Re: Inflation/USD/Oil - From Fed's Best Friend to Fed's Worst Enemy.

Pusillanimous Powell's Premature Pivot has turned the USD's Equilibrating Mechanism from the Fed's Best Friend into the Fed's Worst Enemy by potentially igniting a Competitive Cutting Cycle.

Pusillanimous Powell's Premature Pivot has turned the USD's Equilibrating Mechanism from the Fed's Best Friend into the Fed's Worst Enemy by potentially igniting a Competitive Cutting Cycle.

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Global Competitive Cutting Cycle Coming?

Last spring, in Ball In A China Shop I wrote about how China’s Structural DEFLATION could be the Fed’s Best Friend in its Inflation Fight, given how a Strong USD (the USD Wrecking Ball) acts as an Equilibrating Mechanism that exports US Inflation while it imports Chinese Deflation:

Given Pusillanimous Powell’s Premature Pivot, however, I fear that this Equilibrating Mechanism has been disrupted and that the Fed’s Best Friend has the potential to transform into the Fed’s Worst Enemy, depending on how Rest of World (RoW) responds:

• Scenario A: a Weaker USD (which results from the Fed Out-DOVING RoW) re-imports Inflation from RoW. Just like a Strong USD yielded a more “Zero Sum” outcome by exporting US Inflation to RoW, a Weak USD does the same in reverse.

• Scenario B: RoW’s CBs don’t allow the Fed to Out-Dove them, because it doesn’t behoove them to have Strong FX; in this scenario, they stymie a Weaker USD by aggressively cutting themselves, igniting a Competitive Cutting Cycle which gooses Global Inflation for everyone. Think of this as “growing the overall Inflation pie” vs. the “Zero Sum” Equilibrating outcome.

Unfortunately, I think Scenario B is not only more likely but also MUCH MORE INFLATIONARY.

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US Relative Economic Strength Remains Problematic For RoW

In “Battle of the Bads,” I took you around the world and explored the dilemmas facing CBs around the world when faced with a Fed that was not yet finished with its Inflation Fight, given the relative strength of the US Economy vs. RoW.

In every single case, the Less Bad choice (regardless of whether it’s the BOJ, ECB or PBOC) was to let its Local FX weaken against the USD because the mitigating factor to Importing Inflation was the boost to Export Competitiveness.

As we noted in West Point Paper, Part 4, because the US is the least Export Dependent nation of the world’s largest trading blocs, a Strong USD was the best Equilibrating Mechanism in a world with Asynchronous Economic Cycles (uneven Inflation/Growth between the US and RoW):

If the US Economy showed demonstrable relative weakness to RoW, then one could make the claim that PP was justified in Out-Doving RoW. However, the aggregate data show exactly the opposite, with US Relative Strength a clear standout amongst world economies.

This table is from Koyfin, 9/24/24:

This chart from DB compares conditions for the current Pivot vs. 2001 and 2007. Again, the conditions for aggressive easing are NOT ripe:

Even higher-frequency data that showed some signs of softness have begun to inflect higher, as this chart from my friend Nicholas Glinsman shows:

The point I’m making is that RoW’s need to Out-Dove the Fed has NOT CHANGED despite the Return of PP — and that has significant ramifications on the reaction functions of RoW’s CBs.

I summarized my logic in my recent post in The Return of PP:

The result, I fear, is that PP’s actions will likely usher in a GLOBAL COMPETITIVE CUTTING CYCLE.

I spoke about this dynamic in my recent Wealthion Interview:

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Isn’t China a Deflationary Safety Valve?

If there is a poster-child for an economy that is diametrically out-of-sync with the US Economy, it’s China’s Structurally WEAK, Deflation-prone economy.

The PBOC recently unveiled a multi-pronged stimulus package and what many are calling its “Bazooka”:

China expert Brian McCarthy at

Macrolens

begs to differ and thinks this package was “more like buckshot than a bazooka”:

ICYMI, if you haven’t listened to my Interview with Brian McCarthy on KAOS THEORY, it’s a must-listen if you’re to understand China.

I agree that this is just pushing on a string and putting the proverbial “Lipstick on a Pig.” If you think China’s recently announced measures signal its intent to reflate its moribund Real Estate sector, “You’ve Got Another Thing Comin’” (had to throw in a Judas Priest reference).

My friend and commodity expert Alex Stahel posed this poll in the wake of the recent PBOC headlines that they’re cutting the minimum down payment requirement for second homes from 25% to 15%:

What does Alex mean by “off-plan”?

I guessed the correct answer because I believe that Xi has no intention to reflate China’s domestic Real Estate sector, and the 3 Red Lines Policy which I cite above tells you where his head is at: “homes are for ‘living in’ vs. ‘speculating on.’”

Here is an excerpt from a 2022 blog by

Pekingnology

that Alex brought to my attention:

It’s no surprise that we are witnessing a dramatic Reverse Wealth Effect in China as a result of these policies.

Interestingly, the ebullient response of Chinese Equities to the recent stimulus was not matched by USDCNH (yet):

Short term technicals aside, I think the truth will shake out somewhere in the middle. Given the depth of China’s economic rot and the heretofore half-hearted stimulus measures, I think that headlines like these will suck people into Version XXX of the Chinese Reopening Thesis only to spit them back out again, while USDCNH will find its footing when people realize that Chinese Devaluation Pressure remains significant if not worse.

Here is the optimistic take:

Here is the not-so-optimistic take that I tend to agree with:

Although I’ve already delved into China’s Structural Problems last spring in Ball In A China Shop, I cannot emphasize enough that ONE CANNOT EVALUATE XI’S ECONOMIC POLICIES THROUGH THE LENS OF WESTERN ECONOMIC RATIONALITY.

I have voiced this sentiment repeatedly:

I still think the PBOC needs to significantly Devalue CNY at some point because the CCP's main concern is STAYING IN POWER, and to stay in power they need to keep people employed. To keep people employed, they can no longer push construction jobs given decades of Capital Misallocation to the Real Estate sector.

Like the Eye of Sauron, China’s Top-Down GDP Targeting has turned its unwavering attention from Real Estate to INDUSTRIAL CAPACITY — specifically Industrial Capacity for the Gretaverse (what I call the GreenTech space):

I’m reminded of Saturday morning cartoons where a RUNAWAY ASSEMBLY LINE churns out goods so fast that the workers can’t keep up with being able to package them. China’s Runaway Assembly Line simply cannot stop, because to do so would lead to SOCIAL UNREST:

This is where a Strong CNY (especially in the face of growing Anti-China Protectionism) can really hurt China’s Export Competitiveness.

Michael Pettis and Brad Setser have both argued that the PBOC needn’t worry about Exports or a Strong CNY given that China already runs the world’s largest Trade Surplus. Again, while this is an economically sound argument from a Western perspective, I do not think Xi’s policies can be evaluated through the lens of Western economic rationality.

This is an excerpt from Nicholas Glinsman’s “Ahead of the Herd” on 9/25/24:

To me, there is no mystery behind Xi’s actions — witness what Mao put the Chinese population through during his reign. One must be willing to shed conventional Western economic rationale and think about Xi’s core philosophy of staying in power, first and foremost.

I believe that Export Competitiveness absolutely matters to China, not because Xi cares about the economic well-being for the masses or even for its State-Owned Enterprises, but because Export Competitiveness is a prerequisite for its Runaway Assembly Line to keep running, so that it can gainfully employ China’s restive population, which in turn allows Xi and the CCP to STAY IN POWER.

Here are some interesting excerpts from

Shannon Brandao

’s China Boss Substack:

This doesn’t even cover China’s Structural Debt Issues that I wrote about in Ball In A China Shop and that China experts like Brian McCarthy have voiced:

From a recent

Macrolens

post by Brian:

China needs a Strong CNY like it needs an icepick in its skull — especially with growing Anti-China Protectionism around the world.

Yet with the recent Return of PP and only half-measures undertaken by the PBOC, USDCNY has weakened substantially. This hurts China’s Export Competitiveness and dampens its ability to export Chinese Deflation.

Until China pulls the Band-Aid off with a Structural CNY Devaluation, the real exporting of Chinese Deflation will be stymied. I think a discontinuous and significant CNY Devaluation is still a risk, but the Return of PP has stymied this Deflationary Safety Valve in the ST and with it, the Fed’s Best Friend in its Inflation Fight.

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Could Low Oil Be Another Deflationary Safety Valve?

On 9/26/24, Saudi Arabia hinted that it would finally start bringing back some of its artificially withheld Supply:

My piece from last year, Will Atlas Shrug?, not only highlighted the risk of KSA eventually tiring of subsidizing cheaters but also delves into hard lessons from past Oil Bear Markets, which I suggest could be upon us in Oil in the ST.

Only a Global Competitive Cutting Cycle could mitigate that, but even that will take time if the Saudi Atlas truly Shrugs.

As I’ve stated many times since early last year, KSA painted itself into a corner by unilaterally cutting 3 mmbpd and now has no viable Exit Strategy without seriously disrupting markets. This sounds just like the conundrum BOJ faces with trying to exit YCC:

Nevertheless, I’d be remiss if I didn’t acknowledge Low Oil prices as a possible Safety Valve for Inflation, as my Scenario 3 outlines from USD Wrecking Ball To USD Pickleball. That said, I also mention that Low Oil is a necessary but insufficient condition for the Inflation Fight to be won given that it just one of many Supply Inelasticities the US is contending with simultaneously:

The Return of PP potentially spurring a Global Competitive Cutting Cycle mitigates the Oil Deflationary Safety Valve just like it mitigates the China Deflationary Safety Valve (especially without significant CNY weakening).

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Conclusion

In a world with Asynchronous Economic Cycles driven by the relative strength of the US Economy vs. RoW’s Economies (especially China’s Economy), the BEST way to sync up was to have the USD Wrecking Ball finish its job of Equilibration.

Alas, with the Return of PP at a time when the US Economy still stands tall amongst its global peers, the reaction function of RoW’s CBs (with perhaps the exception of China’s PBOC, which is arguably less economically rational than any other CB) is likely to be just as aggressive.

In a GLOBAL Competitive Cutting Cycle, the USD’s role becomes less of an Equilibrating Mechanism that exports US Inflation to RoW in “Zero Sum” fashion; rather, with every CB cutting aggressively at the same time, it grows the entire Inflation Pie by boosting Aggregate Demand everywhere.

Given the myriad of Supply Inelasticities in the US meeting a rightward shift of the Aggregate Demand Curve that I wrote about in The Return of PP, I thought that the specter of importing Chinese Goods Deflation was one possible Deflationary Safety Valve. I also thought that Low Oil from KSA ending its unilateral cuts could be another Deflationary Safety Valve. That all changed on 9/18/24 with PP’s aggressive 50 bps cut and equally dovish Forward Guidance.

Rather than allow these Deflationary Safety Valves to do their work by Exporting Inflation and Importing Deflation, a Competitive Cutting Cycle would likely dampen if not completely swamp these Deflationary Safety Valves and result in boosting Inflation GLOBALLY.

Unfortunately, Pusillanimous Powell’s Premature Pivot all but greenlights such an outcome, which would turn the USD’s role as an Equilibrating Mechanism and the Fed’s Best Friend into a Competitive Cutting Cycle that becomes the Fed’s Worst Enemy.

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