Hugh Hendry is back writing after a long hiatus. His latest commentary to investors makes for good reading. His thesis: we are in a world of debt deflation for which there are no policy remedies; the Fed is fighting an uphill battle and it will lose. Long-time readers will now I agree with the thrust of Hendry’s core thesis. I certainly advocate some policy remedies, but I do not expect them to arrest the debt deflationary trend, simply to mitigate its effects.
He starts in on quantitative easing this way:
I fear that just as Whitman’s musings on sex and sexuality seem rather tame to the modern eye, a later generation might feel the same way about our squeamish reaction to the Fed’s initial stab at quantitative easing. They might guffaw, “two trillion dollars, how quaint. And they thought that might produce inflation!?” For a not so distant future generation may bear witness to far greater monetary debauchery.This has been my argument in April 2009. Given the impediment of such a large quantity of private sector indebtedness, I speculated that should the global economy suffer a further debilitating setback over the course of the next two years, the Fed and especially its acolytes at the Bank of Japan would print much, much more paper money. And only under such dramatic economic circumstances would we establish the pretext for a truly gigantic monetary intervention which would surely undermine the fiat system.
Today, however, we are learning that additional money, perhaps $600bn, is to be printed even without the occurrence of a serious crisis. This has come as something of a surprise to me. I had thought that intense scrutiny and political discontent from the US Congress would have tempered the ardour for such intervention. The QE announcement has also produced a rise in the risk premium associated with term structure. The yield on the ten year Treasury has shot up from just under 2.5% in August to almost 3% in November.
I see this episode differently. QE2 as the Fed’s latest campaign is called is really quite tame in comparison to the first. I have called it QE-lite. The Fed is not buying municipal bonds or targeting rates with a potentially unlimited supply of liquidity – although this may eventually come. In fact, the furore over QE2 is much bigger than the one over QE1 despite the fact that QE1 was a more radical program. So clearly, people have had their fill of the Fed’s prescribing more cowbell and the Fed has reacted accordingly by pulling in its horns somewhat. Hendry draws the right conclusion based on this – namely that the Fed has shifted private portfolio preferences as intended – mostly toward risk-on trades; however, the shift has been in the wrong direction for Treasuries i.e. a preference for shorter maturities over longer. The Fed had wanted to persuade market participants to move out on the yield curve and they have done just the opposite. So far, QE is a bust. Hendry has taken a hit as a result.
But what about what I have called the "Scylla and Charybdis flation challenge"? The Fed is conducting an expansionary monetary policy to counterbalance the debt deflation associated with the financial crisis. Who wins that tug-of-war? Here’s what Hendry says:
Evidently there is an all-out war being waged between what we might refer to as the Fed’s fiat money (the ability to increase dollar banking liabilities), and the private sector’s debt-based money (the willingness of the private sector to hold dollar banking assets). The market favours the prospect of fiat printing winning. Perhaps the outcome is a foregone conclusion. However, I continue to argue that the odds seem stacked against this outcome occurring in the short term. Consider that the US authorities are battling against the $34trn of gross debt added by the private sector since the start of Greenspan’s tenure as Fed chairman in 1987. This is a formidable obstacle to quantitative easing…
Exactly. How is the Fed going to be able to counteract $34 trillion of gross debt without going all-in. That’s the Schiff-Schilling debate, isn’t it? And it’s a political question: would the Fed risk extreme levels of currency revulsion and the attendant tax evasion of going all-in? Would Congress allow them to do so? For me the answer is no. You can certainly get other opinions from Marc Faber or Jim Rogers. But I am saying no. More likely, the Fed will have to rein in its horns – unless we hit a Depressionary spiral and then it can take more extreme actions like buying municipal debt or even corporate debt.
I couched it this way last year:
- Since state and local governments are constrained by falling tax revenue… and the inability to print money, only the Federal Government can run large deficits.
- Deficit spending on this scale is politically unacceptable and will come to an end as soon as the economy shows any signs of life (say 2 to 3% growth for one year). Therefore, at the first sign of economic strength, the Federal Government will raise taxes and/or cut spending. The result will be a deep recession with higher unemployment and lower stock prices.
- Meanwhile, all countries which issue the vast majority of debt in their own currency (U.S, Eurozone, U.K., Switzerland, Japan) will inflate. They will print as much money as they can reasonably get away with. While the economy is in an upswing, this will create a false boom, predicated on asset price increases. This will be a huge bonus for hard assets like gold, platinum or silver. However, when the prop of government spending is taken away, the global economy will relapse into recession.
- As a result there will be a Scylla and Charybdis of inflationary and deflationary forces, which will force the hands of central bankers in adding and withdrawing liquidity. Add in the likely volatility in government spending and taxation and you have the makings of a depression shaped like a series of W’s consisting of short and uneven business cycles. The secular force is the D-process and the deleveraging, so I expect deflation to be the resulting secular trend more than inflation.
- Needless to say, this kind of volatility will induce a wave of populist sentiment, leading to an unpredictable and violent geopolitical climate and the likelihood of more muscular forms of government.
- From an investing standpoint, consider this a secular bear market for stocks then. Play the rallies, but be cognizant that the secular trend for the time being is down. The Japanese example which we are now tracking is a best case scenario.
This has certainly been the path so far. I certainly don’t rule out a multi-year recovery; with more tax cuts and deficit spending, it almost looks like a base case again, frankly. But I expect weakness in the medium term and don’t intend to alter my longer-term view unless the data say otherwise.
Hugh Hendry has a lot more to say about this subject, the success of QE1, the divergence of interests within Europe and between the financial class and the common man and a lot of other related matters. This is thought-provoking stuff. The full letter is embedded below. Enjoy.