Q1 2025: “Decades of Inflationism Home to Roost”
CNBC ran an interesting article highlighting the history of the largest daily gains in Nasdaq – of which Wednesday’s 12% spike was the second biggest back to 2001. Of the top 25, I’ve managed short exposure through 24 of them. When markets begin to dislocate, I’ve been conditioned to expect a policy response.
I so hope my analysis is wrong, and this is said with deepest sincerity. I pray my analysis and fears prove too extreme. I’ve analyzed many bubbles. In particular, I can point to the 1997 “Asian Tiger” bubble collapse; 1998, with Long-Term Capital Management and Russia collapses; and the mortgage finance bubble collapse in 2008. In each case, my analysis pointed to quite problematic bubble excess. And in each collapse, things proved worse than what I had earlier considered a worst-case scenario.
I see evidence suggesting history’s greatest bubble has been pierced. This is not the first time I’ve harbored such thoughts. I’ve intensely monitored this multi-decade bubble since the early nineties. I thought the bubble had burst with the collapse of the Internet and technology stocks in 2000/2001. I reversed course in early 2002 with my warnings of an unfolding mortgage finance bubble. I was pretty convinced the bubble had burst in Q4 2008. I reversed course in March 2009, warning of an unfolding global government finance bubble. Then, it looked like the bubble had finally burst with the pandemic crisis in March 2020, but it quickly became clear that egregious monetary and fiscal stimulus had triggered “blow off” bubble excess. To be sure, reckless monetary inflation will never resolve bubbles. It ensures they inflate to only more precarious extremes.
Let me explain why I don’t expect to reverse this call for the bubble’s demise. I’ve argued for years now that the global government finance bubble was the “granddaddy of all bubbles.” Bubble dynamics had finally directed subversive forces to the heart – the bedrock of global finance – to trusted sovereign debt and central bank credit. With momentous consequences, bubble dynamics seized control of perceived safe and liquid “money-like” credit instruments that are subject to insatiable demand.
I’ve argued the government finance bubble is the end of the road. Previous burst bubbles spawned bigger bubbles necessary for system reflation – collapsing telecom debt and junk bonds were supplanted by a much bigger boom in mortgage credit. The mortgage finance bubble collapse unleashed a historic expansion of government debt and central bank liabilities. However, there is today no fledgling colossal bubble waiting in the wings to take bubble inflation to even greater extremes.
And while the inflation of government debt and central bank balance sheets is certain to continue, the trajectory of over-issuance increasingly risks a loss of confidence. I believe markets – notably sovereign bond markets - have begun to signal an evolving crisis of confidence – one that even risks a catastrophic loss of faith in the foundation of global finance.
Last week was extraordinary. A deeply systemic global deleveraging was unfolding – with instability and acute stress slamming markets worldwide. Yet the typical flight to Safe Haven Treasuries and the U.S. dollar was nowhere to be seen. Indeed, Treasury yields spiked 50 bps – the largest weekly move since October 2001. The dollar sank 2.8%.
Understandably, such confounding market developments sparked anxiety and debate. Was the highly levered Treasury “basis trade” unwinding? Were foreigners backing away from U.S. financial assets? Could the Chinese be selling Treasuries as part of a trade war counterattack? Did last week mark a momentous infection point in the era of the U.S. as the reliable anchor of global finance? Were markets perhaps even signaling the undoing of U.S. “exorbitant privilege” and “American exceptionalism”?
It’s difficult to believe stocks hit all-time highs less than two months ago. So much has changed – as if the world is being turned upside down. We live in a critical period in history. For starters, we’re witnessing the transition from a multi-decade boom cycle to a new cycle of utmost uncertainty. Systems are in the throes of monumental transformational change, instability, turbulence, and uncertainty. I chose the title “Decades of Inflationism Home to Roost” for today’s call, intending to expand on analysis I hope provides a little clarity to developments in the process of dismantling conventional wisdom.
When I took my first investment management position at a hedge fund in 1990, total U.S. non-financial debt was $10 TN, with outstanding Treasury securities at $2.2 TN. The Fed’s balance sheet came in at $315 billion – about Elon Musk’s current net worth. Fast-forward to the end of 2024. Treasury securities have reached $28 TN; total non-financial debt $77 TN; and the Fed’s balance sheet $6.8 TN. For decades, Federal Reserve officials, the economics community, and Wall Street all trumpeted the exceptional age of price stability. They glorified an enlightened Federal Reserve that had slayed the inflation dragon and achieved price stability.
But it was deeply flawed analysis. Recent decades have experienced historic credit inflation – monetary inflation with far-reaching consequences. From my earliest Credit Bubble Bulletins back in 1999, I’ve tried to highlight all aspects of what for centuries was labeled “inflationism”. Since my 1990 introduction, I have had deep appreciation for Austrian economics, especially its focus on the distorting effects credit inflation has on price structures, financial and economic structural development, and society more generally. Importantly, credit expansions have myriad inflationary impacts - higher consumer prices being only one. There are effects on asset prices and speculation, along with distortions in investment decisions, resource allocation, and economic structure. The great German economist Kurk Richebacher was prescient when he repeatedly warned that asset inflation and bubbles were much more dangerous than rising consumer prices. Credit inflation and asset bubbles fuel over-consumption, trade deficits, and currency devaluation. The deleterious effects of deranged credit and inflationism include inequality, deep structural maladjustment, and an insecure, distrustful, and resentful society.
I believe the rise of Donald Trump and the populist MAGA movement is the consequence of decades of monetary mismanagement and pernicious inflationism. President Trump is such a divisive figure. In a CBB after the election, I wrote that half the country believes “nation saved” – the other half, “nation doomed”. No hyperbole there. Families, organizations, and communities are split, the country is spilt - along with the world. It’s impossible to analyze the current environment without an emphasis on one of history’s most powerful individuals and his new administration. So, if you disagree with my analysis – you see it as uninformed, politically ignorant – if you believe I suffer from TDS – “Trump derangement syndrome” – I understand. I get emails saying all of that and worse every week. I hope we can agree to disagree and focus on analyzing today’s precarious environment.
Not only is the Trump phenomenon a product of inflationism, I believe the President’s policy course has pierced history’s greatest bubble. Bubble collapse was inevitable. So, I won’t hold him responsible for decades of bubble excess. He’ll share blame with many for the post-bubble environment. But I certainly fear his policies will greatly exacerbate social, political, and geopolitical instability.
I’ve long feared the social and geopolitical consequences of decades of inflationism and bubble excess. Bubbles are, after all, at their core mechanisms of wealth redistribution and destruction. Corrosive inequality has become such a critical societal and political issue – at home and abroad. For the most part, the wealth destruction nature of bubbles remains masked so long as bubbles inflate. And with the great bubble now pierced, the specter of epic waste and structural maladjustment will begin to be revealed.
Society is already insecure, fractured, and bitter. Trust in our institutions has sunk to alarming depths. This also a global phenomenon. Little wonder this is the era of the “strongman” ruler, with populations gravitating to persuasive individuals championing anti-establishment populist agendas with the promise of security, retribution, and forceful change.
Today, half the country is certain Donald Trump is the right person at the right time - the other half convinced he’s the wrong person at the wrong time. I identify with the latter. Especially as the great bubble culminated in crazy excess, extending into a fourth decade, my concerns for post-bubble societal and geopolitical instability only deepened.
An already deeply polarized society couldn’t be more poorly situated for the bursting bubble. It’s become a tinderbox – and it’s difficult to envisage a President with a greater capacity to inflame. I believe this unfolding bursting bubble, with dreadful effects on markets and the economy, will create a precarious backdrop for the administration’s culture war fixation. I’ve always believed that holding society together post bubble would present a major challenge of paramount importance. These days, I have serious worries about scenarios that previously seemed “lunatic fringe.”
The consequences of decades of inflationism could be even more dangerous from a geopolitical perspective. I’ll repeat a general framework I’ve shared previously that I believe helps explain the rapidly deteriorating global environment – what is shaping up to be a breakdown of the existing world order: Bubbles are mechanisms of wealth redistribution and destruction – with detrimental consequences for social and geopolitical stability. Boom periods engender perceptions of an expanding global pie. Cooperation, integration, and alliances are viewed as mutually beneficial. But late in the cycle, perceptions shift. Many see the pie stagnant or shrinking. A zero-sum game mentality dominates. Insecurity, animosity, disintegration, fraught alliances, and conflict take hold.
From a geopolitical perspective, President Trump simply could not be more polarizing. It’s like the great disruptor is taking a sledgehammer to the brittle global order. And it’s alarming to see such fracturing, animus, and conflict heading right into deflating bubbles. Certainly, an unstable and rupturing world - and faltering bubbles - are not coincidental.
Donald Trump has been lamenting trade deficits for 35 years. I haven’t been a fan myself. But I can’t imagine a more perilous juncture to experiment with the most disruptive tariff regime in a century. Markets and economies are too fragile - fraught global relationships and alliances too frail. The President will wield his phenomenal power and coerce trade concessions. But will it prove a Pyrrhic victory? If my bursting bubble analysis is correct, a focus on bolstering our nation’s security and well-being would emphasize strengthening relationships with friends and broadening our alliances. We’ll need all of them.
The unfolding trade war with China is alarming. Hopefully cooler heads prevail. Perhaps President Trump will make more concessions. But there is clearly potential for this war to spiral out of control – during a precarious juncture for such a fight.
Chinese officials have stated they’re ready to “fight to the end.” I don’t think they’re bluffing. They’ve been preparing for this scenario for months, if not years. The President and his team, along with most analysts, believe the U.S. goes into this confrontation in a much stronger position than China. China is suffering from a real estate collapse, stagnation, and fragile finance, while most assume markets and the economy in the U.S. are structurally robust.
Conventional analysis fails to recognize our system’s acute bubble fragilities. Beijing likely comprehends U.S. vulnerabilities more adeptly than Washington. I’ve written that President Trump’s tariff policies have pushed our system to the edge - and pondered whether Xi Jinping will resist the urge to provide a nudge.
There is surely no greater priority for Xi Jinping than to see the downfall of so-called U.S. “exorbitant privilege.” This competitive advantage has for decades provided incredible benefits to China’s global superpower adversary. We enjoy the extraordinary benefits of having the world’s safe haven Treasury market - and the most robust financial markets generally - coupled with the globe’s dependable reserve currency. Now, President Trump has unwittingly exposed U.S. bubble fragility. This vulnerability, combined with reckless policymaking, puts U.S. markets, the American economy, and the dollar at great risk. Today, our financial system and economy are too fragile for misguided and haphazard risk-taking.
The U.S. and China each have a tremendous amount to lose from a trade war. But the administration and most analysts don’t appreciate that Beijing has much to gain. This trade war presents Xi Jinping with a unique opportunity in history. A global financial crisis would create challenges and risks. But blame would be directly cast on Donald Trump. The Chinese population is rallying around Xi and the communist party, a timely deflection of blame away from Beijing’s own policy blunders and mismanagement.
A Trump global crisis would also afford China a great opportunity to expand its close circle, its alliances, and its global influence. In the battle for global supremacy, one superpower would be expanding alliances and relationships, with the other at risk of being discredited and in retreat. Beijing might also calculate that a U.S. in disarray would be less compelled to exert influence throughout Asia - and less likely to come to Taiwan’s defense. A world with a wounded U.S. would be a playground for China and Russia. And for Beijing and Moscow, a world without U.S. “exorbitant privilege” would be a dream at long last coming true. It’s rational for Xi Jinping to accept short-term pain for the prospect of a level playing field that ensures China’s destiny as the supreme global power unencumbered by U.S. repression. Might Beijing do a cold, strategic calculation - and go for the jugular?
The stakes couldn’t be higher. Secretary of Defense Hegseth recently traveled to meet with Asian allies, vowing to strengthen U.S. resolve against China’s aggression. Days later, China launched major live-fire military exercises that simulated a blockade around Taiwan – while issuing stern warnings directed at the U.S.
Last week’s market behavior was fascinating, including a remarkable one-day rally following the tariff pause. At least for a day, markets dismissed President Trump’s China trade war escalation. But as yields spiked higher through the end of the week, concern shifted to whether China might be trimming its large Treasury holdings.
The administration – especially Treasury Secretary Bessent – keeps repeating what a big mistake China is making – that they’re playing with a weak hand – “a pair of twos”, as described by Bessent. For an administration that has specifically stated the objective of lowering long-term market yields, to have its trade war adversary sitting on an estimated $760 billion of Treasuries is not a “weak hand”.
There are big problems if these two adversaries refuse to back down. The world is in the throes of a major deleveraging – a dynamic that could easily spiral out of control. Just last week, global markets were at the cusp of seizing up. The leveraged speculators were caught on the wrong side of dislocating markets, forced to liquidate stocks, Treasuries, sovereign and corporate debt, and commodities. Acute stress developed across derivatives markets, notably in interest-rate and currency “swaps” markets integral to hedging strategies.
Deleveraging is a really big deal. Secretary Bessent last week called it “normal deleveraging.” And there’s some justification for complacency. There were flareups over recent years soon forgotten – the October 2022 Liz Truss UK gilts episode; the March 2023 bank run mini-crisis; and then last August’s yen “carry trade” instability. In all cases, quick policy responses reversed nascent deleveraging – and in no time it was right back to leveraging and speculating business as usual.
The last sustained deleveraging erupted with the March 2020 pandemic panic. Many of the indicators I closely monitor – CDS prices, credit spreads, risk premiums, derivatives pricing, and such – recently posted their biggest moves since 2020. This is serious and won’t be resolved with tariff concessions. Once deleveraging starts, the liquidation of positions and the unwind of speculative credit drive lower market prices and waning liquidity - a dynamic that spurs risk aversion and the impetus to reduce speculative leverage. When deleveraging is quickly reversed, the impact of waning liquidity, contagion, and risk aversion is thwarted before momentum is gained. But deleveraging attained powerful momentum last week on a systemic basis – across global markets. An ebb and flow would be typical, but it’s likely too late to get the genie back in the bottle.
A meaningful tightening of financial conditions has developed. Corporate debt issuance has slowed to a trickle. Importantly, junk bond and leveraged loan prices came under significant pressure. This needs to be reversed quickly. Our system is now years into a major “subprime” lending boom, exemplified by the imprudent ballooning of so-called “private credit.” High risk lending is always a seductively rewarding endeavor during boom times – boundless eager borrowers willing to pay exorbitant rates to finance all sorts of things. And so long as credit is readily available, a lot of overstretched and crooked borrowers will stay current on their obligations – borrowing from Peter to pay Paul – borrowing against inflated asset prices for fun and pleasure. But let there be no doubt, this is a game of musical chairs – a Ponzi scheme. When finance tightens and borrowers lose access to new borrowings, the party ends abruptly and the downside of the credit cycle takes on a life of its own.
Markets are signaling tighter finance and rapidly escalating credit concerns. There was an article a couple weeks back that highlighted the ranking of communities by the highest average household credit card balances. No surprise, California dominated the top slots. At number one, average households in Santa Clarita were carrying $22,753 on their credit cards. Chula Vista placed second at $20,567. These are wealthier communities, so I have to assume that stomaching such expensive debt was part of a strategy of plowing cash into the booming stock market.
This illustrates a fundamental vulnerability that is not well appreciated by mainstream analysts. Households have never been as exposed to stocks. A bursting equities market bubble will come with negative wealth effects and more cautious consumers. It will also expose extraordinarily problematic over-indebtedness – even for higher income households. The marketplace has started to back away from high-risk consumer credit – which will force companies to tighten credit limits and lending more generally.
From my Austrian economics roots, I often refer to the U.S. as a “bubble economy”. Bubble economies appear sound – even robust – so long as financial conditions remain loose, credit growth strong, asset prices inflated, and spending and investment elevated. However, problems fester below the surface. Vulnerability is revealed as conditions tighten. Well, conditions have tightened significantly.
It is central to my bubble thesis that uneconomic and negative cash flow enterprises have proliferated throughout this most protracted period of ultra-easy “money”. I believe years of deranged finance have come home to roost. Unless conditions loosen quickly and debt markets get back open for risky borrowers, we’ll see a ramp up of layoffs and business failures. There’s already been a collapse in small business confidence. When financial conditions remained extraordinarily loose, my analysis pointed to a tenuous continuation of “bubble economy” dynamics. Now, I believe a downturn has begun, with the potential to stun conventional analysts with its depth and duration.
But don’t listen to me – hear what markets have to say. I’ve already mentioned last week’s extraordinary spike in Treasury yields. Benchmark mortgage-backed securities yields surged 56 bps last week to 5.91%, the largest jump since 2020. Junk bond yields were up 96 bps in seven sessions to 8.58%, trading to the high since October 2023. Junk bond yield-spreads to Treasuries widened 119 bps in four sessions. Leveraged loan prices traded to lows since July 2023. CDS prices had their biggest moves since the March 2020 crisis – investment-grade, high yield, and bank CDS prices.
At Wednesday’s close, muni (AAA) yields were up 89 bps in three sessions, before ending the week 66 bps higher. Importantly, such dramatic yield spikes are indicative of markets seizing up. Debt markets – including leveraged lending - were essentially shut down. Worse yet, acute debt market stress was a global phenomenon.
Last week, 10-year yields surged 57 bps in Colombia, 49 bps in Turkey, 48 bps in the Philippines and Mexico, and 46 bps in Indonesia. EM currency losses, especially versus the surging Japanese yen, meant speculator pain and “carry trade” deleveraging. A Bloomberg headline: “Emerging Stocks Sink Most Since 2008 as Tariff Turmoil Deepens.” Down 13%, stocks in Hong Kong suffered their worst session since 1997. Major stock index losses included Taiwan down 9.7%, Japan 7.8%, South Korea 5.6%, and China 7.0%.
I view the past couple weeks in the context of an expected arduous and protracted deleveraging period. Deleveraging last week went to the precipice – and recoiled after the 90-day tariff pause. This episode provided important thesis confirmation. Highly over-levered systems at home and abroad exposed their fragility. From experience, such market dynamics tend to be unpredictable. But I am confident that the leveraged speculating community and market systems more generally have suffered impairment. Leveraged speculation over years ballooned to become THE key marginal source of liquidity throughout global markets – and this key source of liquidity is now unsteady and weakening. Confidence has been shaken – confidence in policymaking, market structure, and in the future. While timing is always uncertain, mounting fragility raises the odds that the next phase of deleveraging turns highly destabilizing.
Last week, we also learned that the Treasury market and dollar face serious issues. In past crises, so-called U.S. “exorbitant privilege” provided critical system ballast. Now, important new market dynamics are afoot. In particular, the Treasury market now seemingly creates a key source of potential instability. Concerns - including Chinese selling and even a replay of a Liz Truss-style crisis of confidence - have the potential to destabilize the most important market in the world.
Count me skeptical that Congress will rein in deficit spending. It will be difficult, if not impossible, to offset anticipated tax cuts with a combination of spending reductions and tariff revenues. I expect tariff receipts to come in much below the numbers bandied about by administration officials. I also fear that dynamics associated with deflating bubbles will see a problematic increase in countercyclical federal spending, coupled with weak receipts from personal income, corporate and capital gains taxes.
Prospects for inflation are both troubling and highly uncertain. Global market instability and deleveraging have put pressure on crude oil and some of the more industrial commodities. A seizing up of global markets has the potential to unleash the forces of economic depression and deflation. But beyond the shorter-run, inflation prospects are troubling. Globalization has been a powerful force for lower goods prices. I’m all for rebuilding our industrial base, but for many things, the U.S. would be a high-cost producer. And, at the minimum, the unfolding trade war with China will accelerate decoupling between the world’s great consumer and producer economies, a dynamic conducive to supply-chain problems and ongoing inflationary pressures.
As crisis dynamics gain momentum, I see no alternative for the Fed and global central bank community than to aggressively expand their balance sheets to accommodate speculative deleveraging and counteract acute systemic stresses. The administration’s new tariff regime will be an inflationary shock, though the intensity and duration are unclear. There is the clear possibility that the Fed is forced into another aggressive round of QE despite elevated inflation risk.
A future scenario that has for years occupied my thinking could now turn into reality. How might the Treasury market react in an environment of massive issuance, elevated inflation risk, and aggressive Federal Reserve “money printing”? I never contemplated that such a scenario would also include pursuit of the most extreme tariff regime, fraught relations with our allies, a potentially perilous trade war with China, and a trillion dollar plus highly levered “basis trade.”
For years, I’ve expounded my analytical framework and bubble thesis, warning of dire consequences. I appreciate that it has often seemed like stubbornly pessimistic analytical musings, especially with markets rising inexorably higher. Well, my overarching message is that bursting bubble risk is reality today. I purposely titled today’s call “Decades of Inflation Home to Roost”. Not “coming home” – it’s here now, knocking on the door, if you will. Reckless monetary inflation and loose financial conditions were never a solution.