Elections, Inflation, and the Bond Market

The Federal Reserve believes inflation is no longer a concern for consumers and the time has come to ensure the rate of change of prices does not decline any further. To this point, Susan Collins, the Boston Federal Reserve President, said recently that if you take out food, energy, and shelter, inflation is pretty much back to growing at around the 2% level. So, this Fed President thinks that if you can live like a caveman and are pretty good and being a hunter-gatherer and don’t use any energy and ride your bike to work, then inflation is no longer an issue for you. However, she fails to realize that both the headline and core CPI are rising from a price level that has already severely injured the middle class. And, the cost of living is currently rising further away from the Fed’s asinine 2% target level. In other words, consumers don’t care that inflation is back to rising close to 2% if don’t count the necessaties of living; what they care about is that they are struggling to afford adequet nutrition and to buy a house.

Of course, the bond market gets the joke and has sent rates rising across the yield curve. The 2-year note is up 75 bps, and the 10-year note is up over 80 bps after the day Jerome Powell thought the economy needed lower rates and that it was a good idea to lower the Fed Funds rate (FFR) with a panic 50 bps move. And, mortgage rates have jumped by 90 bps since September 17^th as well.

Clients of PPS know I’ve made a lot of trading moves post the election of Donald Trump and the republican sweep of Congress. But please do not think I’ve suddenly become a perma-bull on the long-term prospects for the US market or economy. The election of DJT in no way negates or annuls the existence of the credit, real estate, and equity bubbles. Their reconciliation is inevitable and will be extremely chaotic and damaging to the economy. Nevertheless, in the short-term, the changes in D.C. have led to at least the belief, for now, that both growth and inflation will be rising in 2025 and beyond. I am sympathetic to that view.

On the growth front, lower personal and corporate taxes and reduced regulations are very stimulative. The prospect of no taxes on tips, overtime, and social security will be a huge boost for consumers. Trump also wants to cap interest rates on credit card debt, allow for the deduction of auto loan interest, lift the cap on state and local taxes, and increase the child tax credit. Extending the Trump tax cut and Jobs Act of 2018 would keep corporate taxes at 21%. However, Trump would like to see this rate drop to 15%. Again, all this is very stimulative to growth but will lead to a massive jump in the deficit next year.

Offsetting some of these growth measures will be the very likely imposition of 60% tariffs on imports from China, which could lead to a trade war. The deportation of millions of illegal immigrants would reduce the labor force, which is half of the input to GDP growth. Most importantly, rising interest rates are an immediate impediment to growth in this highly indebted nation. More on that in a bit. However, tax cuts and deregulation measures will not become law until at least Q1 of next year, and deportations and tariffs can happen much sooner.

On the inflation front, significant banking deregulation should spur increased lending, which is inflationary as it increases the broader money supply. And, after all, Trump is the self-avowed king of debt and lover of a weak dollar. That must be accretive to inflation. However, the most important boost to inflation will come from the Fed. Mr. Powell and his merry band of money printers have already dropped the FFR by 75bps and have laid the groundwork for about another 100bos of rate cuts between now and the end of next year. But this is nothing compared to what is coming. Due to the massive increase in deficits coming in the next few years, the Fed will be forced to monetize a gargantuan amount of existing and new Treasury bond issuance and then put all those trillions in debt in cold storage on its balance sheet. The idea will be to take the debt out of the realm of public price discovery to make the Treasury appear solvent. In other words, we will have deeply negative real interest rates for a very long time. This will be the main driver behind inflation.

Total non-financial debt has soared to a record $75.3 trillion as of Q2 of 2024, which is 260% of GDP. We now pay 20% of all Federal revenue on interest payments alone. The current average interest rate on US debt is just about 3.3%. However, this amount is rising rapidly because there is no interest rate across the entire yield curve currently that low. The yield curve ranges from 4.25% to 4.6%. All things staying equal, we will soon be paying 30% of all revenue on interest payments alone. Of course, the debt is soaring along with interest rates therefore the debt-to-revenue ratio will worsen. But the hope is that GDP growth and revenue will grow faster than the debt. If you’re betting on that, I have some swamp land in the Metaverse to sell you.

The National debt is 720% of revenue, and the deficit is 44% of all revenue. Try getting a loan from a bank with those metrics. Even most loan sharks would take a hard pass.

However, it is not just government debt that is an issue.

US household debt is over $20 trillion, and Business debt is $22 trillion. Add to that the shadow banks, which have gorged on debt, too. Take private credit, for example. It has exploded 10-fold since the Great Financial Crisis to $2 trillion. These are loans to non-public businesses that can’t get a loan from an FDIC-insured bank.

What else would you expect when the cost to borrow money has been warped into negative real terms and below 1% in nominal terms for 11 of the past 14 years? And our central counterfeiters want it to go lower.

The welcomed and decisive election result is consequential to our investment strategy because it further delays the recession. The fiscal and monetary policies under Harris would have been awful in that the increased debt would have done little to encourage capital creation and increase productivity in the longer term. In other words, a Harris presidency could have been much more stagflationary. But dangers are still prevalent. In fact, the gambling on Wall Street is intensifying. Target date funds, buy-and-hold indexing, and AI are all pushing more and more funds into just a handful of holdings. Wall Street has become a concentrated casino. Spiking rates are the most salient danger to derail the whole game. Our Inflation Deflation and Economic Cycle Model is designed to let us know when a recession or liquidity crisis is near. Until then, we continue to cautiously ride this bull market higher. Knowing that the grand reconciliation of asset prices remains inevitable.

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