2020 is calling and it wants its money back. And at this point, so does 2008.

Back then, printing money and getting interest rates to unnaturally low levels felt like a no-brainer – a solution to stave off financial disaster.

And during times of crisis… it is.

But in the long run, all you’re really doing is borrowing from the future to pay for the hard times of today. That’s because at some point all that printing does turn into inflation, despite what some economists believe.

And now that debt is due. At first it was a necessity…

The Origins of Today’s Inflation Debt

During the 2008 Financial Crisis, former Fed Chair Ben Bernanke saw the financial markets freeze, liquidity dry up, and credit become non-existent.

In order for the financial system to work, banks need to trust each other. Without trust, there’s no lending, no credit, and no financial system.

It’s interesting to note how perfect Bernanke was for the job at hand. Some even said he was divinely chosen to lead the Fed.

He was an expert in the intricacies of the Great Depression. And he knew that without an enormous injection of liquidity into the system, the Financial Crisis would turn into the second Great Depression… maybe worse.

So unprecedented measures were taken to stave off a repeat, and it worked perfectly. But necessity turned into addiction.

When the good times were back, central banks didn’t scale back their balance sheets. They continued with unnaturally low interest rates. 2020 was even worse…

For the first time, monetary accommodation from the Fed was combined with the government putting checks into the hands of Americans. People were paid to stay home, whether they needed to or not.

That was fine in 2020, when we needed it. But it continued in 2021 when it was clear we didn’t.

There were massive spending bills and continued hand-outs at a time when the global economy was back on track – and even exceeded pre-COVID levels.

And all we got from the Fed were quotes like, “we’re not even thinking about thinking about raising rates.” But all of this does something else that most people don’t see…

It causes bad behavior… overspeculation with too much leverage.

And when financial institutions get margin calls, they begin selling wholesale to meet cash requirements, which is what actually triggers financial panic.

They also tend to do it at the same time.

Cracks in the System Are Showing

We got a snippet of that from the events that just unfolded in the U.K. The Bank of England (BOE) had to step in to avert a “Lehman moment” of its own sovereign bond market.

The reason, once again were margin calls.

Institutions holding gilts were on the wrong side of the trade as rates were rising and triggering a cascade of selling. That’s why you may have seen rates skyrocket here in the U.S. earlier in the week until the BOE stepped in.

I’m not blaming central banks for easing financial conditions during recessions. That’s their job.

I’m blaming them for keeping it there when the economy no longer needs it. When we recovered from the 2008 and 2020 crisis… they insisted.

When a sick patient is cured, they don’t continue taking medicine. And if they do, ultimately, they’ll need medicine for the medicine they didn’t need in the first place.

I don’t think we’ve truly seen that yet. So far, all we’ve seen is the stock market enter a bear market. But as we saw this week, there are plenty of cracks in the system that no one sees coming.

In fact, it’s over a decade’s worth of cracks that may have seeped into the very foundation of the global economic system. 

For instance, the 1997–1998 Asian financial crisis began in Thailand as a currency crisis when Bangkok unpegged the Thai baht from the U.S. dollar.

Back then, this set off a series of currency devaluations beyond most people’s radars.

Inflation Is All About the Velocity of Money

Over the last decade, global central banks have confused the lack of material inflation as a nod to continue propping up the market.

Some went so far as to surmise that inflation is forever dead… that they have re-engineered the laws of physics.

But it’s Newton’s second law that has me really worried… which states that the force on an object equals its mass times its acceleration.

In economics, this acceleration is called the velocity of money. It’s calculated as aggregate prices over money supply.

Velocity will rise if prices rise and money supply stays the same, or if prices stay the same and the money supply shrinks.

But it’ll explode when prices rise and the money supply shrinks at the same time… which is what’s happening right now.

The Fed is in the middle of shrinking its balance sheet, and that process known as “quantitative tightening,” is now set to accelerate.

And as you can see on the chart below, the last time we saw real inflation – during the 1970-1980s – velocity was rising hand in hand with inflation, feeding on itself…

Unfortunately, this is where we seem to be headed. That’s why the last Consumer Price Index (CPI) report was so consequential.

It showed inflation is rising, despite commodities recently falling – a sign that inflation has become much more than just commodities or shipping rates.

As the Fed runs down their balance sheet, velocity will only increase until prices fall.

So, what we’re witnessing now is not just a bear market… but the beginning of a return to equilibrium. I doubt there’s anything the Fed can really do other than crash the economy.

Amid the recent price decline in the market, one big looming event is coming up in mid-October – and that’s earnings season.

I believe the only reason the market isn’t much lower already is the strong showing from corporate earnings this summer, which spurred the summer rally.

But, the market is forward-looking. And if earnings have peaked, which is highly probable, then this is just the beginning.

Pre-COVID levels on the S&P 500 are starting to dial in… it wants its money back too.

Regards,

Eric Shamilov
Analyst, Trading With Larry Benedict

Reader Mailbag

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– Chuck O.

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