Adding to the recent confusion of why the markets are moving up is whether liquidity is, or is not being added to the financial system. It appears bank lending is contracting but other things are happening behind the scenes in swap rates and yield curves. While some of us point to the Fed saying it is tightening and reducing its balance sheet some economists point to a back channel inflow of liquidity juicing the system.

A case can be made that recent market action remains more about liquidity than interest rates. A lack of liquidity can be poisonous. When you need money, whether the amount is small or large, not being able to get it can lead to a life-changing or grave outcome.  Interestingly, as noted above, the liquidity issue remains unresolved. Central banks are well aware that contagion from one area can spill over into other sectors of the economy and markets. This is why China continues to inject liquidity into its market. How much of that money is getting out of China is an issue.

So, here we sit, new market highs at a time when many economy watchers are voicing concerns the economy is rapidly slowing and the Fed is already behind the curve in dropping rates. The counterargument being floated is that all is well and we are in the midst of a soft landing or no landing. The latter is the optimistic view that we have entered a Goldilocks moment and the markets are set to go ever higher.

Those taking the stand a quick reversal of Fed policy and looking at rapidly falling rates may be failing to consider trees don’t grow to the sky. It could be argued a major pullback is necessary to avoid a much more severe problem or bigger disaster in the future. Inflation is a key component in assessing where things go from here.  Again, I point to The Hard Asset Inflation / Paper Asset Deflation Theory

Much of the current market danger stems from the fact the fluid financial and economic situation is highly leveraged. If something breaks, the amount of money needed to backstop and halt a collapse of the system will be far larger than anything we have seen in the past. Remember a massive drop in asset prices and the value of bonds directly impacts pension funds and many other aspects of our financial structure.

A great deal of what we call growth has been, or is now financially engineered by companies buying back their own shares and other companies rather than growing organically. This risk is constantly being downplayed as more and more of the concentration of wealth pushes takes place, into just a few companies. A case and point often raised is the huge market capitalization of what is known as the “magnificent seven.”

As usual or maybe even more than usual, we should continue to factor in the idea things could be shaken by another pandemic, massive war including the use of nuclear weapons. The whole idea that stocks climb a wall of worry and fall like a stone underlines the fact that markets are non-linear and do not move in a straight line. People tend to slip into a generally optimistic feeling of complacency and discount this reality.

Lower inflation figures strongly into the euphoria we see in the market. Much of this has been driven by lower gasoline prices which are likely to prove temporary and the idea the costs of “shelter” or keeping a roof over your head will soon decline. These notions brush aside several important facts such as the rising cost of labor and other factors feeding into housing. These include insurance, soaring maintenance costs, and rising taxes. All of these are expected to move higher in the future.

A bond fella recently recently made the case that yields would drop as inflation falls. Several pundits have speculated the Fed must “know something, or be spooked” to have changed course. Pulling on this thread could lead us back to the notion China’s economy is in free-fall and it is the main reason rates will be falling everywhere. This has resulted in the notion we will see super strong demand for bonds during a recession even if the supply is huge.

Still, buying long-term bonds to hold is far different than buying them to hold. Long term we have to look at the future of fiat money and inflation from currency debasement. I’m not convinced it is wise for investors to lock themselves into any fiat currency long-term as things could change rapidly.

Consider the possibility that the Fed is yielding to pressure rather than making a policy change based on choice. By prematurely declaring inflation as no longer an issue it takes pressure off government bonds and banks. When we look back at how this plays out it is likely the importance of liquidity and the money supply will prove far more important than minor changes in interest rates.

In a recent video delving into inflation in commodities, Daniel Lacalle claimed there are only three ways to halt inflation and inflation is fueled by monetary conditions. Lacalle says the only way to stop inflation is raise interest rates, reduce the amount of money in the system, or to create an aggregate demand reduction of credit.

The public sector, or to qualify, governments are busy thwarting all these factors. As long as governments and central banks continue to overspend and print money the inflation beast will remain a ferocious creature.