Former US Secretary of the Treasury (1974 – 1977) William Edward Simon (one of the best Secretaries of the Treasury the US ever had) exclaimed once that, “I continue to believe that the American people have a love-hate relationship with inflation. They hate inflation but love everything that causes it.”
According to Michael Hartnett, chief investment strategist at BofA Global Research, .... “bonds will have a tough decade but they will post positive returns in 2023.” He added “What's the best thing about stocks in 2023? Bonds.”
According to economists John Greenwood and Steve Hanke the Fed seems “unlikely to ease off contractionary policies...... Seeing a tight labor market, the Fed says it anticipates upward inflation pressures to persist through 2023, so quantitative tightening and high interest rates will remain in place until further notice. Given that, we are lowering our forecast for the year-over-year inflation rate from 5% to between 2% and 5% at the end of 2023.”
Byron Wien strategist at Blackstone lists among his 2023 surprises that, “While the Fed is successful in dampening inflation, it over-stays its time in restrictive territory. Margins are squeezed in a mild recession.” Wien add that, “Despite Fed tightening, the [stock] market reaches a bottom by mid-year and begins a recovery comparable to 2009.”
MF: Provided the Greenwood/Hanke team of economists and Byron Wien are right that the Fed is successful at dampening inflation, a fair assumption would be for US Treasuries to rally strongly at some point in 2023. Since I believe that the typical US household is already in recession in real terms I have sympathy with these economists’ views. The potential for far lower inflation is further reinforced if we consider the fact that the US monetary base in real terms has already collapsed more than at any time since the 1930s Depression. However, I also need to point out that it is far from evident that monetary policy is truly restrictive yet.
According to Larry Lindsey, “Fed rates aren’t restrictive yet” because they were below the rate of inflation. Another commentator tweeted that, “The Federal Reserve is LOSING the fight against inflation. The Taylor Rule suggests the Fed Funds Rate should be at 9.13%, RIGHT NOW. It's currently at 4.58%, and the target rate is somewhere around 5.15%. And, financial conditions ARE LOOSENING.”
Focusing on the next six to twelve months and I consider three scenarios: 1) The fed keeps on increasing the fed fund rate at a rapid pace. 2) The fed continues to increase rates but at a more moderate pace. 3) The fed shortly embarks on easing monetary policies and cuts the fed fund rate back to around 2%.
Scenario 1: Further rapid increases in fed fund rate would be positive for the US dollar. Initially, these rapid rate increases would be negative for the bond market, but positive once a recession gets underway.
Scenario 2: Bonds decline slowly but for a long time as the small fed fund rate increases do not portend a recession with the same certainty as rapid fed fund rate increases would do under scenario 1. Scenario 2 is clearly unfavorable for bonds as it is inflationary on a persistent basis.
Scenario 3: The demand destruction scenario comes into play and leads to immediate and obvious economic weakness and a collapse in the rate of consumer price inflation. As is common in cases of impending recessions, the Fed slashes the fed fund rate rapidly, and long-term Treasury bonds rally. This scenario is unquestionably bullish for Treasury bonds. In this scenario, it is likely that real US Treasury yields turn positive as the inflation rate drops to between 2% and 3%.
I concede that there are other scenarios that we would also need to consider, such as the World War III scenario. In the WWIII scenario it is likely that what you own is less important than where you own it. As an example, I would not recommend to own properties and live close to the NATO headquarters in Brussels. But that aside, war scenarios tend to be inflationary, and bullish for commodities and bearish for bonds.
In previous years, I repeatedly talked about the investment strategy of my friends Sean and Mike O’Higgins, which normally includes the allocation of money into bonds, out-of-favor equities and precious metals (www.ohiggins.com).
This year, for the first time since I have known the O’Higgins team, they replaced their bond allocation with precious metals. They concluded a recent paper: “So what has changed that makes us doubt that the favorable environment for stocks, bonds and inflation that prevailed for the last 40 years is largely over? First, the new administration seems very happy to pursue policies that have already produced rapidly rising rates of inflation and will likely continue to do so. [A recent headline read: The Fed is trying to lower inflation: Biden’s actions are increasing it – ed. note.]
The time has come, in our view, to replace our bonds with precious metals in the expectation that we are in the early stages of a multi-decade cycle of rising interest rates and inflation. Given that both platinum and our Dogs of the World (Brazil, China, Italy, Korea and Spain) are selling at a 60% discount to our estimate of ‘fair value’ a portfolio invested equally in both should do quite well in the environment that we are anticipating.”
I assign a high probability to this scenario because the record indicates that the Fed is a horrible central planner that regularly intervenes, distorts, and manipulates the capital market with ill-timed policy measures. Furthermore, the Fed is not only an institution that messes up everything but its forecasting record is equally poor. What else would you expect from left leaning academics?
Consequently, while having great sympathy for the O’Higgins strategy shift, based on the monetary policy errors as outlined by Greenwood/Hanke, I shall maintain my approximately 25% allocation to bonds and cash. But from a longer-term perspective, a rising cycle of inflation and higher interest rates, as outlined by O’Higgins, is the most likely outcome.
Lastly, let us never forget the words of Friedrich von Hayek who stated that,
“I do not think it is an exaggeration to say history is largely a history of inflation, usually inflations engineered by governments for the gain of governments.”
With kind regards
Yours sincerely
Marc Faber
Ready to get started?
