Liquidity and inflation

I want to expand a bit on market liquidity and why modeling it is so crucial to the economy, inflation, and money management. Liquidity is the progenitor of Pento Portfolio Strategies’ Inflation Deflation and Economic Cycle (IDEC) model. It is the primary force behind what drives the inflation/deflation dynamic and, ultimately, the direction of stocks, bonds, currencies, and commodities.

The Factors affecting liquidity are bank lending practices, the level of real interest rates, debt and deficits, credit spreads, financial conditions, the direction of the Fed's balance sheet, the RRP, and the TGA. The IDEC strategy specializes in mapping this dynamic.

Liquidity is needed for the proper function of money markets, which involves the trading of short-term debt (commercial paper & the repo market, for example). Hence, it is the plumbing for the entire financial system, including shadow, commercial, savings, and investment banks. Thus, it runs the whole economy. When liquidity runs dry, the economy grinds to a halt, and of course, this causes capital markets to falter. Rcessions/depressions and deflations are the results. When liquidity is sufficient, the economy and markets function normally. But when liquidity is superfluous, inflation can run intractable.

There is much debate and confusion about the causes of inflation. Central banks do not understand the real cause of inflation; and also cannot measure it accurately. Inflation is not caused by prosperity or high rate of employment. It isn't even about supply shocks—they are a symptom of inflation.

Inflation is the result of market losing confidence in a fiat currency's purchasing power due to the profligate actions of a government and its central bank.

Of course, the Fed gets this all wrong, and some high-profile money managers and market pundits even hold a very sophomoric view of inflation. The Fed is wedded to the inane Philips Curve theory, which believes inflation comes from too many people working.

Some money managers believe that quantitative easing (QE) and a zero interest rate policy (ZIRP) do not necessarily result in inflation. But this is a fallacy. The Fed creates high-powered money, credit, and reserves through fiat. This money is used to buy banks' assets such as Treasuries, MBS, and sometimes even corporate bonds. The banks then take this credit to buy more of the same—sending the prices of assets much higher as these rates fall. Artificially low interest rates lead to capital misallocation, raising real estate and equity prices. Therefore, programs such as QE and ZIRP lead to asset price inflation and bubbles. Some may argue that asset price inflation is not real inflation…but it is.

The expansion of bank credit can lead to a broad-based increase in the money supply if the increase in bank reserves also leads to an increase in bank lending. When governments run huge budget deficits, banks tend to use these reserves to monetize government spending, leading to an increase in the broad-based monetary aggregates.

Since the government is a very inefficient distributor of capital, the new money creation goes towards consumption rather than capital investment. This exacerbates the supply/demand imbalance, and CPI runs rampant. This was the case in post-COVID era of helicopter money. Governments sent out checks, and they were monetized by private banks using the reserves printed by central banks. Much of this money was used to pay people not to work, resulting in the classic definition of inflation:  too much money chasing too few goods. If you don't understand these fundamental concepts, you should not be managing money; or sitting at the head of a central bank.

If the Fed isn't concerned about America’s inflation and insolvency issues, then the bond vigilantes must care much more. Inflation remains an issue due to the $2.3 trillion excess reserves poured out of the Overnight Reverse Repurchase Agreement Facility (RRP facility) and into the economy over the past three years. But that process will exhaust itself imminently, which should be a significant change in store by the second half of this year.

But for now, inflation has destroyed the purchasing power of the middle class and the poor. Inflation is causing rates to rise, and rising interest rates are the predominant problem facing markets in early 2025.

The major issue facing the U.S. is the same across most of the developed world: The highest real estate values and equity valuations in history exist while the level of global debt as a percentage of GDP is at a record level. The $37 trillion U.S. debt and the $1 trillion-plus per annum debt service payments on that debt are pouring a tsunami of issuance into the debt markets. These dangerous conditions exist just as interest rates are rising to levels not seen in decades across the globe. The Japanese 10-year bond yield has been the highest since 2011, and UK borrowing costs have been the highest since 1998. Not to be left out, U.S. benchmark Treasury rates have climbed to levels last witnessed in 2007, just before the GFC.

This is happening as central banks are trying to push rates down. But, as they reduce short-term interest rates, which are the rates they directly control, longer-duration rates are rising. This means that central banks could lose control of the yield curve.

What will surprise Wall Street is that governments are rendered powerless to prevent the rise in yields when inflation and insolvency risks are the salient issues. After all, what governments have done in the past to "fix" problems in the economy, stock, and money markets is to borrow and print money to bring down borrowing costs. After all, that is what they do best.

But what happens when governments are already choking on debt and inflation has already destroyed the living standards of many Americans? Those inflation fears are fresh in the minds of the bond vigilantes, causing bond yields to rise. Therefore, any further increase in deficit spending that is monetized by central banks only validates the insolvency and intractable inflation concerns—sending higher borrowing costs. Thus, making the problem worse.

When bond and stock prices are both in a bubble, the buy-and-hold, 60/40 portfolio becomes a recipe for disaster. A robust model that capitalizes on these boom/bust cycles could help ensure your retirement nest egg doesn't go down with the ship.