This is not my favorite topic but it’s impossible to watch the stimulus plans since 2008 and not think about the meaning of money and credit. This tweet-gif reminds us of what is happening. And this tweet-gif will set the appropriate mood before I continue. Ok, here we go. A friend sent me this post because it was formative for him in how to think about the nature of money from first principles. I agree it’s fantastic.
Key points that resonated:
- The distinction between credit (economy’s money) vs monetary base (bank’s money which credit references) and how expanding the base dilutes the credit which rests on it
- Money is not wealth
- The difference between accounting plane vs physical plane and his identity relating deficits to balance of payments
- Gold is not money. It’s a tradeable asset that references money.
- Hyperinflation is the catch-up period when prices zoom up to match the expansion of the monetary base which it typically lags in the beginning. Requires feedback loop of lack of confidence leading to expanding base more
I have been thinking about hedges to inflation. Not because I expect it but because if it happens it will be painful. Same reason I buy homeowner’s insurance. I don’t expect a fire. In thinking about inflation I maintain skepticism of traditional hedges. Not for a specific reason but just because I’m paranoid about consensus solutions to any macro voodoo.
Let me give 2 examples of why I’m skeptical.
1. Elliott Management’s Q1 letter wonders about the conventional wisdom of commercial real estate being an inflation hedge. Yes, it’s a real asset. Yet they write:
Take real estate, for example. Of course, it is “real,” and you might think that it is a slam-dunk to preserve value in a serious inflation. But commercial real estate is a peculiar asset. It looks real because kicking it can break your toes, but it is generally highly leveraged and depends upon the relationship between rents and costs. If there are rent controls or moratoria, formal or forced by circumstances, and no controls on costs, commercial real estate can produce rapid insolvencies. A little thought will reveal many more examples of the complexities involved in a period of monetary destruction such as the one that is possible in the near future.
2. Since the Fed can control the short end of the yield curve it’s reasonable to think a curve steepener trade via options would be an effective inflation hedge under the dual premise that the Fed will be slow to raise rates and they can’t control the long rate anyway. But then I learned about the Fed Yield Curve Control Policy. That’s a mouthful. From an era without acronyms like TARP. I humbly offer FUCC. Not so much because it fits the words that well, but because what it would have done to a curve steepener.
You see, shortly after the US entered WWII, the Fed pinned the long rate at 2.5% to keep borrowing costs low. To an option trader, this means vol goes to zero. You think you have the right hedge on but forgot to read the rule that says the Fed can change the rules. Nothing like getting a prediction right and losing a ton of money on how it plays out.