Markets see a possible inflation shock, but who will have the courage to raise rates?

Markets are anticipating an inflationary shock and a possible rise in interest rates, but almost no one can afford higher rates given the level of indebtedness in the system.
by Maurizio Novelli, manager of the Lemanik Global Strategy Fund

Today, who could afford to raise rates if an inflation shock were to loom? Certainly not the United States, which has accumulated levels of indebtedness in the public and private sectors never seen before in history; certainly not Europe, which has been economically struggling for more than six years in stagnation; perhaps not even Japan, which would like higher rates but lacks the courage to raise them for fear of crashing the carry trade operations that support the Dollar Standard.

We are therefore about to undergo yet another inflationary shock with no possibility of countering it, since the vulnerability of the American financial system would not withstand a rate hike just as part of the Shadow Banking System has been showing signs of crisis for almost three years now. However, any surge in inflation would be short-lived, because American households’ purchasing power will suffer another setback, quickly causing a collapse in domestic consumption financed at rates above 24% (that is how much credit extended through credit cards costs).

The United States has now shown that it has no room for manoeuvre to get its economy back on track, because:
1) it cannot pursue fiscal policies aimed at controlling debt without causing a crisis on Wall Street,
2) it cannot pursue monetary policies aimed at defending the system from inflation without putting speculative finance in crisis,
3) it cannot even pursue the geopolitical objectives it has set itself because the financial system cannot withstand the resulting instability.
Finance, in practice, holds hostage any decision to repair the system and any geopolitical move aimed at defending American First.

The road therefore seems set and very difficult to change, given that the USA cannot bear any correction to the bankruptcy policies it has been implementing for years to support unsustainable speculative bubbles, with the result that the very expansionary policies now in place will paradoxically bring it to crisis. Even the “perma-bulls” have begun to understand that the current mechanism has a marked and inevitable destiny, and the SPX index could wipe out all the gains made since 2020: not because of a rate hike, but because of a deterioration in domestic consumption and a speculative credit crisis in the Shadow banking System; the latter, in particular, will soon weaken the banking system, a generous provider of speculative credit (roughly $2.5 trillion) to Private Credit, Private Equity and Ventur Capital.

The market rally supported by these policies should not be a cause for celebration. In fact, to inflate the speculative bubble, a bankruptcy policy had to be implemented without pause. For years we have been basking in “financial populism”, which has effectively replaced “panem et circenses”, since now the “circenses” is online trading. These “financial populism” policies are the factor that has also blown Private Markets up to more than $14 trillion, which, together with the crypto sector, pose a gigantic problem in assessing the true value of the assets they manage and pledge as collateral to obtain financial leverage from the banking system. If a sector of such size can: a) define at will the value of the assets it holds, b) determine the credit rating it extends and c) in effect generate performance that you can only see but not collect, should we not perhaps ask some questions about the credibility of the entire financial sector, where a major business has been built before the eyes of compliant regulators willing to go along with that “financial populism” that has created a financial system completely outside market rules.

The macroeconomic backdrop was already slowing sharply before the attack on Iran, but now a recession is looming. In this regard, it must once again be stressed that the macro data we use to assess the economy’s real situation do not indicate what is actually happening in the economy. The US government will therefore be forced to step in with further fiscal stimulus to support this system hit by yet another geopolitical crisis which, in a short time, has already turned into an economic crisis. The scenario taking shape can be summarised as follows: A) the current energy crisis will have a significant impact on purchasing power and consumption; B) Central Banks will not raise rates because they fear a weakening economy; C) the decline in domestic consumption will bring the economy to a halt and the inflationary spike will be temporary.

The US Government, however, in preparation for the Mid Term elections, will intervene fiscally to support households’ purchasing power and public debt will grow further beyond expectations. Central Banks will continue to stand pat on monetary policy, given that the system’s cost of debt is already problematic. The bond market will therefore remain under downward pressure, but the current phase can be considered a buy opportunity, given that it is almost certain the economy will struggle to emerge from stagnation and the risks of a financial crisis are increasingly significant. So: if rates rise because bonds keep falling, that pressure on rates will create yet another factor slowing the economy, thereby laying the groundwork for a subsequent rate cut. Gold has only undergone a deep technical correction, since expectations of higher rates cannot be realised. When the market begins to understand that rates cannot rise too far without creating global financial disorder and a recession, Gold will resume its upward trend and the Dollar will resume its decline, interrupted only by a temporary geopolitical event.

Equities may also rebound on fiscal intervention, but it is likely that such fiscal intervention will not be able to provide an additional boost to consumption and, at best, will merely keep it where it is for a while. The weakening of domestic consumption was already under way before the Gulf War and credit defaults had already been deteriorating sharply for some time (see Consumer Credit and Private Credit). The conditions for a significant financial crisis are steadily increasing and policy makers have ZERO room for manoeuvre on fiscal and monetary policy. Everything must remain in expansionary territory, but even though that is now the rule, credit and economic fundamentals are nonetheless deteriorating steadily. The big risk from here on is that Buy on Dip will turn into Sell on Rally.
The stock of liquidity in the system relative to GDP is still growing, even with the FED having raised rates in 2022 (Source: Federal Reserve). Despite this, the crisis of the Shadow Banking System has nevertheless begun, default rates on consumer credit are rising and the economy is weakening despite the addition of fiscal stimulus of more than 7% of GDP. It is as if the system were already in a liquidity trap. Any crisis under these conditions would have a heavy deflationary effect on the economy because of a resulting speculative debt crisis, which today accounts for 45% of US GDP. The support policies implemented so far are steadily losing effectiveness and serve only to prevent speculative bubbles from collapsing. The system will therefore be dragged into crisis by the very policies implemented to avoid crisis.
Another problem concerns the state of the US banking system which, although everyone is quick to say that banks are solid (as they were in 2007), shows a colossal exposure to the most vulnerable sector of the economy: the Shadow Banking System. To give a few figures useful for framing the situation, bear in mind that all American banks generate annual profits of around $300 billion, but currently unrealised losses on securities investments made during the zero-rate period amount to about $350 billion. The entire banking system shows average NPLs of 0.64%, a very low figure but not very credible. The main problem lies in exposures to Private Equity, Private Credit and Venture Capital, which show loans to this sector amounting to $2.5 trillion.
However, the basic problem lies in the classification of these loans. Under regulatory rules, banks must present a loan classification of the loans they have extended in order to understand what kind of capital must be allocated to each business sector. Depending on the business segment, the capital requirement the bank must allocate to cover the risk of the various loans (Tier One) changes. There is, however, a compartment called OLL (other loans & lease), where it is not clear what is inside. This “container” allows banks to allocate “unclassified” loans in order to have greater “flexibility” in the use of capital. It emerges that JPMorgan has 12% of its loans to the NDFI sector (Shadow banking System) but also has 32% of loans booked under the OLL category (other loans and lease), equal to 150% of Tier One. Bank Of America has 10% of loans classified as NDFI (Shadow Banking System) but another 10% classified as OLL (other loans and lease), equal to 135% of Tier One. For US Bancorp (USB) OLL-classified loans amount to 106% of Tier One, for Citigroup they are 107% of Tier One and for Wells & Fargo they reach 187% of Tier One.

Well then, since it is generally believed that loans in the OLL category are those with a risk profile above average, the narrative that the banking system is sound holds until a crisis begins. Those who understand structured finance, Shadow Banking, and speculative credit have already grasped the situation: banks too have, against their will, become part of the Private Markets category, where opacity is the rule. It is however highly likely that as of this quarter the publication of accounts will begin to reveal the decision to bring problems into the open gradually, simply because they are now so large that they can no longer be kept “under the carpet”. The overall backdrop is therefore becoming more and more critical, and the US administration will be forced to focus on the usual recipe: public spending and out-of-control deficit so as not to lose the mid term elections. Any rebound in the market on stimulus policies will be a selling opportunity.