Recap of Episodes 1 to 4

Throughout this series, I’ve covered how and why the Biden Administration has created a fiscally dominant monetary policy, which integrates a temporarily paused Fed with a high-spending Treasury.

The result is a complex liquidity recycling mechanism that’s aimed at funding the President's election-year spending amidst rising debts and deficits, which I’ve named Treasury is Fed, Fed is Treasury, or TIFFIT.

In Episode 1 we discussed how TIFFIT allows the Fed to fight inflation with higher rates for longer and pretend to remove liquidity (via a slower balance sheet reduction process) while Treasury builds up ‘stealth liquidity’ in its general account and reverse repos and gets ready to spend up to US$1.5 trillion to stimulate the economy and markets.

In Episode 2, we stepped back a little to better understand how the global c.US$20 trillion printed and dropped from helicopters during Pandemic lockdowns and supply chain disruptions birthed the inflation that the Fed is still trying to combat.

Inflation from these demand and supply side factors was exacerbated by geopolitical tensions, and the Fed's delayed interest rate adjustments.

Having examined the factors contributing to inflation, we then pivoted to the overlooked lessons from past Fed administrations.

We noted that the way the Fed Powell unnecessarily delayed action against inflation was reminiscent of the Burns Fed approach of the 1970s.

Despite historical precedents (minus the ongoing oil shocks in 70s and 80s) higher for longer inflation persists today. And given Treasury's access to substantial funds, the TIFFIT liquidity machine is likely to sustain or even increase consumer prices, posing a threat to the success of the Fed’s 2% inflation targeting. We covered that in Episode 3.

After establishing how Pandemic easing by central banks and fiscal welfare/spending by treasuries was utilised to combat the Pandemic, we noted that while those policies did sustain the global collateral base amid lockdowns/geopolitics, there was a massive tax to pay for the relief.

We also noted that relief actually started in 2009 in response to the GFC and was never withdrawn, which is why today, the four largest central bank balance sheets total US$26 trillion.

In Episode 4 we discussed that the price of stability was currency debasement and that it can be observed by understanding the rate of growth of the Fed’s balance.

This is because Treasuries, mortgage-backed securities, and other assets which are added/removed from the balance sheet are a proxy for the amount of ‘money’ that needs to be added to/subtracted from the money supply, to create a stable fiat-based financial system.

Taking the U.S. alone, the balance sheet grew from under US$1 trillion before the GFC, to US$8.9 trillion at the height of Pandemic easing. It’s now at US$7.36 trillion while the Fed pretends to tighten, however the remaining deficit is being gapped over by Treasury.

The resulting growth in the balance sheet can be thought of as the rate of monetary debasement, and it works out to ~15.4%. This level of debasement represents a massive tax that has pushed us into a prolonged global financial depression, or GFD.

Having discussed the consequences of the GFD, we then delved into the implications of the GFD for the risk-free rate (RFR) and the capital asset pricing model (CAPM).

In that discussion we noted that what’s really intriguing from a finance perspective is that the 15% debasement tax that we are paying probably means that we are seriously underestimating (and need to recalibrate) the true quantum of the risk-free rate (RFR) in the capital asset pricing model (CAPM).

We concluded that if correct, we would need to debase, which is to say increase the RFR (where it is used in the left-hand side of the CAPM formula) from say 4.5% to 19.5%, such that the cost of equity or expected return on an asset would be closer to 21.0%!

That result assumes: (a) we only debase RFR on the left-hand side of the CAPM formula; (b) we do not debase RFR where it’s used to calculate the non-diversifiable market risk premium (which is calculated inside the brackets on the right-hand side of the formula) such that the market risk premium, or (rm-rf) continues to utilise the relevant yield on a risk-free government security; and (c) beta is set to 1.0.

And you can imagine how profound an implication the resulting 21% rate has for discounting cashflows, and investment multiples which are the reciprocal of the discount rate, as well as investment relativities, portfolio allocation and assessing the benefits (or otherwise) of diversification.

But the basic implication is that if a unit of money continues to debase by ~15% per annum, investment returns should be reduced by that amount by debasing (increasing) the denominator or the ‘asset cost base’.

In other words, the same income or gain will make up a smaller percentage of the expanded (debased) cost base, leading to a lower return for the same amount of risk taken.

Here’s a more useful example. Let’s assume a gain or income of $10 in one year on a $100 asset cost base. This translates to a 10% pre-tax annual return in a world where the money supply is backed by productivity and zero central bank asset purchases.

However, if monetary expansion requires the central bank balance sheet to grow by 15% annually, then the asset base has been debased by 15% and it should be adjusted to $115, resulting in a lower return of 8.69%.

Extrapolating that out over the 15 years since the GFC, we end up with a mere few hundred basis points of return.

We concluded that profound debasement leads to a material loss of investment returns for individuals and might in the future lead to material rotations between industries, asset classes and investment instruments.

After examining the implications for individuals, we noted an even greater requirement to consider how TIFFIT affects companies, particularly in terms of project selection, financing decisions, and future growth strategies as well as industry attractiveness, competitive theory, and corporate development strategy.

And now for the conclusion of Treasury is Fed, Fed is Treasury.

What TIFFIT means for the economy and markets?

Until there’s something better that becomes available to replace our current system of money and credit, the GFD playbook seems to be as follows.

• More debt and rising deficits. More currency debasement. More silent debasement tax.

• More monetisation of more debt by the big four (and some other) central banks, whether it’s called QE or some other acronym.

• Frequent ‘parking up’ of the QE Infinity train to nowhere while the Treasury takes us somewhere, and with the price of that somewhere being monetised by the Fed in a future asset purchase program, resulting in further debasement.

• Some semblances of restrictive monetary policy to ensure inflation is well anchored for longer, but perhaps not as low as 2%.

• More fiscal dominance until robots can replace ageing populations and refill the tax coffers so that future budgets might balance.

• If Treasury’s borrowing becomes challenged and liquidity becomes too scarce, the Fed will step back in to monetise government debt and create ample liquidity which is supportive of treasuries, and more borrowing.

• Some central banks, like the RBA might explore a move away from interest rate targeting and allow banks to set the required level of liquidity under ‘ample reserves’ or other systems.

In a GFD world, we must acknowledge that financial returns are not going to be as rich as they once were, once the GFD debasement tax is factored in.

Debasement plus inflation of 2% to 3% and higher will add to an even weightier tax that we will continue to pay while we live in the GFD.

At best, more fiscal sending and eventual monetisation of that spending will need to continue; and at worst we’re seeing evolutionary changes to our current system of money and credit which probably leads to another reset like 2009, or a new system that can’t be ‘overprinted’ by a central arbiter.

Because without that, it’s not clear how sovereign debt will be repaid, with most of the largest economic blocks already having a debt to GDP ratio of > 100%.

So far, this is currently the case in Japan, the U.S., and China (once you add in debt from State Owned Enterprises) plus most of Europe via Portugal, Italy, Greece, and Spain as well as France, but not Germany.

The consequence of pursuing stability and preventing another GFC is a GFD fuelled by profound currency debasement.

It means we can expect a continuation of incremental borrowing by Treasury from the issue of new securities that will simply end up refinanced (monetised) by the Fed. That’s why Treasury is Fed, Fed is Treasury.

And it will occur in future open market operations when the Fed buys paper by crediting the seller's account with new money supply that will ultimately be recycled and lent out by commercial banks. While it might be called something else at the time, it will represent QE Infinity.

Actionable insights for a GFD world

Under TIFFIT, the GFD will continue, and I recommend you consider adopting some or all of the following:

• Adjust your RFR and cost of capital/expected returns for debasement (use your own numbers and assumptions) to provide a more accurate result when you next assess projects, investments, or acquisitions.

• Given multiples are the reciprocal of discount rates, decrease the multiples you are prepared to pay.

• Focus on high growth, high margin businesses in your corporate development and M&A strategies that have the capacity to provide positive returns once debasement is factored in.

• Consider different mixes of assets that you might hold in your treasury.

• Given the potential for continued currency debasement, consider diversifying currency holdings beyond traditional fiat currencies. Explore alternative stores of value such as stablecoins or digital currencies that may offer greater stability in the face of monetary policy shifts.

• Understand that central banks are buying gold and certain corporate treasuries and investors are buying Bitcoin.

• Consider whether your growth versus value mix is relevant under debasement and that while technology companies may look overvalued, perhaps they are not once you take debasement into account.

• Embrace innovation by investing in companies at the forefront of technological disruption. These companies may demonstrate resilience and growth potential even in the face of macroeconomic challenges.

• The economic landscape is dynamic and subject to rapid change. Maintain flexibility in your investment approach and be prepared to adapt to evolving market conditions. Regularly review and reassess your asset allocation to ensure it remains aligned with your investment objectives and risk tolerance and elegantly caters for debasement.

Treasury is Fed, Fed is Treasury until November or until further notice.

Thank you as always for reading and see you in the market.

Mike