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*This article was written 11/4/22*

Inflation

The annual rate of inflation in the U.S. increased by 8.2% in September after the Consumer Price Index (CPI) saw a 0.4% increase.  Both of these numbers were slightly above expectations (bad news). 

Source

Headline CPI encompasses the whole basket being measured, whereas Core CPI removes the food and energy components. What does this mean? Inflation is still rising despite the Fed's efforts to control inflation via rate hikes and quantitative easing (QT). Additionally, the overall inflation metric is being buoyed by services (chart below).

Energy (green) and goods (red) are compressing. This is good news and has been anticipated in the data ever since oil fell from $120 to ~$90 over the last few months. However, services (blue) are rising, which is concerning because services inflation (wages) are far harder to revert once begun.

Quantitative Tightening (QT)

QT, or quantitative tightening, removes liquidity from markets and generally has a negative impact on prices. The chart below puts into perspective just how unusual the last ~three years have been regarding global central banks and their balance sheets. The magnitude, speed, and whipsaw reversal of central bank policy since COVID is unlike anything in history. The second chart illustrates that, while there are many factors at play in the global economy, there’s no escaping the effects of the central banks’ tampering. Nearly all markets and their analysis begin and end with the simple fact that a small group of central bankers expanded the money supply at unprecedented rates in 2021 and are now contracting it at nearly the same rate. 

Sovereign Debt

Government debt yields the world over have risen dramatically in 2022, putting strain on nations and their currencies. 

Source

Just in the last two quarters, interventions by the Bank of England (BoE), Bank of Japan (BoJ), and European Central Bank (ECB) (to varying degrees) have been needed to stabilize the markets. These efforts have provided temporary respite thus far, but the core issue(s) remains. As larger-scale issues (such as the U.K. pension funds insolvency risk) develop, it’s probable that all "temporary" liquidity infusions/interventions will become more permanent features. However, central banks are still talking tough about using rate hikes to combat inflation and reduce it to their 2% target. If they’re to be believed, restrictive rates could remain while central banks purchase bonds in the background (QE) in response to various liquidity problems.

Servicing the U.S. debt

For the entirety of the 21st century, the U.S. government has gotten into the habit of running enormous deficits, only made possible by ever-declining interest rates. Unfortunately for our current situation, the majority of the debt is very short-term, and interest rates look to 20x by next year. This means servicing the enormous debt will become far costlier and require a greater percentage of the nation’s budget than in years past.

In 2019, debt service accounted for ~13% of the federal budget. This is before COVID and the subsequent ~$6 trillion that was added to the nation’s balance sheet.

2019 Budget:

• Healthcare: $1.245T
• Pensions: $1.1T
• Defense spending: $940B
• Debt Service: $580B 
• Welfare: $370B
• Education: $150B
• NASA: $22B

In 2021, the Federal government paid $392 billion in interest on an average outstanding debt balance of $21.7 trillion, or an average interest rate of 1.8% APR.

Now, imagine the Fed Funds rate truly reaches ~5% (where markets are currently forecasting the terminal rate) and remains there for an extended period of time. What impact would that have on the national budget? 

Source

It means fewer tax dollars for necessities, such as infrastructure, education, defense, etc., and more to simply paying off the COVID money-printing. Debt service would grow to ~27% of the federal budget. Roughly speaking, if U.S. citizens wanted the same services as they had in 2019, taxes would need to increase by ~20% to make up the difference! 

2023 budget (at ~5% interest rate):

• Healthcare: $1.6T
•  Debt Service: $1.6T 
•  Pensions: $1.4T
•  Defense: $1.2T
• Welfare: $510B
•  Education: $240B
•  NASA: $26B

All of this and we haven’t even accounted for the reduction in national tax collection due to a recession. The government will have even less money to try and plug the holes. This means something’s got to give.

USD

The USD continues its multi-year climb, strengthening at the expense of other fiat currencies. Since the USD accounts for a substantial percentage of worldwide trade (85%), its value compared to other currencies has enormous implications across the globe.

Recent dollar strength can be ascribed to the following three factors:

1. The U.S.' aggressive monetary policy tightening
2. The U.S.’ economic health relative to other developed nations, and
3. The popular belief that USD is a safe haven during international unrest.

While it may appear the USD’s strength will continue to grow unabated, the reality is that the U.S. and global economies can only withstand so much dollar strength before it wrecks other nations’ economies, primarily the vulnerable emerging markets. This is because, as rates increase, U.S. debt service eventually becomes impossible without printing more money as mentioned above. The higher the price of the USD, the greater the risk of default for countries and corporations that have USD-denominated debt that they must pay off with a weakening local currency. Below is a ~30-year chart highlighting the enormous strength gained by the USD since ~2021. It’s reach year-over-year levels that have historically coincided with recessions and/or economic crises.

Checklist

Below are a few macro indicators that drive Fed policy and markets in general. Each one has its own effect on risk assets and crypto. Red = bad for crypto. Green = bullish. Unfortunately, no green this month.

1. Inflation: Too high. September numbers came in higher than expected with an increase in services inflation.
2. U.S. jobs market: Strong(ish).
3. U.S. Dollar: Strong, but displaying signs of local top over the last month. 
4. Stock market (SPY): Weak. In a weekly structural downtrend of lower highs and lower lows.
5. Fed signaling: This is subjective, but given Powell’s recent statements (discussed below), this is also bearish. Powell stated the Fed is looking to continue to raise interest rates, even it means lower stock prices and a weaker jobs market.