Saturday, January 1, 2022

Denial Of Japanification

The U.S. has been in a Japanified environment for at least 13 years, more likely as far back as the DotCom bubble. And yet, policy-makers and the public at large remain in total denial. The current fear of "inflation" is exhibit A of rampant denial...

First off what do I mean by Japanification? I mean mired in a permanent state of structural deflation. Japan first entered this state 30 years ago and they've been stuck in it ever since. The "good news" is that they appear free to use monetary and fiscal policy to extremes previously considered impossible. The bad news is that their economy is totally stagnant.

The U.S. has been sliding down the deflationary slope since 1980. Free Trade and Supply Side economics solved the stagflation of the 1970s by exposing the economy to wide open global trade. Since that time the twin deficits consisting of the trade deficit (current account) and U.S. budget deficit have been growing faster than the domestic economy itself. The demolition of the middle class due to free trade and open immigration has been papered over with debt. The corporate sector has been the primary beneficiary of this easy way out from U.S. lack of  manufacturing competitiveness that began in the mid-1970s. Now the U.S. is totally dependent upon other countries (aka. China) for manufactured imports. 

All of which conventional economics would predict spells inevitable doom for the U.S. dollar. However, Japan has been doing this for decades and their currency is still considered the SAFEST on the planet. Even safer than the dollar. Why is that? It's because during boom times Emerging Markets borrow from the lowest yielding economies i.e. slowest growing, which is where they can find the lowest interest rates. That "carry trade" continues throughout the economic cycle until such time as the Minsky Moment occurs and EM currencies implode. At that point in time all of that borrowed money must be returned post haste to the lender. Which is why the Japanese Yen always catches a massive bid during global margin calls. It's not really due to implied solvency, it's more due to lack of concern over Japanese inflation. No one is worried it will ever get out of control, because it's structural. 

I first became disillusioned with U.S. economic policy in the aftermath of the Dotcom bubble when the Fed lowered interest rates to 1.5% and recommended that home buyers start using adjustable rate mortgages. They were clearly trying to offset the implosion of  the Tech bubble by stoking another one in real estate. And it "worked". For a time. 

Nevertheless, after 2008 and zero interest rate policy "ZIRP", the rules around "markets" changed dramatically. For one thing "valuations no longer matter". Meaning they are no longer useful as a timing mechanism with any precision measured within years. In addition, similar to Japan, the U.S. is now "free" to overuse fiscal and monetary stimulus on a level previously considered impossible. All as a proxy for a real economy. 

However similar to Japan this newfound profligacy does not necessarily portend the imminent demise of the U.S. dollar. In fact, the U.S. dollar is now a carry currency of choice similar to the Yen. During the March 2020 meltdown, the U.S. dollar skyrocketed. Anyone who IS worried that the U.S. dollar demise is imminent, should buy gold. However, don't be surprised if better prices lie ahead. 

What this monetary and fiscal monster now portends is larger and less stable asset bubbles over time. The largest of which to date we are witnessing right now. To believe the pundits of the day we too would have to ignore this latent fragility that I wrote about in detail this past week. The mega asset bubble and attendant continual monetary bailout has ensured that the next global RISK OFF event will implode the machines that create this carefully fabricated new permanent plateau of delusion.

Here we see S&P (eMini) futures open interest as a proxy for the current level of liquidity, is at the lowest point in this cycle. This is the consequence of automating markets to the point at which human market makers have been replaced by HFT algos front-running Robinhood gamblers. Someone on my Twitter feed said they don't think the Fed will go through with taper. It already started, and it will accelerate in January. The goal is to be wrapped up by the end of March - from $120 billion/month down to $0/month.  

This chart shows that the global reach for risk peaked way back in February and hit a second lower high aka. second wave retracement in November. Then the market tanked into early December which was the first (minor) wave of third wave down. The subsequent retracement in December was minor ii. I show the Bitcoin Trust because it has the clearest wave structure, and because all risk assets are now correlated to the downside, as we see via Nasdaq lows in the lower pane. For those not familiar with Elliott Wave Theory, at its most elemental level it's merely pattern recognition. Beyond that it's the belief that greed and fear ultimately control markets, NOT central banks as so many people today assume. 

If this wave count is accurate then indeed third wave system test is near at hand. 

We must acknowledge that this society has an overriding need to believe that NOTHING has changed over these decades and therefore they are free to extrapolate the past 70 years of stock market returns into the indefinite future. Which is what they are actively doing right now. To their minds, nothing dramatic has changed to the underlying economy which would indicate that "stocks" are outside of historical bounds. In other words, those who don't believe in any form of market timing, now rely solely upon extrapolation of a 70 year volatile trend by assiduously ignoring the experience of the past twenty years. Millennials at least have an excuse not to see this coming. No one else has an excuse other to claim they are functionally brain dead. 

In summary, going forward, the definition of "retirement" is going to change. In the past it meant reaching a fixed age and  heading out to the golf course. Going forward, it  will mean that people work longer but they will begin to trade off time and money earlier in life.

In a world in which future returns are highly uncertain, it's the rational choice. 

A lesson the Japanese learned a long time ago.