Fed, ECB’s QE-driven inflation – who blinks first?

Enormous, unsustainable QE continues unabated which means that Federal Reserve, European Central Bank, Bank of Japan continue to expand M2 monetary supply on an (unfunded) basis post-GFC and post-COVID. RRP reverse repos data tells the chilling tale of central banks continuing to expand monetary supply, leading to massive inflationary trouble down the line. The key to post-COVID economic recovery was always built on productivity, yet this does not seem to be the focus of governments and central banks who seem more intent to print money on an unfunded basis without much regard to the underlying dangers of risking unbacked currency collapse. Since the collapse of the Bretton Woods system of backing currencies with gold, fiat currencies have been operating essentially on an unbacked basis. Some argument can be made for a currency being somewhat representative of the strength of its overall economy – but this is not relevant to the core intrinsic backing of any one currency. Whatever remedial policy action by central banks that may be taken down the line is highly likely to be too little, too late.

In terms of Gold holdings per country or monetary region (Euro) – arguably a worthwhile exercise given the multiple claims of the impending demise of the world’s global currency, the US dollar, or the Eurozone’s Euro – it is worth noting the current state of play. Theoretically at least, you could make a case for gold holdings being a factor in the event of a major currency crisis – a kind of underlying currency backing, if you will. The US has by far the largest gold reserves (8133 tonnes) well over double Germany (3359 tonnes), and more than Germany and Italy combined. Naturally, Germany no longer has its own currency – but recent evidence indicates that some 6.3BN Deutsche Marks are currently held in Germany – an astonishing statistic for a country which has long since given up its national currency – and, potentially, a worrying indication – along with the size of Germany’s gold holdings – that holds a contingency position to exit, in extremis, a collapsing, debt-laden Eurozone. The size of Euro Area gold holdings is particularly modest (505 tonnes) – what is notable is the amount of Eurozone countries with their own gold holdings, with Germany (3359 tonnes), Italy (2452 tonnes), France (2436 tonnes), and even The Netherlands (612 tonnes). Speculation of a rise in gold holdings by China (1948 tonnes) and Russia (2299 tonnes) amounting to a potential attack on the US dollar has to be weighed up against the immense amount of gold already held by the US relative to other nations. It should be noted that after the infamous “Brown bottom” moment when Gordon Brown sold off over half of the UK’s gold reserves between 1999 and 2002 – at the bottom of the market – to pay for his pension policy plans – against the advice of the Bank of England – the UK has relatively low gold reserves (310 tonnes).

It is clearly ill-advised for central banks to swell the monetary supply on an unfunded basis, which can end up creating a very false impression of performance and deficit status. The two major world currencies, the US Dollar and the Euro, are highly vulnerable under such prevailing circumstances – entirely driven by the Federal Bank and European Central Bank’s persistent unwillingness in recent times to curb excessive post-GFC printing of money, or quantitative easing (QE). Any tapering of QE will, by necessity, need to be followed by a rise in interest rates in an effort to stave off inflation created by the unfunded expansion of monetary supply. Incredibly, both have disingenuously claimed that the inflation of their own making is merely “transitory” (Jay Powell, Federal Reserve) or “temporary” (Christine Lagarde, European Central Bank). Latterly, Powell has distanced himself from this type of characterisation – but there is strong justification for levelling “too little, too late” criticism at the major global central banks. It should be noted that there have been major concerns voiced at European Central Bank Council level – particularly from German quarters – as to the strength of inflation and the dangers posed by moving poorly collateralised positions into a Target 2 which is reaching frightening levels of liability. Liability well in excess of $10TRN going forward does not seem at all unrealistic. Let us not forget that Christine Lagarde, now ECB Head, is the former France Finance Minister under investigation who was more than happy to gloat, alongside now-disgraced IMF Chief Dominique Strauss-Kahn – at what a mess the US had made of its economy in the GFC retrospective film “Inside Job”. Not forgetting Lagarde’s treatment of Greece whilst Head of the IMF – ensuring 2-3 decades worth of recession on the Greek economy after her inflexibility and ruthlessly hardline response to its economic crisis. Whilst we now witness her crashing the Eurozone for all it is worth to support the likes of indebted France, Italy – showing a plain lack of monetary policy ability or experience – a key tenet of the ECB Head role, as exemplified by the Draghi years. In the Eurozone, rules are always applied differently – depending on the Member State concerned – with Germany, France, Italy endlessly accommodated. What goes around, comes around…

Nevertheless, the political objectives of the Euro Project mean that the ECB will continue to try to mask the fragility of its Member State economies by pressing on with further QE in a vain effort to cover individual government deficits. Particularly given the recent demand by President Macron of France and Prime Minister Draghi of Italy that Brussels loosen its spending rules whilst France and Italy break EU rules on debt to GDP, deficit levels. Further echoed by Greece, who wants EU debt rules relaxed. This presents the ECB with a double whammy down the line – press on with money printing, increasing inflation, or taper and increase interest rates to contain inflation, creating havoc with indebted Member States dependent on the ECB’s QE drip feed to their economies already lacking underlying productivity. The ECB cannot continue to serve two entirely separate, distinct, and divisive masters indefinitely – namely, the fiscal prudence demanded by the EU’s North, versus the fiscal looseness, or flexibility – demanded by the EU’s South.

Much continues to be made of the potential demise of the US Dollar. Despite the more obvious fall guy – namely the Euro – with the ECB’s current QE program equivalent to 80%+ of total EU GDP. Far in excess of the Bank of England at 41%, or the Federal Reserve at 38%, and heading towards the unenviable 130%+ level of the Bank of Japan. Indeed, it is worth noting that much of the noise surrounding the supposed demise of the US Dollar is from US and Gold, Silver quarters. Which does not reflect the huge strides made by the US Dollar in recent decades as the only true global currency with reserve currency, forex and commodities-backing status – not to mention geo-political, extra-territorial sanctions clout where US Dollar exclusion for non-US financial institutions is a clear and present danger. The Euro possesses none of these qualities yet is strangely overlooked as the most obvious major currency collapse candidate of the two. Indeed, it is not remotely unreasonable to suggest that the Euro as a currency may struggle to see out the 2020s intact. In many ways the currency markets have already made up their mind. With the Bank of Japan’s deflationary, decades-long policy a harsh reminder of the dangers of expanding the monetary supply on a low interest rate basis ad infinitum. True productivity, as ever, is the key ingredient and way forward. The UK – freed from the burden of EU tariffs and obligations – should continue to see exponential, productive growth globally – and be a major beneficiary. But it must prioritise productivity and go global at all costs. The inflexible, non-pragmatic Eurozone will, inevitably, be left behind.

As yet, based on the current inflation calculation methodology adopted by the major central banks, inflation has yet to correlate fully to the massive expansion of money supply. Yet the indicators are certainly there. In Germany, for example, producer price inflation was 19.2% in November 2021, and this will inevitably feed into consumer inflation before long. The former methodology used to calculate inflation is producing some extraordinarily worrying data – pre-1980 methodology shows current consumer inflation levels – when many inflation inputs (long since omitted from official figures) are factored in – running at clear double digit levels, with official figures running at a mere 5% or so. This can only mean one thing – rampant inflation coupled by major interest rate rises is all but inevitable. With poorer quality collateral used to prop up funding by the European Central Bank than even in the US, defaults across the major systemically affected EU banks are inevitable, as their exposure to the unfunded money printing machine that is the ECB is so high, and the entire system has been accustomed to near-zero level interest rates for a sustained period.

Any necessity to quell very evident raging inflation by even slight interest rate hikes will cause disproportionate damage to debt held at prevailing, low rates. Here, the quality of collateral for debt, as ever, will come to the forefront. It is certainly the case that the ECB is prepared to accept poorer quality collateral than the US as a basis for QE – the wider ramifications of a major default moment or currency crisis across the entire Eurozone would be profoundly felt across all 27 EU Member States. So a hike in interest rates – as the ECB is only too well aware – could have a major knock-on effect for more vulnerable EU Member State economies of the South reliant on the constant QE drip feed from the ECB. Whether or not this would provoke a Eurozone exit from a disgruntled North remains to be seen. Of course, the US and other major nations would not be unaffected – having become used to low interest rates for such an extended period of time. US low grade junk bond debt, for example, remains at elevated levels and would be disproportionately adversely hit by any interest rate hike by the Federal Reserve. The more acute inflation levels we are already seeing on a producer price basis and based on a more candid appraisal, 1980 methodology, of true inflation levels, mean that the interest rate hikes required to stave off inflation will need to be significant. The Eurozone is particularly susceptible to major collapse as its entire monetary policy thrust is politically motivated and entirely mis-directed – given the wide disparity and mismatch of the EU Member State economies under the ECB’s purview. As a share of total GDP, the monetary expansion policy of the ECB is unabated and heading closer towards excessive Bank of Japan levels than the Federal Reserve and the Bank of England.

Geo-politics, and the wider geo-financial risk element that is so evident in the post-9/11 US sanctions era, are ever-present as we observe the global tussle between the US and its allies, NATO – and the combined might of China, Russia and their acolytes. From South Sea China military build-up to Ukraine, Afghanistan, Iran and its proxies – Vienna Talks and hopes of JCPOA revival, Russian Gazprom’s Nord Stream 2 gas pipeline ostensibly designed to supply energy to the European Union, yet under US sanctions – there are few economic and strategic activities at government level which do not involve head-to-head geo-political engagement and potential US sanctions exposure, or, more menacingly, the prospect of US dollar exclusion. President Biden’s move away from former President Trump’s unilateral “America First” policy approach to a more multilateralist one has led to a far more acute impact on nations on the receiving end. Multilateralism is far more powerful by comparison – and thus far more likely to lead to eventual conflict as disgruntled nations find themselves globally hamstrung by major multilateral restrictions. To date, the likes of Russia and China have been adept in handling the disparate nature of the European Union’s foreign policy approach – with each Member State being approached due to the overall lack EU foreign policy – aside from very broad overall objectives and guidelines. With energy price inflation a major concern, this selective approach to energy policy is bound to lead to Nord Stream 2-related trouble for the EU down the line – with energy supply dependence on Russia so evident amongst many EU Member States.

Coupled with these issues – particularly the pressing concern that central banks may be prevaricating on taking affirmative action to quell the inflation that they set in motion – is the impending property collapse in the Chinese real estate market. Evergrande has been the poster child for the frightening potential levels of liability relative to the size of China’s overall economy – roughly one third of exposure. But a veritable cascade of contagion is occurring now with many major property developers affected, and the supply chain dislocations brought about by persistent COVID-related worries are not helping. China’s cement production and excavator sales – two very common forward property Construction indicators – are hitting lows – indicating the sorry state of affairs. The confluence of policy errors – from central bank monetary expansion inducing inflation to President Biden’s ill-timed major spending plans of beyond Keynesian proportions – to President Xi’s apparent lack of awareness of the contagion impact of shutting down – or restricting – entire areas of commercial activity (property, private education, crypto mining spring to mind) – is having huge global knock-on effects.

President Biden’s foreign policy errors – the hasty, premature withdrawal from Afghanistan an unwanted example – likely merely to empower the likes of Presidents Putin, Xi – and, on recent evidence, Iran – to provoke the US into submission. After President Trump’s more strident, ex-diplomatic foreign policy approach, there is no doubt that such major non-democratic global nations regard President Biden as a soft touch by comparison. That said, US sanctions policy – at least in terms of volume of designations, if not robust policy action per se – would indicate that President Biden may be far more strident that assumed. Indeed, his strident take on human rights abuses – as defined by the US – would indicate that Russia, China, Iran are entirely susceptible to sanction and censure.

Crypto has been the focus of much recent attention, and has swelled to a multi-trillion dollar market. Inevitably, and one would do well to caution this type of approach, the usual investment parameters and prevailing assumption criteria continue to dog this somewhat unique investment instrument. It is very evident that the very origination or inception of the likes of Bitcoin came about in the throes of the Global Financial Crisis (GFC) for very good reasons. So – whilst understandable, the use of existing parameters or valuation techniques for predictive or retrospective purposes must be conducted with great care. As a specific attempt to delineate itself from existing fiat, market parameters, crypto and the Metaverse must be treated very differently from other financial or investment instruments.

Treating them as mere alternatives to existing commodity or currency, stock investments is a very dangerous game indeed – likewise the chartist preference for reading trends in retrospective-to-forward-basis fashion. Naturally, crypto is becoming more mainstream and companies, countries, institutions are starting to adopt it. Exogenous risk is now a relevant factor for crypto and crypto mining in general – as by definition overall economic prosperity, infrastructure (or apparent liquidity via government COVID, QE, low interest leverage/credit) is key to any investment. That said, we may see continued attempts to revamp environmentally-friendly energy projects used to support crypto mining in jurisdictions in need of an economic boost – as low electricity prices are key to profitability for crypto miners, and environmentally-friendly energy often on the receiving end of government subsidies. Certainly, it is well worth noting the 5-year performance of “Innovation” investments – which now include crypto, ARK’s ARKK, S&P500 – which carries so many top global Big Tech names, Tesla. Versus the lacklustre performance of gold, silver, top European stocks under Germany’s DAX – the “non-Innovation” component.

What is so interesting about the march forward of established investments in the likes of Bitcoin, Ethereum and further NFT, Metaverse positions is the motivation for doing so. This behavioural aspect is perhaps key to identifying why this area has been so misunderstood to date. Simply put, the prevailing expertise behind market observance is not geared up to handle the level of active investor (often Retail) engagement sometimes witnessed in these newer markets. For sure, institutional engagement is critical and on the rise, but the social media spread of information, the global market access to investments on a very lightly regulated basis – and the 24/7, cross-border nature of crypto trading makes for a highly volatile, reactive and sensitive market environment. Which cannot be easily extrapolated into a bunch of chartist generalisations, candlestick-type indicators, and the like.

The true role of crypto as the ultimate recession hedge to prevailing status quo of financial markets, market observance assumptions has been widely tested since, for example, the inception of Bitcoin in the aftermath of the GFC. We should expect to learn a good deal more about its ability to withstand (or not) the pressures that a global economy facing, potentially, all of the following – in no particular order: inflation, stagflation, deflation and recession. But it is unlikely that this will be achieved with any great clarity unless its fundamental purpose – as a store of value, transactional utility – regardless of prevailing economic conditions – is understood. For sure, charting the various low/high test levels is of interest – as are comparisons with how the likes of gold, silver – the classic inflation hedges, or “Innovation” companies – are faring, will be somewhat instructive. But the overall impression based on the evidence to date is that crypto is a stand-alone asset class. Any perceptible “bubble” narrative may be justifiable only provided market observers are willing to admit that all commodities, Tech, even currencies – started off in exactly the same position – and Bitcoin, for example, has been running for well over a decade now. The now $2TRN+ crypto market means that this is a serious player which may, along with the staple inflation hedges gold and silver, be another component worth considering in recession, inflation-“proof” portfolio allocation. With the S&P 500 returning 28% in 2021 – and so many major, established companies including crypto activities or acceptance – there is a strong basis for arguing that the crypto “moment” has already arrived. Many major investors would be delighted with those sorts of returns – versus, for example, China real estate in 2021.

As Mark Twain was famously quoted as saying: “…Reports of my death have been greatly exaggerated…” It seems highly likely that the same will be true of the US Dollar and Crypto – although the latter for sure – as with all investment types – will have its winners and losers. Whether the same can be said of the Euro and the Eurozone is a different matter. If the ECB continues on its current course of having to serve two masters – North and South – eventual rupture in continued challenging COVID economic conditions – is inevitable. Ironically, the timing of the far from enlightening Brexit moment could not have been worse for Brussels – as losing touch with London as a key global European financial centre at this juncture nothing short of calamitous.

The UK’s GDP has grown to $3.2TRN (source: worlddebtclock.org) with the same source putting France – its most relevant comparator – at $2.7TRN – after the UK ended a poor 2020 at $2.7TRN. Whilst only a small economy relative to the total size of the EU, the UK’s wider global trade partners have not held back in awarding it – crucially without the encumbrance of EU tariffs, budgetary payments – major trade deals almost immediately. Critically, these can feed in quickly to overall economic output. The more localised pan-European business engagements, however, continue to be troublesome – which will inevitably impact the EU more than the UK – who is far less dependent on EU trade than the disingenuous “44% of UK exports go the EU” refrain attempts to portray. As this represents a mere 10% of total UK economic output – as the UK is now predominantly a service-oriented, not export-oriented economy. And has been for some time. Whilst 10% still represents a large slice of the economy, it is easily replaceable given the wide, often free trade partners the UK has around the world – now trading under non-EU obligatory trading conditions.

It is now the great irony that after another sustained period of low interest rates – now coupled with extensive money printing QE on the part of the Federal Reserve and the ECB – that with US junk bond levels highly elevated in the US after a record $500BN sold in 2021 – we are back, post-GFC – to square one. Any uptick in interest rates from the Fed – now inevitable – will lead to major repercussions in the US junk bond market, defaults and failures being commonplace. President Biden’s frantic efforts to up public spending in the US are not going to help. Naturally, China is hardly in a strong position with a failing property market, brakes put on its productivity by President Xi. Nor is the Eurozone – artificially keeping interest rates at unsustainably low levels to placate the heavily indebted EU South dependent on the drip feed of ECB inflationary QE. In terms of global players, there are therefore weaknesses everywhere as the world tries to emerge from COVID – desperate for meaningful recovery, productivity. Should the Eurozone come under further pressure – as is highly likely given prevailing rates of inflation – the UK may find itself well placed as a sovereign nation with its own currency, global trade possibilities – to weather the various post-COVID storms it faces. As for the US – President Biden now faces his own moment with destiny – as the 2022 Midterms will provide a strong indication of how he is faring – and the omens do not look good given his falling popularity and the even worse popularity of his Vice-President Kamala Harris. Far from the “dream ticket” that was hoped for – and, at least on current evidence – hopefully alternative candidates will emerge in the interim, setting up the rather dubious prospect of yet another geriatric 2024 US Presidential election campaign with Trump (78) v Biden (81) II. Quite how this represents the best of US leadership talent is anyone’s guess. Particularly amidst further complex geo-political trouble with Russia (NordStream 2, Ukraine), China (Uyghurs) and Iran pushing the limits against the world’s major superpower, the US.