Doomsday predictions that the US Dollar is on the verge of collapse have been a common click-bait theme my entire career. In large part this is a function of the incentive structure of 21st century media, where click quantity is valued over content quality. The fate of the greenback has crept back to the fore recently on the back of the FDIC takeover of Silicon Valley Bank (SIVBQ), Signature Bank (SBNY), and Silvergate Bank (SI) followed by the forced sale of Credit Suisse (CS). This lifted the rug on structural weaknesses in the US economy, but I decided to write on the dollar’s future because there are other macro changes afoot that deserve analysis.
Throughout 2021 the US experienced significant and painful inflation, but the Fed repeatedly assured everyone that inflation was “transitory”. The chart below from CFI shows that in June 2021 the Fed was telling everyone rates would be between 0.50% and 0.75% or lower all the way out to 2023 (follow the green line to 2023). The key point to understand is that every bank, insurance company, and pension built their portfolios on these estimates.
By the end of 2021 the error of that forecast was undeniable and the Fed was forced to pivot aggressively. We now sit at a target rate of 4.75% - 5%, over 9x higher than they told market participants it would be.
Additionally, they constricted monetary policy further by pulling $600 billion out of the money supply. An almost 7% reduction.
This left bondholders unprepared and on the receiving end of heavy losses, but the more important point is what it signals for the future. The Fed provided the market with poor estimates, which led banks to make poor investments. These investments are under water and the Fed is now in a pickle. If they prioritize fighting inflation they may collapse the banking system because tighter monetary policy will inflict more losses on the banks. After SVB, Signature, Silvergate, and Credit Suisse, they were forced to reinject $400 billion of the $600 billion they had just pulled. The chart below shows a grim picture of the Fed’s balance sheet. The story this tells me is one of a central bank with no choice but to keep the printing press turned on. Every attempt to tighten supply is short-lived and followed by massive supply expansion.
Now, just as this article is being published, it appears that First Republic Bank (FRC) is set to join the ranks of dead and soon forgotten banks. Systemic banking weakness will require liquidity injections by the Fed or acceptance of collapse. On the other hand, if they prioritize the health of the financial system they must accept that their ability to tighten monetary policy further is handcuffed.
The outcome of option 1 would lead to a collapse and catastrophic deflation. This is not going to be viewed as an acceptable course of action. Option 2 likely results in stagflation, meaning meager economic growth with higher than desirable inflation. This is the likely path forward in Ray Dalio’s view as well as my own.
Stagflation would result in the degradation of the US dollar’s purchasing power. It would be unlikely this would manifest as a sudden collapse. Instead, it would mean increasing cost of living, additional widening of the wealth gap, and lower wage growth sustained over long periods.
Ways to Position a Portfolio in Response to Inflation/Stagflation
In an environment of excess liquidity and inflation investors often look to precious metals or commodities for protection and diversification. These are traditional diversification plays. However, more and more investors are looking at bitcoin to protect their wealth.
Bitcoin offers an alternative to holding assets outside the banking system, the security of the most powerful computing network in history, and a known supply schedule (i.e. no central bank creating more out of thin air). It’s returns have displayed low correlations to other asset classes, and the risk/reward tradeoff is lopsided (in a good way) because while the pullbacks have historically been severe, the bull markets have stampeded past every other asset class in the world and provided multi-triple digit returns each cycle. The chart below illustrates how bitcoin has dwarfed other assets for the 10-year period ending 12/31/2022.
Ultimately, the massive amounts of unrealized losses on bank balance sheets, as well as the balance sheets of other financial firms, is creating a constraint on the Fed’s ability to fight inflation and this will act as a headwind for the US dollar. Investors should consider their positioning in relation to this and the other factors to be discussed in the follow up installments of this TRADE STREET series.
I truly appreciate the time you’ve taken to consider my views. Please do your own research. Also, your feedback is greatly encouraged and your subscription is highly valued. Lastly, remember this is just money. Take time today to meditate on the blessings money can’t buy.
“A wise person should have money in their head, but not in their heart.” – Jonathan Swift
Trade street, great article! I have seen a lot news on the bond market and nice to get some clarification on why it's been down lately. Question on banks specifically, with the FED continuing to try and save FRC, will this create a scenario where banks will be more risky in future knowing that the FED will come in and save them?