Alternative (Economic) Reality
After a decade of money printing and loose monetary policy, policymakers are rediscovering market forces.
“We can ignore reality, but we cannot ignore the consequences of ignoring reality.”
Ayn Rand
The quote above should be on the desk of every single policymaker. Reality has been ignored for far too long, and the consequences of this ignorance are just starting to be felt.
The latest example of this ignorance is in the UK, where the Truss government just announced massive tax cuts for the wealthy. Financial markets were quick to react: The British Pounds lost 3.5 percent against the US Dollar in a single day on Friday.
For a country that is importing pretty much everything it needs to survive and that is already grappling with high inflation, it is an understatement to say that it’s bad news. Stimulating consumption is the exact opposite of what a country with an eight percent deficit of its balance of payment should do!
With the cost of everything imported about to go up for everyone in the UK, most of the expected increase in purchasing power coming from the tax cut has already been wiped out in a single day. You didn’t need a PhD in economics to see this one coming.
Capital markets also sent a strong signal to the British Government: The yield on government debt better go up or the government won’t get the financing it needs. In less than two years, the yield on five-year UK government bonds went from 0 percent to more than 4 percent.
Readers of this newsletter shouldn’t be surprised that both the British Pound and the Euro have been tanking heavily against the US Dollar. I warned two newsletters ago that it was going to be the likely consequence of ignoring math (see here). What was surprising was the velocity of the collapse of both currencies.
Unless European leaders change course and decide that enriching Russia through their own sanctions may not be the smartest move, there is no reason to believe that the euro is done depreciating against the US Dollar.
Unfortunately, Europe seems to be determined to inflict as much pain as possible on itself. Who benefits from these bad policies? Of course, it’s the US.
European governments are deliberately sacrificing their industry to protect consumers. Probably the right move in the short-term to avoid civil unrest, but the long-term consequences will be slower economic growth and higher unemployment. Once factories have relocated to the US, it’s game over. They won’t come back.
In Germany, PPI, which measures inflation experienced by producers, reached 45 percent over the past 12 months. How many companies can survive when their input costs go up by 45 percent in a single year? We will find out soon enough.
The Great Dollar Milkshake
Several months ago, I published a newsletter on the Dollar Milkshake theory (here). This theory explains why the US Dollar is structurally bound to appreciate against most other fiat currencies. While the US Federal Reserve injected a lot of liquidity during Covid and since 2008, it is now taking it back. How? Let’s dig in.
Since 2008, the Fed and other G7 central banks have been engaging in what they call Quantitative Easing. It sounds fancy but it’s not. It’s very simple: They printed money. Central banks created money out of thin air and used this money to finance the deficits of governments by buying their debt. This newly created money kept interest rates close to zero since 2008.
QE works as long as all central banks are doing it at the same pace and at the same time. Fiat currencies are all debased at the same time and people don’t notice that the purchasing power of their fiat currency is eroding year after year. But they overdid it during Covid, which led to out-of-control inflation.
Now, the US Federal Reserve is doing two things at the same time to tighten financial conditions:
It is raising interest rates
It is burning $95 billion a month
You read this right. The Fed is destroying $95 billion per month. This is called Quantitative Tightening (QT) but it’s really the Fed burning US Dollars. It’s doing it by letting US government bonds it owns expire without reinvesting the money received from the US government. Let’s say in a given month $200 billion worth of US government debt owned by the Fed matures. The Fed reinvests $105 billion into new US government debt, and it destroys the other $95 billion it received. What can be created by fiat can be destroyed by fiat…
Every month, $95 billion of liquidity has to be sucked in by the Fed and destroyed. The consequence is that US Dollars from all over the world are being repatriated to the US. Now that anyone can get a 4 percent yield by lending to the US government, why bother lending to riskier borrowers? QT has barely started, but it’s already inflicting a lot of pain on the economy and financial markets.
It shouldn’t take long before the US housing market cracks under the weight of rising mortgage rates.
Buying the exact same house as two years ago now costs twice as much if you take a 30-year mortgage.
So, is the Fed right to tighten monetary conditions so aggressively? Not according to Wharton Finance Professor Jeremy Siegel. Watch his epic rant on CNBC on Friday. More than two million views in 24 hours already!
Historically, every time the US Dollar strengthened materially, an economic crisis usually followed. See below the excellent chart illustrating the annual change in the US Dollar Index (DXY) that measures the relative strength of the US Dollar against other fiat currencies.
The world has never been as indebted as it is today. This was bearable as long as interest rates were low. This era is now over. Act accordingly to protect your assets.
Best Podcasts Episodes of the Week
Decouple A Cold Old World feat. Doomberg. If you still haven’t listened to a single episode with Doomberg despite my repeated recommendations, it’s not too late! The Doomberg team took Twitter and Substack by storm with their high-quality content on energy (I am a paid subscriber of their Substack newsletter). This episode doesn’t disappoint.
The "What is Money?" Show Predator-Prey Economics with Oswaldo Lairet. Fascinating discussion on the financial system and why Bitcoin fixes the “predator-prey” dynamic.