Frozen with fear at 23-year lows

Should you be worried? There are some odd things going on in financial markets…

The amount of trading – volume – is at 23-year lows on the US stockmarket. It’s much the same for the world’s major foreign exchange currencies. The Volatility Index (Vix) for US stocks is at 23-year lows too. Why?

Gold is dipping while bitcoin surges. The cryptocurrency is now up almost 90% in 2017 while gold continues its steady fall towards $1,200. Why the divergence when they’re supposedly similar?

The financial media can’t make heads or tails of what’s going on in China. The headlines range from stimulus to austerity, from lending booms to crackdowns and from commodity gloom to boom. What’s going on?

Let’s get to the bottom of some of this…

Bitcoin leaves gold in the dust

Bitcoin’s rise is easily explained. Why gold isn’t following suit is harder to figure out.

In contrast to the US, in the last few months Japan’s government has moved to allow bitcoin to become part of financial markets and even an allowed payment system in the rest of the economy. Russia may follow suit. The increased demand for bitcoin is sending the price soaring.

Japan and Russia’s plans are an enormous political move. Bitcoin is nationless. Its payment infrastructure is decentralised. This means it challenges the US government’s control over the international financial infrastructure. For example, the US shut Iran out of the SWIFT system, preventing international funds transfers in and out of the country. With bitcoin, Iranians can bypass this easily.

Russia’s motivations are clear. Why America’s ally Japan is fostering bitcoin is unknown. Perhaps the Japanese just like the new technology.

You also have the self destruction of Venezuela to add to the list of bitcoin bonanzas. Many Venezuelans use bitcoin to order day-to-day necessities from in the US. These are then smuggled to Venezuela by dedicated companies.

Yes, smuggling is alive and well in our modern world. And bitcoin is the currency of choice.

But why is gold lagging behind? It shares so many key characteristics with bitcoin. It’s supposed to be a bet on geopolitical instability and there’s plenty of that to go around lately.

Remember, speculators control the gold market. The amount of gold bets traded each day dwarfs the amount of gold changing hands out there. This is what lets companies manipulate commodities so easily. They’ve become financialised to the point where the underlying commodity seems to matter less and less.

The eerie calm in markets

So why are financial markets so quiet?

My best guess is the same answer I give to everyone about every financial and economic question these days: central bankers control the market. And they don’t like instability. Now that they’re active in buying stocks, there’s no reason markets should fluctuate. They have buyers and bailouts of last resort, not just lenders.

In a world where markets aren’t markets, instability is below the surface. It doesn’t show up in the day-to-day fluctuations of the market, but in the overall failure of the system eventually.

We’ll look at one of the symptoms of this below. As for China, more on that tomorrow.

Another inflation alert

For many decades, conspiracy theorists and contrarians have claimed that governments enormously understate inflation. At university they tell you the opposite – that inflation is in fact overstated by governments’ measures.

The Devonshire Research Group recently studied the problem in the US and sided with the conspiracy theorists. But why should you care? The same problems apply to the UK’s own measures of inflation.

Every year most people’s incomes are adjusted for inflation – the official amount. If real inflation is far higher, you’re actually getting poorer.

On the bigger scale of things, inflation devalues the meagre gains in overall wages that economists already identify as a big problem. Imagine if they used the true inflation figures.

Inflation is also used to figure out how much of our economic growth is just price increases and how much is real increases in economic output. The data collection of both inflation and real economic output is surprisingly dodgy and requires impressive amounts of adjusting and fiddling. But here’s the key point: if inflation is in fact far higher, then the economy has been growing far slower than officially claimed. Or not growing at all.

In the investing world, breaking even after inflation is the bare minimum you’d hope to achieve. A higher rate of inflation sets the bar higher. What if you’re losing money fast in your savings account, your dividend-paying stocks aren’t even breaking even and an inflation-adjusted FTSE 100 is in a two-decade-long bear market? All without you realising it.

Worst of all is the tax story. Bracket creep is the phenomenon where inflation slowly pushes you into higher and higher tax brackets. You pay more and more of your income in tax without necessarily earning more in real terms.

So, given the importance of inflation, and the official statistics, what did Devonshire actually find in the US?

The first thing is that the enormous understatement of inflation is deliberate. Hidden inflation is good for governments and debtors, and bad for everyone else. The recent presidential candidate Newt Gingrich and former chairman of the Federal Reserve Alan Greenspan led one of the deliberate inflation understatement efforts in 1995. It was all official government policy, led by the Boskin Commission. But the economists have taken things a little further than intended in the 1995 changes.

Of course there were many changes before 1995. But Devonshire isolated those to demonstrate the point. Since 1995, the government reckons the US has had about 3% inflation (average and compound). Devonshire puts the same figure at 8%.

To put it simply, nothing has kept pace with inflation. Not wage growth, not economic growth, not the stockmarket and certainly not bonds.

The only thing that did keep pace is how much money the US government saved from the hidden inflation. The Chapwood Index, another attempt at honest measurement of inflation, puts the savings for the US government thanks to the 1995 changes at $680 billion over the ten years that followed.

Remember, the inflation rate is used to sort out true economic growth from price increases. Given the updated inflation figures, the US economy is very much in a depression. And it’s been ongoing since 2000.

The blue line shows official GDP, decreased by the official inflation. And the red line decreases GDP by Devonshire’s estimate of inflation.

Graphic showing the real evolution of GPD and the growth trajectory using and alternative contrarian.
                                        Source: Devonshire Research Group

The dodgy data and results puts into question all the supposed achievements of economic policy in the last few decades. We’ve supposedly had remarkable stability in economic outcomes since central bankers and governments figured out economics. Everyone has been arguing about what this means. But it simply might not be true to begin with.

Devonshire’s findings are in line with other less formal studies. For example, publishes the inflation data based on how the US government used to do it.

If Devonshire, Shadowstats, Chapwood and many others have it right, then we’re living in an Orwellian world. Our economic statistics are designed to placate us politically, not reflect truth. The daily hubbub in financial markets where traders claw for the release of economic data is a bizarre game.

How does all this apply to the UK? A lot more than you’d think.

US government bonds are the base of the financial system. They are the designated risk-free asset. Open any finance textbook and find an equation. It’ll almost certainly have an “rf” in there somewhere. This is the risk-free rate – the return on taking no risk. It’s sort of like the wind direction for a sailor, the Earth’s rotation for an astronomer and friction for a physicist. It’s the base of the calculation whereby everything else is adjusted.

If inflation is high, this risk-free rate is in fact far lower in reality. The Earth is spinning faster than we thought and the wind direction was different all along. Everything in the financial world changes perspective.

That’s aside from the fact that our own British inflation statistics are gathered in much the same way. And fiddled with in the same way too. Many of the symptoms you’d expect are all around us. The tax burden of the British rich has trebled since the 1970s – when inflation got out of hand. This is largely due to bracket creep.

I met a British inflation statistics economist in New Zealand at a rugby 7s tournament. My friends thought I was flirting with her. We were actually both animatedly discussing how dodgy the inflation data collection methods are. Not to mention the adjustments done to that data. As she put it, it’s all “complete b******t”.

She probably thought I was flirting with her too.

Until next time,

Nick Hubble
Capital & Conflict

Category: Economics

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