Inflation Part 2 The US Fed has indicated that it will start to taper its buying sometime next year.
But what exactly does that mean? What are the implications? What are the historical parallels?
Right now the US Fed is continuing with its "whatever it takes" strategy which means that the US Fed through it Open Market buying program is essentially buying all of the yearly US Government budgetary deficits. As long as it continues to do this, the additional cost of financing the deficit costs the US Government nothing since The Fed, under The Federal Reserve Act of 1913, is obligated to pay back to the US Treasury Department any profits after it covers its operaring expenses and pays a 6% dividend to its owner banks (ie JPM, Bank of America etc). Since the Fed already owns so much US Government debt it more than covers these costs and so any interest income from new debt goes straight back to the Treasury Department.
Now, if the Fed starts to taper, and the US Government continues to incur deficits and this is surely going to happen especially if Biden gets his his mult trillion dollar Build Back Better plan approved, then more of this debt will be financed by people other than The Fed and the Government will have to pay interest to these people which will increase the deficit and create a debt spiral.
As the borrowing not covered by The Fed increases, the Government will start to crowd out borrowing by businesses and consumers (eg mortgages) and this will drive up interest rates and further accelarate the debt spiral. This is exactly what happened in the early 1980s when interest rates spiked.
Higher interest rates do a couple of things -
1.....fixed income investments provide greater risk adjusted returns and so people take money out of the stock market and buy fixed income. I did precisely that in the early 1980s - getting guaranteed returns by buying Government of Canada bonds at a discount to face value and reducing my stock portfolio
2....people paying higher borrowing costs have less to spend and so consumer spending goes down and this in turn affects business activity and profits and so earnings go down and hence the SP of companies
If you look at a chart of this time period you will see for yourself how all this came together.
IMO, where we are now and the current trends suggest that we are in much more worse shape than we were in the early 1980. At that time, Government made the decision to address the problem and The Fed Chairman Volcker took extraordinary steps to right the ship as did the Government through program changes. I personally don't see that happening now with the likes of the next generation of lawmakers like AOC in the US. In fact it would appear that they have the opposite view from the 1980s and will make it even worse.
As I mentioned before, I have no idea when all this will come to pass but have taken steps to protect myself and remain vigilant and not allow myself to get carried away with the current exhuberance in the market.
I sincerely hope that I am wrong in all this for the sake of future generations. At my age and personal financial situation, none of this will likely affect me in a material way but I do lose sleep over what might happen to future generations.
In its simplest terms what is going on is that my generation has, in effect, borrowed from future generations to live high on the hog today and future generations, as consequence, will suffer a lower standard standard of living as they pay for the excesses of my generation. Sad but true!!
Sorry for being so long winded but I hope that these ramblings by an old man will help some of you make better investment decisions or at a minimum have a better sense of how to put the pieces together.