There’s still a bullish cohort out there arguing that the inflation outlook isn’t so bad, that the oil spike will be temporary, and that consequently US stocks are now a buy here due to the price “correction” the market has already suffered.
Uh… nuh uh.
There’s a debate raging over whether the Iran War oil shock is inflationary or deflationary. That is not the question though. The right questions are:
- What happens as the deficit expands to fund Trump’s war whims,
- Where the deficit spending goes,
- And whether the Fed’s inevitable response produces the same outcome it did from 2009 to 2021, or something different and uglier.
CPI is not one thing and treating it as one number is misleading. Energy is 7% of the index but its inflationary reach is broader. It’s an input cost embedded in virtually every good that gets manufactured, packaged, and delivered. At the same time, housing is 40% of core CPI and is deflating, but the numbers won’t show up until late this year.
The shelter component of CPI does not use home prices, which have turned flat. It use owner’s equivalent rent (OER), a fictitious construct loosely based on a survey of renters’ contract rents. Contract rents lag market rents by a year or more and are still minimally rising. Market rents are already negative year over year. The shelter component of CPI is still rising, giving a false impression of inflation in the headline number. Consequently it doesn’t really reflect current reality.
Even with full energy transmission through goods prices, the math favors deflation in the headline number by next year. Claude, my AI OnlyFans helper, called it, “A fire in one room, a flood in another.” The headline CPI number tells you nothing useful about either.
What the oil shock does do is squeeze consumers. They spend more on energy and cut back everywhere else. The economy slows.
When the economy slows the US federal deficit blows out automatically. Unemployment benefits, Social Security and food assistance all kick in without any act of Congress. That matters because this spending goes directly to people who spend every dollar immediately, on food, rent, and gas.
This will be unlike the post-2008 QE. That appeared first in Primary Dealer accounts, and the dealers spent it buying more Treasuries, and, at the margin, using it and leverage to add to their inventories of equities. Institutional and retail customers then piled on in an endless positive feedback loop for the 12 years of QE. That drove financial asset prices higher without ever reaching a grocery store. Stock prices kept rising, only pausing or pulling back when the Fed paused the QE machine, aka the “printing press.”
This time, the money that comes when the current QE program is enlarged will hit consumption goods with full force because significant deficit spending will be directed toward the consumer, and industries that will send additional flows toward economic consumption, not speculative financial activity.
The supply side compounds this. Gutting immigrant labor doesn’t just push wages up, as producers compete for scarce labor. It creates genuine agricultural supply destruction. There aren’t enough workers to harvest crops or butcher chickens. This creates cost-push inflation in food staples that monetary policy cannot touch. You can’t solve a harvest shortage by slowing the money printing or adjusting the federal funds rate.
The Fed’s response to a slowing economy and deficit out is not in question. It will print. In the 2009-2021 QE, the Fed funded 85-90% of Treasury issuance. That enabled the massive wave of supply caused by the constantly growing deficits, to be absorbed at near zero yields.
I’ve documented the mechanism in my Liquidity Trader reports since 2009, through examining the Fed’s weekly H.4.1 balance sheet release, and Treasury issuance data, week in and week out.
We observed as the Fed bought Treasuries and MBS with new Fed imagineered deposits paid into Primary Dealer accounts at the Fed. Dealers deployed a portion of that cash into equities, using additional leverage. Asset prices rose. . The consistent correlation across a dozen years was not coincidental. It demonstrated cause and effect. We knew the logic, and we saw it in action, week after week.
If the Fed goes back to that playbook, the most likely outcome for financial assets would be, up. In theory, if the the Fed again funds 85, 90, 95% of net new Treasury issuance, the remaining supply will again be absorbable at near-zero yields.
But as Professor Lawrence Berra of the New York Yankee Institute of Economics taught, “In theory, there’s no difference between theory and practice. In practice there is.”
With that in mind, let’s look at what might be different in practice regarding the coming round of increased QE, above the current $40 billion per month of T-bill purchases.
In 2009 the deficit spending was recycled almost entirely through the financial system. This time a war economy running simultaneously with automatic stabilizer spending will send money to consumption goods in addition to brokerage accounts. Transfer payments go straight to consumption. Spending on defense contracts fans out through wages and supply chains, causing inflationary pressure to increase on consumer and producer prices across the spectrum. The same QE mechanism may drive asset prices higher while goods inflation runs persistently in the real economy. That is a different animal than anything we saw 2009-21.
Or maybe this time, there will not be excess cash available to the financial sphere. We just don’t know in that regard, or whether bullish sentiment can be maintained under the geopolitical and economic backdrop that is now developing. Bullish sentiment, aka animal spirits, is a necessary component to drive speculative activity. We don’t yet know if a narrative can be conjured up for that, with an unpopular war under way, and what is widely recognized as a capricious regime running the show.
There are two additional threats to the asset price scenario that aren’t getting enough attention.
The basis trade is already unwinding. Leveraged fund short positions in 10-year Treasury futures have contracted by 700,000 contracts since last August, per the COTs. DVP repo outstanding has fallen by $500 billion since last November. That means that 10% of that leverage was retired in just 5 months.
The basis trade requires cheap leverage and a positive spread to function. As those conditions deteriorate, the basis trade becomes less and less profitable, so it contracts. If the Fed drives yields toward zero the spread disappears entirely and the remaining positions unwind into whatever market exists at that moment. We saw what that looks like in March 2020. It wasn’t orderly.
Alongside this process sits the question of corporate debt. Year after year of cheap money funded corporate buybacks and increased leverage. When revenues contract in a slowing economy the debt won’t contract with it. Where the funding comes from to service that leverage is a question nobody has even asked yet, let alone answered.
Lower revenue insufficient to cover debt service can only mean one thing There will be liquidation. That will drive asset prices lower, including stock prices, and possible even bond prices, meaning higher yields despite the Fed absorbing most new Treasury issuance. This process will feed on itself as lenders and brokers send their margin men enforces out, tire irons in hand and ready to kneecap corporate borrowers.
In short, the system will go haywire. Collapse can’t be ruled out. Whether deflationary, or inflationary.
That’s just one possible, if not likely scenario. There are more variables here I won’t pretend to game out. Whether foreign investors quietly reduce U.S. exposure, or loudly. Whether domestic US investors with a global mandate elect to take their money out of the US to deploy elsewhere. Whether the Iranian situation persists, escalates, or resolves. Each branches into its own scenario tree. More than two moves out you’re writing fiction.
What I can say is this. The Fed can suppress rates. Stocks may well go up for a while. But this time the deficit spending has a real economy transmission that 2009 didn’t, supply destruction that monetary policy can’t address, a basis trade unwind already underway, and a consumer who remembers exactly what inflation felt like three years ago. We have investors who can and will move funds out of the US. What we don’t yet have is a concept that would drive a bullish narrative necessary for animal spirits to keep investors and speculators borrowing and buying US debt and equities.
The old saw about markets hating uncertainty is true. And the only uncertainty I see tilts deeply negative.
