The Dance Between Liquidity - Asset Inflation - Consumer Inflation and Monetary Policy

As we find liquidity once again entering the global financial system and monetary policy being loosened - amid consumer inflation coming down - looking forward at the macroeconomic picture, we expect liquidity to rise exponentially. Today we look at how this will affect asset inflation, consumer inflation and ultimately - monetary policy.

Why liquidity looks set to increase.  

1. Bond yields are dropping, and bond values are increasing.  With banks holding massive reserves of US bonds, their collateral holdings increase in value - increasing their overall capacity to issue debt - and inject liquidity from the private sector.
2. The U.S. Fed Powell adopted a decisively dovish tone in his recent annual address at Jackson Hole saying the “Time has come” to reduce interest rates. Additionally, central banks in the UK, Eurozone and Asia have already started cutting interest rates - paving the way for the U.S. to follow - in today’s globalised economy, central banks will usually move policy in tandem. Most importantly - with bond yields dropping - we know that the U.S. Bond markets, the biggest and “smartest” money in the world - have historically front-run the U.S. Fed’s interest rate policy. A signal from the big players that rate cuts are imminent. Lower interest rates increase borrowers’ capacity to service larger amounts of debt.

   

With bond yields falling off - the U.S. interest rates usually follow - with the big players signalling an expectation of rate cuts coming soon.

Increased liquidity leads to asset inflation first… then consumer inflation.

With lower interest rates on U.S. dollar deposits and lower yields on U.S. government bonds - investors are encouraged to move capital away from the U.S. dollar to seek returns elsewhere - moving liquidity towards assets like gold, silver, land and stocks. Increasing liquidity (supply of dollars) reduces the value of the individual dollar units - raising the value of assets priced in dollars like gold and bitcoin, U.S. land and U.S. stocks. 

While asset inflation (gold, bitcoin, land, stocks) moves near lockstep with liquidity, consumer inflation (bread, eggs, clothing) tends to lag by approximately 18 months. This gives us 18 months of low consumer inflation, falling dollar value, and high asset inflation amid increased global liquidity - resulting in greed, euphoria and complacency. 

The consensus that inflation is fixed would permeate - with investors seeing blue skies ahead. This also aligns from a timing perspective - on the final phase (called the “winner's curse” phase) of the 18.6-year economic cycle - which we are currently on track to enter. This phase of the macro cycle is typical of assets becoming exponentially overleveraged and overvalued - leading to parabolic price increases across the board. However, as history has shown time and time again - parabolic price increases tend to resolve spectacularly to the downside - amid broad-based complacency - leading us into an “unexpected” crash.

Eventually, liquidity finds its way into the grocery store and the benevolent central banks are “forced” to step in once again to fix a problem they created in the first place (consumer inflation is back!) - by tightening monetary policy. So, liquidity influences Inflation, which influences monetary policy, which influences liquidity - and the dance starts all over again. 

Looking at the bigger picture of where we sit in the 18.6-year economic cycle it would be reasonable to expect this next correction to be a big one - involving broad-based systemic failures, similar to the 2008 “Great Financial Crisis” - potentially at the scale of the “Great Depression” nearly 100 years ago. In the typical fed fashion of acting too late, in a system that might be unable to handle tighter monetary policy this time around, it is possible that the 2, of the 1-2 punch, is the hit that causes these broad-based systemic failures - the details of which are yet to be revealed.

While gold and silver increase in value with increasing liquidity during the euphoric phase (and experience some short-term volatility during the crash phase) - they continue to increase in value through systemic failures - while stocks and land struggle - as investors and institutions seek shelter, during the storm of systemic collapse.  

During the GFC in 2008, gold continued gaining value while the S&P spent years recovering.

While land and stocks can be dicey to navigate during these final few years of the macroeconomic 18.6-year cycle – gold and silver provide steady growth - and shelter from the storm – away from the emotional cycle of euphoria and panic – during this phase.