Last week we wrote:
“You might be asking yourself why we’re not seeing inflation just yet, and you’d be smart to ask. In addition to a temporary decrease in consumer demand there is also deflationary pressure on the dollar coming from foreign governments’ need to service their US denominated debt obligations.”
In this newsletter, we’ll dive further into the complex global forces affecting the US dollar’s value so that we may understand why we’re on the road to inflation, where inflation will manifest, and how that impacts the investment strategies one must consider in order to build wealth and protect purchasing power over the next decade. Unprecedented times require deep analysis and creative solutions derived from lessons of the past.
Global Demand For Dollars is High
Prior to, and especially following the Great Financial Crisis, the issuance of USD through the creation of credit increased dramatically. The corollary is that the world had accepted the newly created USD without much, if any, negative impact to the Dollar’s value.
However with the world grappling with recession, the US dollar has now come under immense deflationary pressure (and therefore the US Dollar should appreciate). Naturally you’re asking yourself how we could be on a path toward inflation if deflation is the first order effect of economic slowdown. However it’s important to remember the road to inflation starts with deflationary pressure, which prompts reflationary action, and finally results in inflation.
US Dollar supply is largely created through newly issued debt at commercial banks - domestically this is tracked as part of M2 and M3 money supply and abroad under the “eurodollar” system. As economic activity is destroyed in a recession, and dollar-denominated debt needs (or is forced) to be serviced, there is increased demand for available dollars in order to pay down this debt and its associated interest payments. Additionally, servicing outstanding debt destroys the available supply of outstanding dollars. This increased demand and simultaneous decrease in supply of dollars creates deflationary pressure on the dollar and, all else equal, will cause the value of the dollar to rise.
Deflation (the appreciation of a currency's value) is detrimental to the host country’s economy, as it impedes its ability to engage in foreign trade (since its goods and services become comparatively and cost-prohibitively expensive). As a result, many countries will elect to devalue or debase their currencies in an effort to stimulate exports and capture a larger share of the world economic pie. Some countries do this as a matter of course (and are therefore considered currency manipulators) - such as China - and others will only engage in this behavior in response to significant economic stressors - generally the United States falls into the latter category.
Based on the economic fallout of the Great Financial Crisis, it follows that the Fed should (and did) expand the supply of USD in order to combat the global deflationary bid for dollars, stimulate the domestic economy and to attempt to push inflation toward its 2% goal (something it has failed to do for the most part of the past decade). In normal times, with expanding economic activity, this new supply is absorbed/accepted by the market in connection with increased production of goods and services.
However we’re not in normal times. We’re in the midst of both a global pandemic and a recession that sparked the largest creation of USD supply in the history of the world. Simultaneously with the drastic expansion of USD supply, supply lines have been disrupted and the workforce has been encouraged (read: paid) to stay home and avoid economic production (therefore fewer goods are being created).
Too much capital chasing too few goods leads to inflation
This alone generally leads to inflation. Yet we haven’t seen it yet in traditional metrics (e.g. CPI). Especially now, with much of the country quarantined or under stay-at-home orders, consumer demand has taken a drastic hit alongside the reduction in supply of goods. As a general hypothesis, we believe that consumer demand will likely recover quicker than the supply of goods is able to meet that demand and we’ll be left with a large monetary supply overhang from these stimulating actions.
In order to stay concise we won’t dive into the following topics (perhaps we’ll discuss them in a future letter), but it’s important to understand that there are a variety of potential inflation tailwinds on the horizon:
The forgiveness of civilian debt, especially student debt (we're in the early innings of what amounts to a debt jubilee).
The strengthening of emerging market currencies can result in those markets being better able to service their dollar-denominated debt, decreasing overall dollar demand.
Countries are exploring alternative global reserve currencies to decrease their reliance on US monetary and fiscal policy.
A quicker than expected real economy recovery will result in far too much stimulus than was needed.
Adoption of Modern Monetary Theory (MMT) and/or UBI would result in continued dollar liquidity glut.
With this backdrop, the savvy investor must determine how to take advantage of the Fed’s behavior. We’ve long believed that shorting the USD would be ineffective as it requires taking a position against the dollar but in favor of another sovereign currency. With every country in the world taking equal or more drastic measures than the Fed, this is a foolish trade at best. Other currencies only have domestic (or regional) demand for the most part, while the USD has reserve and large commercial use status in other jurisdictions as well (see e.g. outstanding foreign USD-denominated credit in charts above).
Nevertheless, comparing the US Dollar to a non-sovereign currency in gold demonstrates the drastic effect of a decade of easy-money policies. And this effect is only just beginning to manifest. As investors are continued to be pushed out of typical safe haven investments in bonds by Fed purchasing activity (or as they reject these instruments as ‘safe haven’ because of the lack of inflation protection), they will further seek positions in hard assets such as gold and bitcoin.
We can’t stress enough how early it is in the inflation narrative. Most capital managers, newspapers, and news outlets won’t begin to report on this until after the effects of inflation have hit. We're witnessing gold and bitcoin begin their ascents as savvy and experienced macro investors build their positions. We’ve already established that we firmly believe bitcoin to be the best performing hedge against inflation for the near and medium term, and as such believe that it is severely underpriced at these levels.