It's Inflation, Stupid!

Despite the rosy economic headlines cheered by the mainstream financial media (MSFM), the real challenges people feel in this economy can be summed up in one word: Inflation.
 

The current administration counters that the inflation rate is going down, but remember that it is not so much the rate of change of inflation as it is the level of prices. And it’s the price level that has rendered most consumers without savings, cash flow negative, and pushed asset prices to the brink of collapse. It is the primary reason consumer confidence is failing, and small business owners are burdened with a record amount of uncertainty.
 

The average American’s desperation when they go to the grocery store is in the data, just below the well-publicised talking points. For instance, the Michigan Consumer Sentiment Index is trending down with increasing consumer inflation expectations for the near term. Consumers also predicted inflation will be around 2.9% next year, up from their estimations in the prior month. Higher prices have remained a top concern, as 44% of consumers reported this as the primary reason their finances are perilous.
 

It is the same frustrating battle with inflation that is crushing small businesses. The NFIB Small Business Optimism Index continues to fall below the 50-year average of 98. The Uncertainty Index recently climbed to 103, the highest reading recorded. Nearly one-quarter of all small businesses said inflation is their number one problem. Again, not so much the pace of increase but the level from which it is rising. The fact that it is increasing is just salt in the wound.
 

US Consumer Delinquency Fears are the Highest Since April 2020, according to the recent Fed survey of consumers. The anticipated probability of missing a minimum debt payment over the next three months continues to rise, according to the New York Fed’s monthly Survey of Consumer Expectations results.
 

The US Conference Board Leading Economic Index continues to decline. Over the six months between March and September 2024, the LEI fell by 2.6%, more than its 2.2% decline over the previous six-month period (September 2023 to March 2024). ”Weakness in factory new orders continued to be a significant drag on the US LEI in September as the global manufacturing slump persists”, according to the Senior Manager of the Index.
 

US DEBT IS OUT OF CONTROL

According to Redfin, existing home sales recently hit their lowest level on record aside from the pandemic’s start. Pending home sales have shown some strength as home buyers submitted applications to buy a home in anticipation of the Fed’s oversized 50bps rate cut, which was supposed to be the start of a rate-cutting campaign that would lead to cascading mortgage rates. In sharp contrast, mortgage rates have not only not declined, as hoped for and advertised by the lemmings in the MSFM, but rather have surged past 6.8%, from just 6.08% on the day of Powell’s panic rate cut.

And this gets to the heart of the matter: interest rates are ramping up across the board, from Treasuries to Munis to MBS, because of the insolvency, illiquidity, and inflation issues associated with holding long-duration bonds. Indeed, the benchmark US Treasury bond has surged to as high as 4.3%, from just 3.6% on the day the Fed decided lower interest rates were precisely what the doctor ordered.
 

So, let’s unpack this as they say.
 

On insolvency, total US debt is out of control, racking up almost $500 billion in a matter of a few weeks. In comparison, the entire budget deficit was under $200 billion before the Great Financial Crisis of 2008. Uncle Sam’s interest payments were over $1 trillion this fiscal year. The national debt is now $36 trillion, 125% of GDP. And, looking ahead, the debt will rise to nearly $60 trillion in the next 10 years. That is, if everything goes unbelievably perfect. In other words, there will be no recession or inflation for the next decade. Of course, that does not include any of the bread and circuses schemes promised by our next President. So, you’ll have to add in whatever spending Kamala wants to do if she is allowed to send checks to everyone who wants to start a business, buy a first-time home, or have a child.
 

Bi-partisan estimates for Kamala’s spending plans will add $3.5T to the debt over the next decade. That figure is $7.5 for Trump. I estimate a lot less for Trump because his policies are more prone to spur growth. However, the main point here is the US is insolvent and getting more so by the day. That condition will worsen unless our next President has the guts to cut SS, Medicare/Medicaid, and Defense. But nobody is talking about that. Instead, both candidates promise to keep the status quo.
 

The Fed is doing QT on the Liquidity front while the RRP facility has been neutralised. It is just the TGA left, which should be exhausted by Q2 of next year. The free money pass is over, and the Treasury needs to issue new debt and roll over existing debt, sopping up all available funds.
 

On the inflation front, we have a Fed that has given up the fight for the middle class even though inflation has wiped out their purchasing power and prices continue to rise well above its asinine target. I say asinine because the Fed’s target should be 0 inflation, not 2%. Inflation has been above 2% for the past 43 months, and our central bank wants it to go higher. That is blatantly ridiculous! The bond vigilantes say that if the Fed no longer cares about inflation, we must care a lot more.
 

Investors fully understand how willing the Fed is to reduce the cost of money at the slightest hint of trouble in the labour market and the economy. In Pavlovian style, bond investors anticipate rates will be reduced to zero percent if needed. They have been well taught by Greenspan, Bernanke, Yellen, and now Powell that the Fed stands ready to take the bottom out of rates with alacrity. Therefore, Wall Street has already front-run all of the rate cuts in the pipeline. This means further interest rate cuts on the short end of the yield curve, which the Fed controls, will only push higher rates on the long end of the yield curve – and that is precisely what is happening.
 

For example, when the Fed started cutting rates in the summer of 2007, the Fed Funds Rate (FFR) was 5.25%, yet the 10-year note was still slightly above 5%. In a normal rate-cutting cycle, both short and long-term rates fall. This reduction in borrowing costs lowers the burden on consumers and corporations’ debt service costs; thus, it helps remediate the recession.
 

UNCHARTERED BUBBLE TERRITORY

In sharp contrast, this current rate-cutting cycle began with the Effective FFR at 5.3%, but the 10-year note had already anticipated Powell’s well-telegraphed cuts and was trading with a yield of just 3.6%, not 5%. Even if we have a soft economic landing and inflation gracefully retreats to the Fed’s target, nominal GDP growth should be around 4%.

 

Historically, that is where long-term rates tend to trade. Long-term interest rates are most concerned about inflation and insolvency. With $2 trillion in deficits, $1 trillion in interest rate payments, and a $35 trillion national debt (125% of GDP and 720% of revenue), significant solvency concerns have become manifest. In addition, we have a Fed that is now aggressively trying to push the inflation rate higher even though the level of prices is crushing the bottom four quintiles of consumers, and CPI is still well above Powell’s 2% target.
 

This is why the 10-year Note yield has increased since the Fed cut the FFR on September 18th. That isn’t supposed to happen after a panic rate cut on the overnight interbank lending rate. Do not forget that fixed-rate mortgages are tied to 10-year Treasury. That is not good news for a housing market, which is already frozen shut.
 

The bursting of the bond bubble isn’t going to go well for the most expensive stock market in history either. Looking at the most important and accurate valuation metrics of price to sales and the total market cap to GDP, the market is in unchartered bubble territory. In fact, Treasury T-bills pay more interest (4.9%) than the future earnings yield of stocks 4.7%, and trounces the 1.3% dividend yield of the S&P 500. The truth is; passive, indexed, target date and buy-and-hold funds, have left households dangerously exposed to a stock market correction. Households now hold 42 percent of their entire total financial assets in equities. That marks the highest level of those domestic holdings in equities since records began in 1952.

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Spiking bond yields are the Achilles heel of this market. If they continue to rise, it could freeze up the repo market, leading to a bear market in equities. For now, investors should enjoy this bull market higher. Nevertheless, they need to also keep a close eye on the credit markets for the signal to cash out before the inevitable reality check begins.   EG