. Warsh starts draining this excess liquidity, or at least stops adding to it, there will be significant consequences for all non-productive portfolio assets.  Again, two words: Main Street vs. Wall Street.  I think the rabid gold and silver speculators got the message loud a clear last Friday.

Mr. Warsh is also a champion of lower interest rates.  I have no problem with that as long as he reduces liquidity.  Under normal circumstances the Price of money is much less important than the Quantity of money. Hopefully, he will hold firm to his convictions if/when financial markets take a dive and start begging for a bailout.

As a final note, I am no great fan of Mr. Trump, but in this case I applaud his choice.

I Bid 2025 Adieu

 As we bid 2025 adieu, here is a list of what I think were the major themes of the past year and my views for the future.

• Donald Trump became President, again. The world stares in astonishment and ponders if this is how an Empire and its Emperor should act. My view?  "We live in interesting times".
• Artificial Intelligence has fired the imagination of everyone, from Wall Street to Main Street and then some. My view? The positive results will not be visible for several years yet, right now it's make hay while the Sun shines. And as far as I can tell, the technology is still at the brute force level, like using a bazooka to kill a bird.
• Precious metal prices have gone vertical, mostly because many believe they will be used as a monetary backstop. My view? There isn't nearly enough gold and silver in the world to back all the liquidity/debt in existence.  
• The US debt situation is very worrisome.  Unless the government gets its fiscal house in order by raising taxes and lowering expenses things will get really tough.  My view? The dollar's reserve status is at risk, unless..
• China is racing hard, aiming to overtake the US as the next Empire.  My view?  Not so fast, comrade - you are definitely doing well, but be a bit more patient and cautious.  Rome was not built in a day and your Coliseum may yet come crashing down.
• The US middle class - what is left of it - is getting seriously angry at its demise. My view? Mamdani in NYC is a warning shot across the bow of the 1%'s mega-yachts. 
• Climate change is real and the world will forge ahead in dealing with it, no matter what Mr. Trump says or does.  My view? Decarbonization and carbon sequestration initiatives will grow fast, creating new industries and markets.  

Wishing all a very Happy New Year!!

Why Are Banks Using The Fed's SRF?

 Banks are repeatedly using the Fed's Standing Repo Facility (SRF) recently, ie borrowing overnight funds directly from the Fed against Treasury or mortgage collateral.  While such liquidity management moves are not uncommon, per se, the question arises: why and why now?

The most common answer is that financial institutions must balance their books around quarter and year end, so such moves are nothing to worry about. Sure.  But the question remains: why do (some?) banks need to go to the FED for such liquidity, why can't they get it in the normal way through the interbank market?

Some facts:

1. The size of the US interbank overnight market is around $170 billion.

2. Recent SRF volume varied between $25-50 billion. That's actually a very large chunk of the market, meaning that market liquidity is significantly constrained. 

Where is the money going? Some point out that the government is issuing a lot of T-bills recently thus draining more liquidity than normal. Maybe. But this money goes right back into the system by paying obligations, it doesn't just sit in government accounts.

Or, are interbank credit conditions tightening? In other words, the liquidity is there but (some?) banks and/or other financial institutions are having trouble accessing it in the interbank market. Could it be that there are counterparty issues out there? We'll find out soon enough, I guess, but Jamie Dimon's comment about cockroaches comes to mind.

There's a serious complication these days: shadow banking aka private credit. These are non-bank institutions who have become major players in global credit markets but operate with minimal supervision from central banks and other authorities.  The size of this market has gone from $1 trillion in 2020 to an estimated $3-4 trillion today, narrowly defined. Having a bit of experience in this area I can definitely say that loan standards are nowhere near those of regular banks, and credit terms are much closer to junk/subprime levels. 

The problem with such lending is that it often creates its own death spiral: private credit lenders believe that they lower risk by using diversification, but that's just lending to a lot of low credit borrowers. And charging them much higher interest rates just hastens their demise when things get tough.

We are in a troublesome K-shaped economy - and I bet that shadow banking is lending mostly to the lower part of the K.

The Price Of Memory

 The title may sound poetic but the subject is prosaic :)

I was curious at the large earnings upside surprise announced by Micron Technologies a few days ago.  The company makes commonplace DRAM chips and other such storage products used in just about everything these days.  It’s basically an electronics commodity company, albeit sophisticated.

The price of memory has been coming down steadily for decades following Moore’s Law, see chart below.

With prices always dropping, the industry’s profitability was always under pressure. Stock prices suffered for years as companies tried to make up in volume what they couldn’t achieve in profit margins.

Until AI and data centers came along and created a large extra demand for common “low tech” commodity semiconductors. Prices doubled, even tripled, within just a year or two.  Since fabrication costs stayed the same, more or less, profits soared.

Share prices for the likes of Micron, Seagate and Intel exploded on the upside with gains of 200-300% in just a few months. Will it last? 

Interest Rates Disconnect

Despite recent Fed rate cuts, long Treasury bond yields remain stubbornly high.  The chart below shows 3 month Tbill rates (black line) and 30 year Tbond yields (red line).  The recent disconnect is obvious, though not uncommon in and by itself, as the chart also shows. However, the 2008-15 period was one of ultra low short rates from the Fed's QE to get us out of the GFC.

More recently, short and long rates fell and rose in tandem during the COVID scare.

So, what is happening today? Why the disconnect?

IMHO, two reasons:

1. The market does not really believe that inflation is beat.  President Trump's constantly pressuring the Fed for lower rates does not help, either.

2. Credit concerns about the US.  Ray Dalio, in particular, has been very vocal on the subject.

While everyone is focusing on the stock market and its love affair with AI, this is what AI has to say when asked about Treasury bonds (ChatGPT):

Q - "Are there concerns about the creditworthiness of the US government?"

A - "Yes — there are significant concerns right now about the credit quality (creditworthiness) of the U.S. government, and these concerns are being reflected in how major financial institutions assess U.S. government debt. The gist is that, while U.S. Treasury securities remain one of the most widely held and liquid assets in global markets, there’s a growing debate among investors, policymakers, and rating agencies about how sustainable U.S. public finances are over the long term."

The answer then continues with more specific points and concludes with:

"Bottom line: U.S. government debt is still widely viewed as a relatively safe investment compared with many others, but recent downgrades and ongoing fiscal pressures have raised legitimate concerns about its credit quality among ratings agencies, investors, and economists."

Here's my bottom line: The US federal government has to get its fiscal act together.  Raise taxes, cut spending, stop promising kids' accounts and bonuses, stop announcing defense spending in the hundreds of billions.  But, more than anything... raise taxes.  I know this is anathema to most Americans, but what is the alternative?  After all, other than defense, almost all other spending goes to holy grails like Social Security, Madicare/Medicaid.

Here's some ideas:

1. Fuel tax - bring it in line with Europe, at least partially.

2. Wealth taxes - they won't raise huge amounts, but at least it shows a commitment to take actions.

3. National VAT/consumption tax.  That's the one that will raise the most money, by far.

The End Of The Yen Carry Trade

The news are everywhere, particularly amongst the breathless LinkedIn and Facebook pundits: The recent pivot of BOJ towards higher rates marks the end of the yen carry trade, so they predict all manner of imminent market disasters. Well..

Given that BOJ has been telegraphing its intentions for months, markets had -  of course - already pivoted away from the yen as a low cost funding currency.  Just take a look at the data from the Bank of International Settlements: Yen credit growth to non-residents (aka the carry trade, mostly) plunged to zero many months ago (panel C below).  Therefore, don't expect a sudden plunge in markets just because the yen carry trade is no longer operable - participants exited long ago.

What has taken its place? The euro carry trade (panel B), since euro interest rates are lower than dollar rates, though probably not for much longer if the Fed keeps cutting rates.

Note: the BIS data are current up to 2Q2025.  Data for 3Q2025 will be available early 2026.