Wednesday, March 25, 2020

MMT: Modern Monetary Thermonuclear Explosion

In 2019, combined fiscal (5%) and monetary (5%) stimulus equaled 10% of GDP, compliments of Trump's deficit which caused the overnight repo crisis. In 2020, fiscal policy (15%) and monetary policy (unknown) will likely approach 30% of GDP, as the Fed is once again forced to monetize the entire deficit. Position accordingly...

On the face of it, most pundits would view this amount of monetized stimulus to be unambiguously inflationary. And they would be right, IF we were not living in human history's largest credit bubble. As always, economics comes down to sorting out first order and second order effects. Which are often going in opposite directions. As the Fed goes forward with mainlining printed money straight into the economy, all of today's pundits are ignoring the 800 pound elephant in the room, the credit bubble.

Will creditors be willing to accept future payment in lower valued dollars due to inflation? No. They will demand a higher interest rate, across all credit markets. Once, again, as it was with the tax cut, interest rates will rise. I am not referring to the Fed rate, I am referring to market rates. 

In other words, by conjoining fiscal and monetary policy, the Fed just handed control of monetary policy to Trump. Meaning there is no control. From this point forward, the rate of inflation will dictate monetary policy. Which is another way of saying that the monetized deficit will cause interest rates to rise and thereby tighten financial conditions.

At some point the effects of monetized fiscal stimulus will entirely cancel out the effects of monetary stimulus. In a debt laden economy, this will ultimately be highly deflationary. Most people's incomes are leveraged multiple times via the debt markets. Meaning that a sudden rise in borrowing costs will cause a sudden rise in mass defaults.

What the Fed has done is pushed off the threat of Coronavirus defaults and merely delayed them until the monetary go juice works its way into the veins of the economy. Recall, the tax cut of 2018 dumped the S&P 500 -20% by the end of the year, for the exact same reason - an increase in reflation expectations.

By going down this new path of easy money, the Fed has replaced real demand from incomes with printed money. The overall supply of goods has not changed. The first order effects of this Coronavirus are highly deflationary. The second order effects coming after will be reflationary. However, it's at that point, when market interest rates will begin to rise beyond the Fed's control. Between rising defaults and rising interest rates, the credit markets will get obliterated.

Here below I show an approximated sequencing of events with ballpark timelines. We are right now in the most deflationary period in U.S. history. Whenever this quarantine ends, there will be aftershocks in the form of layoffs and defaults. In the background the stimulus package will begin to take effect. However, it will likely prove inadequate and require additional extreme stimulus. At some point stocks will have a tradeable rally long before the economy turns around. Perhaps in a matter of weeks from now. There will be no one saying "BTFD" when the tradeable bottom arrives. 

When the economy does finally bottom months or even a year from now, the incipient reflation will cause interest rates to explode higher. Between defaults and rate increases, the bond bubble will final implode. 

The fool's rally will end. Post haste. Having nuked the bond market, they will proceed to nuke the dollar.