Get Ready for 'Twin Peaks' Inflation
Editor's note: History is poised to repeat itself...
In the 1970s, a rapid expansion of the money supply caused the U.S. government to implement higher interest rates to pull the economy out of a recession.
While today's economy appears under control, Stansberry's Credit Opportunities editor Mike DiBiase believes we're currently on the path toward repeating this inflation cycle.
In today's Masters Series, originally from the December 2024 monthly issue of Stansberry's Credit Opportunities, Mike explains why we're likely to see another "twin peaks" in inflation this decade like we experienced during the 1970s...
Get Ready for 'Twin Peaks' Inflation
The farmers blockading Paul Volcker's D.C. office were out for blood...
Volcker had only been the Federal Reserve chairman for a couple months. But he was already one of the most hated men in America.
You see, Volcker had inherited a mess at the end of 1979. Government overspending in the 1970s on social policies and the war in Vietnam led to budget deficits and a massive increase in the national debt.
It all started when the U.S. ended the gold standard...
Under the Bretton Woods system, the big economies all pegged their currencies to the U.S. dollar, which in turn could be converted to gold at a rate of $35 per ounce. And when other countries saw the growing U.S. budget deficits, they started demanding gold for their dollars.
The demand for conversions got so bad that President Richard Nixon blew up the system. He ended "gold convertibility" in 1971. With gold no longer the anchor of the financial system, it opened the door to a massive expansion of the money supply.
Making things worse, OPEC launched an oil embargo in 1973 to punish the U.S. for supporting Israel in the Yom Kippur War. The price of gas nearly quadrupled between October 1973 and January 1974. The consumer price index ("CPI") climbed to as high as 12% in 1974.
Arthur Burns, the Fed chair at the time, dismissed higher costs as transitory. (Sound familiar?) But he was wrong... and was forced to raise interest rates – culminating in a 13% rate in 1974. Higher rates ultimately choked off inflation but led to a 16-month recession...
The government's answer, of course, was to stimulate its way out of the recession. The money supply exploded higher in 1976 and 1977.
Only one man, economist Milton Friedman, predicted what would happen next...
Inflation began to soar again, shooting up from 5% at the end of 1976 to 12% by October 1979. It was showing no signs of slowing.
Enter Paul Volcker...
Volcker called a surprise meeting on October 6, 1979 – about two months after he was made the new Fed chair. That's where he announced a drastic policy shift: The Fed's primary focus in fighting inflation would be managing the money supply.
That meant that the Fed would slow its purchases of Treasurys and limit the supply of reserves. And interest rates would need to go much higher. These policies, later dubbed the "Volcker shock," would tighten credit and choke off government spending.
With inflation at 15% in 1980, Volcker raised interest rates to nearly 20%. That meant more pain for already hurting Americans. They were furious.
Farmers drove tractors to the Fed's headquarters to protest. Homebuilders and construction workers stamped messages onto pieces of two-by-fours they couldn't use for building and sent them to the Fed. Auto dealers sent keys of unsold cars.
Members of Congress accused the Fed of destroying the American dream and introduced a bill to impeach Volcker.
No Fed chairman has ever been more hated.
But ultimately, Volcker's hard medicine worked... Inflation sank to around 2.5% by the middle of 1983. Volcker succeeded where other Fed chairs had failed... because he understood that there was no easy, painless way to cure inflation.
And that brings us to today...
Just like in the mid-1970s, everyone thinks inflation is tamed. And yet, once again, government spending is out of control – and the money supply is on the rise.
We're not in the situation Volcker found himself in yet. But the Fed's actions have made it an inevitability.
As I'll explain today, a recession is very near. I expect the government will make the same mistake it did in the mid-1970s and try to "fix" the economy with more monetary stimulus.
That will only make things worse. The seeds are in place today for another 1970s-style "twin peaks" in inflation...
The last recession was in 2020, following the pandemic. The Fed responded by unleashing unprecedented monetary support for the economy. First, it lowered interest rates to next to zero. Then, it fired up its money printer and injected more than $6 trillion of new money into the financial system.
This pulled the economy out of the recession after a few months, making it the shortest on record.
But this massive stimulus had a cost. Inflation soared. And the Fed was left with far fewer bullets for next time...
Following the pandemic, never before in our history have we seen that much money printed all at once. You can see this by looking at the U.S. M2 money supply. This is essentially all the money in the system... It includes cash, checking and savings accounts, money-market accounts, and mutual funds.
The money supply soared from around $15 billion at the end of 2019 to nearly $22 billion by March 2022.
No one knew more about inflation and its causes than the late Nobel Prize-winning economist Milton Friedman. Friedman said it best... "Inflation is always and everywhere a monetary phenomenon." In other words, if you want to understand inflation, follow the money supply.
Friedman explained that when the money supply increases faster than the economy, it always causes inflation. It normally takes a year or two for the increase to show up in higher prices. But it always does...
Since World War II, the money supply has increased about 6% per year. Following the pandemic, it ballooned more than 40% in a two-year span. We've never seen that kind of increase before.
This alone explains why we saw inflation soar from around 2% before the pandemic to 9% by June 2022. It had little to do with supply shortages or shipping bottlenecks.
You can see in the previous chart that the Fed began decreasing the money supply in 2022 and 2023. Along with raising interest rates, that helped bring down inflation.
However, there are a few troubling things you should pay attention to in the chart...
First, the money supply is still well above its long-term trend of 6% annual increases. That tells us there is still too much money and liquidity in the system.
Next, the money supply is once again increasing. In fact, it has increased every single month for the past 14 months. This is something you won't hear about in the mainstream media. But this is exactly what Milton Friedman would be paying attention to today if he were alive.
And this trend isn't likely to reverse...
The federal deficit is now around $2 trillion per year. The only way the U.S. government is going to fund its uncontrolled spending is by selling Treasurys.
The Fed is the Treasury's primary lender. When the Fed buys Treasurys with newly printed money, the money supply increases.
And it will continue being a massive net buyer of Treasurys for another reason...
When inflation rises, long-term interest rates rise in response. The Fed wants to keep long-term rates down, too, but it doesn't directly control them. The only way for it to bring long-term rates down is by buying Treasurys in the open market. This is known as quantitative easing. Quantitative easing also causes inflation.
It's for these reasons I expect the money supply to continue to increase in years to come. And as long as the money supply is increasing rapidly, inflation will continue to be a problem.
This is exactly why I think we are headed for another "twin peak" inflationary period like the 1970s.
I think the next recession will begin in the first half of 2025. I expect economic news over the next few months to worsen.
Consumer savings will continue to be depleted and credit-card debt will keep breaking records. Delinquencies and defaults on credit-card and car loans will continue to rise. So will corporate bankruptcies, which hit levels last year not seen since the aftermath of the last financial crisis.
The negative headlines will eventually sour investors. When it's clear a recession can't be avoided, the high-yield credit spread will rise. I expect the spread to spike close to 700 basis points ("bps") by the middle of this year.
But the Fed will act quickly to calm the markets as best it can.
It will aggressively lower interest rates much further. And it will ramp up its quantitative easing. This means buying hundreds of billions of dollars of Treasurys in the open market to drive down long-term interest rates that securities like mortgages and corporate bonds are tied to.
It will work... for a while. The recession will end. Markets will recover. The spread will fall, signaling fear has waned from the credit market.
But just like in the mid-1970s, this monetary stimulus will be highly inflationary. Inflation will begin to surge again, most likely in 2026. Remember, it takes around 12 to 18 months for large increases in the money supply to show up in inflation figures.
The second wave of inflation will be devastating for consumers, businesses, and investors who didn't see it coming. The high-yield spread will soar as investors lose confidence in the Fed.
It will have little choice but to channel the spirit of Paul Volcker. The Fed will be forced to raise interest rates much higher and move to aggressive quantitative tightening policies with a primary focus on contracting the money supply and credit.
This will kick-start the next true credit crisis. I expect the high-yield spread to soar past 1,000 bps as the economy plunges into another recession. This one, however, will last much longer than the one in 2025.
Here's what this forecast looks like in a chart of the high-yield spread (with recessions highlighted in gray). The blue part of the line is our forecast of the spread...
While this might be a scary forecast for most, if you understand credit cycles, you don't have to fear them. You can use them to make more money in safe, fixed-income investments than you ever thought possible. It's the best time to "back the truck up" for bond investors.
Our Stansberry's Credit Opportunities newsletter track record is proof of that.
Our returns have been far better on recommendations we made when the high-yield spread has spiked.
For example, when the World Health Organization declared COVID-19 a pandemic in March 2020, the high-yield credit spread suddenly soared to more than 1,000 bps.
In our Stansberry's Credit Opportunities newsletter, we recommended eight very safe bonds soon after. Our timing was excellent... The wave passed almost as quickly as it came.
The average return of those eight closed bonds was 18% over an average holding period of 112 days. That's a phenomenal 59% annualized return.
To sum it up, while the coming recession is a legitimate reason for concern, I believe the next few years promise to be extremely profitable for corporate-bond investors...
Good investing,
Mike DiBiase
Editor's note: Between geopolitical conflict, the banking crisis, and ongoing volatility, many investors are unsure about where the market is headed. And Mike believes we're on the verge of financial turmoil...
He says a recession will hit the markets as soon as next month. To help you prepare for this key inflection point, he's hosting an online presentation to reveal the one step you must take immediately. Learn more here...