“It’s a good time to retire that word,” said Powell, seated comfortably next to Yellen. Senator Toomey had asked how long inflation must run above target before the Fed decides, maybe it’s not so “transitory.” The Senate Banking Committee’s Ranking Member appeared as surprised as virtually every Wall Street economist that two consecutive years of 15% deficits, financed by Jay’s magic money machine, lifted inflation in ways that have begun to appear persistent. “I think what we missed about inflation,” Powell admirably conceded, “was we didn’t predict the supply-side problems, and those are highly unusual and very difficult, very non-linear, and it’s really hard to predict those things, but that’s really what we missed, and that’s why all of the professional forecasters had much lower inflation projections.” No doubt our Fed Chairman is right. There’s not an economic model in the solar system that could have forecast today’s extraordinary inflation without first predicting the “highly unusual, very difficult and very non-linear” supply constraints plaguing the global economy. But that is all now understood. What is not known is how monetary policy can or should be used to alleviate these supply constraints. For nearly half a century, the Fed reaction function was nearly linear. When the system deviated unacceptably far from stability, equilibrium, the Fed added new monetary tools. Forward guidance. Average inflation targeting. Whatever it took. And it is possible that once the invisible hand restores global supply chains, markets and economies will return to their familiar states. But having just retired the notion of transitory, the entire system appears to be moving towards a non-linear mode.

Week-in-Review (expressed in YoY terms): Mon: Biden urges Americans not to panic wrt Omicron, Japan shuts borders to foreign travelers, S. Africa officials say Omicron infections associated with mild symptoms so far, Erdogan continues to push for lower rate policy, OPEC+ says may reconsider its Jan prod increase in light of Omicron, Dorsey stepped down as Twitter CEO, Spain CPI 5.6% as exp, Mexico unemp 3.95% (4.07%e), German CPI 6% (5.5%e), US pending home sales 7.5% MoM (1%e), S&P 1.3%; Tue: Powell suggests Fed should consider wrapping up tapering a few months sooner, Moderna expects Omicron to elude vaccine but expects to have new vaccine ready by early 2022, Japan IP -4.7% (-4.5%e), Australia private credit 5.7% (5.8%e), Japan housing starts 10.4% (5.5%e), Turkey GDP 7.4% as exp, France PPI 14.9% (11.7%p) / CPI 3.4% (3.2%e) / cons spending -5.3% (-5%e), German unemp 5.3% (5.4%e), Poland CPI 2.7% (1.8%p), Italy CPI 4% (3.3%e), EU CPI 4.9% (4.5%e), Brazil unemp 12.6% (12.7%e), India 3Q GDP 8.4% (8.3%e), US Case Shiller 19.05% (19.3%e), US cons conf 109.5 (110.9e), S&P -1.9%; Wed: Turkey CB intervenes to defend lira collapse, Biontech/Oxford say vaccine should still protect against severe disease, S. African hospitalizations jump (although still much lower than August wave), US reports first omicron case, S. Korea impts 43.6% (39.6%e) / expts 32.1% (27.2%e), UK house prices 10% (9.3%e), Swiss CPI 1.5% (1.4%e), Hungary PPI 18.5% (14%p), S&P -1.2%; Thur: Senate passes bill to avert gov’t shutdown, Erdogan fires Treasury and Fin min given his opposition the recent interest rate policy, S. Africa announces omicron transmits faster than delta and prior infection doesn’t provide protection but looks to cause less severe illness, S. Africa in talks with Pfizer to gain access to covid treatment pills, CB Hungary hiked 20bps – 15bps exp (brings total hiking to 130bps), OPEC+ sticks with 400kbpd production increase for Jan after rumors of trimming to 200kbpd amid Omicron, Didi begins delisting in the US amid pressure from Chinese govt, Biden announces tougher testing requirements for abroad travelers/ extends mask mandate on planes / requires insurers to reimburse at home tests, Fed Bostic and Mester reaffirm probability of increased tapering, Russia foreign minister warns Europe of returning to the “nightmare of military confrontation” wrt Ukraine, EU court agreed that the EU has the right to withhold budget distributions to member states backsliding on the rule of law (ie Poland and Hungary), S. Korea CPI 3.7% (3.1%e), Italy unemp 9.4% (9.1%e), EU PPI 21.9% (19%e), EU unemp 7.3% as exp, US initial claims 222k (240k exp), S&P +1.4%; Fri: US NFP 210k (550k exp) / unemp 4.2% (4.5%e) / AHE 4.8% (5%e), US Treasury refrains from naming any ccy manipulators, BoE’s Saunders sees some advantages for the BoE to wait for Omicron data before considering a rate hike, ECB’s Lagarde says 2022 hike unlikely but will act on prices if needed, Maduro kicked out EU electoral monitors, Turkey CB intervened for 2nd time this week, Erdogan bars opposition leader from entering statistics office following CPI release, Turkey CPI 21.31% (20.7%e) / Core CPI 17.62% (17.5%e) / PPI 54.62% (49%e), Brazil IP -7.8% (-5.1%e), Canada emp change 153.7k (37.5k exp) / unemp 6% (6.6%e), US ISM services 69.1 (65e), S&P -0.8%; Sat: Digital asset prices drop sharply (extending recent declines), Omicron news out of S. Africa suggests mild symptoms.

Manufacturing PMI (high-to-low): Norway 63.68 (prev month 58.78), Sweden 63.3 (prev mth 64.2), Italy 62.8/61.1, Switzerland 62.5/65.4, United States 61.1/60.8, Netherlands 60.7/62.5, Greece 58.8/58.9, UK 58.1/57.8, Austria 58.1/60.6, India 57.6/55.9, Germany 57.4/57.8, Canada 57.2/57.7, Czech Republic 57.1/55.1, Spain 57.1/57.4, France 55.9/53.6, Taiwan 54.9/55.2, Japan 54.5/53.2, Poland 54.4/53.8, Indonesia 53.9/57.2, Hong Kong 52.6/50.8, Hungary 52.2/52.9, Vietnam 52.2/52.1, Turkey 52/51.2, Russia 51.7/51.6, South Africa 51.7/48.6, South Korea 50.9/50.2, Singapore 50.6/50.8, China 49.9/50.6, Brazil 49.8/51.7, Mexico 49.4/49.3. Services PMI: Sweden 68.7/68, Spain 59.8/56.6, Ireland 59.3/63.4, UK 58.5/59.1, India 58.1/58.5, US 58/58.7, France 57.4/56.6, Italy 55.9/52.4, Brazil 53.6/54.9, Japan 53/50.7, Germany 52.7/52.4, China 52.1/53.8, Russia 47.1/48.8.

Weekly Close: S&P 500 -1.2% and VIX +2.05 at +30.67. Nikkei -2.5%, Shanghai +1.2%, Euro Stoxx -0.3%, Bovespa +2.8%, MSCI World -0.7%, and MSCI Emerging +1.1%. USD rose +11.1% vs Turkey, +1.7% vs Australia, +1.1% vs Chile, +0.9% vs Brazil, +0.8% vs Sterling, +0.7% vs Indonesia, +0.4% vs Canada, +0.4% vs India, and flat vs Euro. USD fell -9.5% vs Ethereum, -3.0% vs Bitcoin, -3.0% vs Mexico, -2.3% vs Russia, -1.3% vs South Africa, -0.5% vs Yen, -0.3% vs China, and -0.2% vs Sweden. Gold -0.2%, Silver -2.8%, Oil -2.8%, Copper -0.6%, Iron Ore +0.4%, Corn -1.3%. 5y5y inflation swaps (EU +10bps at 1.91%, US -1bp at 2.44%, JP -13bps at 0.40%, and UK +1bp at 3.96%). 2yr Notes +9bps at 0.59% and 10yr Notes -13bps at 1.35%.

Nov Mthly Close: S&P 500 -0.8% and VIX +10.93 at +27.19. Nikkei -3.7%, Shanghai +0.5%, Euro Stoxx -2.6%, Bovespa -1.5%, MSCI World -2.3%, and MSCI Emerging -4.1%. USD rose +40.3% vs Turkey, +5.5% vs Australia, +5.0% vs Sweden, +4.4% vs Russia, +4.3% vs Mexico, +4.3% vs Bitcoin, +4.2% vs South Africa, +3.2% vs Canada, +2.9% vs Sterling, +1.9% vs Euro, +1.8% vs Chile, +1.1% vs Indonesia, and +0.4% vs India. USD fell -7.6% vs Ethereum, -0.7% vs Yen, -0.6% vs China, and -0.2% vs Brazil. Gold -0.5%, Silver -4.9%, Oil -19.1%, Copper -1.4%, Iron Ore -6.8%, Corn -1.5%. 5y5y inflation swaps (EU -9bps at 1.86%, US +2bps at 2.49%, JP +1bp at 0.47%, and UK +21bps at 3.97%). 2yr Notes +7bps at 0.57% and 10yr Notes -11bps at 1.45%.

YTD Equity Indexes (high-to-low): UAE +69.4% priced in US dollars (+69.4% priced in dirham), Argentina +40.2% priced in dollars (+68.6% in pesos), Israel +26.7% in dollars (+24.7% in shekels), Czech Republic +25.9% (+32.7%), Saudi Arabia +25.3% (+25.2%), Austria +22.4% (+33%), Taiwan +21.8% (+20.1%), S&P 500 +20.8%, Russia +20% (+19%), India +19.4% (+23%), Venezuela +18.7% (+379.1%), Canada +17.7% (+18.4%), NASDAQ +17%, MSCI World +15.7% (+15.7%), Netherlands +14.4% (+23.6%), Norway +14% (+21.9%), France +12.8% (+21.9%), Hungary +11.4% (+21.1%), Denmark +10.2% (+19.7%), Switzerland +9.4% (+13.8%), Russell +9.3%, Poland +8.7% (+18.8%), South Africa +7.7% (+18.3%), Italy +7.4% (+16.7%), Sweden +7.3% (+19.5%), Mexico +7% (+14.8%), UK +6.9% (+10.2%), Indonesia +6.5% (+9.4%), China +6.3% (+3.9%), Euro Stoxx 50 +6.3% (+14.8%), Belgium +5.4% (+13.9%), Singapore +5.1% (+9.1%), Finland +3.9% (+12.9%), Germany +1.8% (+10.6%), Greece +0.6% (+8.7%), Australia +0.1% (+9.9%), Portugal -0.6% (+7.4%), Ireland -1.4% (+6.6%), Thailand -3% (+9.6%), Korea -4.9% (+3.3%), Spain -5.6% (+2.1%), Philippines -6.1% (-1.2%), Japan -6.5% (+2.1%), New Zealand -9.1% (-3.2%), Chile -11.5% (+4.6%), Malaysia -12.4% (-7.7%), HK -13.2% (-12.7%), Colombia -14% (-0.4%), Brazil -19.3% (-11.7%), Turkey -29.9% (+29.4%).

Thermodynamics: “The interaction of inflation-focused monetary policies in the west and China’s mercantilist model created what I call The Refrigeration Mode,” said the CIO, sitting atop his prodigious pile. “The process has been ongoing for twenty years,” he continued. “The inflation-focused policy framework is based on the fallacy that you can model an economy using an equilibrium framework,” he said. “Wicksell was the father of classical equilibrium in economics. He observed that for a pure credit economy - with no external gold backing for money, just credit-backed deposits – there were no clear forces that would drive the system toward equilibrium. To the 19th century Wicksell, a pure credit economy was a fictitious, futuristic concept, but it is effectively what we have today - and it is a path dependent system.”

Thermodynamics II: “What is a path dependent system?” asked the CIO, not waiting for my answer. “Take the male driver when lost. Despite all evidence around him, the male believes he is not lost. He is, of course. And yet has no need for a map. The male is merely taking a different route, maybe a better a route to the same inevitable, incorrect destination. That destination being equilibrium. It’s all taking place in the male’s head. The reality on the road, meanwhile, is rather different. He turned left at the fork in the road when he should have gone right. There is, now, no natural force - other than blind luck and a tactful passenger - which can rescue him. Further wrong turns, and his destiny await. His destination is path dependent.”

Thermodynamics III: “So now consider a simplified schematic,” said the CIO. “The economy receives a positive supply shock which lowers inflation and allows rates to fall. This brings forward consumption. Consumers borrow and spend. Asset prices go up. Financiers get excited. More intermediation and engineering. We get inevitable excess. Policy tightens. This causes a financial crisis, which the central bank is forced to respond to - with the fear of deflation in mind - and rates fall further. The net effect is that nominal and real rates ratchet lower in a path-dependent fashion. And this leads to a monetary policy that is so lost we’ve had to create a new word to describe our bizarre destination: a world of financialization or more appropriately, hyper-financialization. It is the optimization of the economy around finance and asset prices - the fuel for the Occupy Wall Street manifesto.”

Thermodynamics IV: “Now let’s look at the other half of this system: China’s mercantile model,” said the CIO. “We all vaguely know the story here - we all tried shorting it at one point or another. China discovered the Magic Money Tree. They used it to build a manufacturing empire and stopped the magic escaping from the capital account. This was MMT used in anger. They repressed the exchange rate to take export market share and accumulated FX reserves in the process. These were recycled into US Treasuries, supporting lower US interest rates. They repressed depositors with negative real returns on deposits to favor investment over consumption. The consumption share of GDP has remained depressed throughout, subjugated to investment exports and government spending. No wonder property became the savings vehicle of choice - and seemed to be an everlasting bubble. Free money allowed a massively accelerated pace of industrial development, especially after China joined the WTO in 2001.”

Thermodynamics V: “China’s rapid industrialization and hunger for global market share kept deflationary pressure on durable goods prices for thirty years, helping to keep consumer price inflation and interest rates lower in the West. And the beauty of the Magic Money Tree was that China could insulate its highly cyclical industry from any default cycle. It monetized bad debt and preserved unprotected, deflationary capacity. The stock of money ballooned. Banking assets are now around $52 trillion. They’ve grown by about $40 trillion since 2008. They’re now twice the size of the US banking system and China’s banks have added the equivalent of the US banking systems in just eight years. This is what hyper MMT looks like.”

Thermodynamics VI: “The net result is that western monetary policy and China’s mercantile model fed off one another to give us this Alice in Wonderland ‘through-the-looking-glass’ transformation of massive monetary growth into a deflationary mechanism: The Refrigeration Mode. Both sides got what they wanted: China leapfrogging industrial development, and the US got low inflation in the great moderation. But it had side effects. A massive monetary overhang in China, hyper financialization in the US. These extremes are now biting back on the system through the political economy.”

Thermodynamics VII: “The Deflationary D’s may still be with us (debt, demographics, disruption, digitization), but the system dynamic is becoming inflationary and there are some new supply side shocks that aren’t deflationary for a change. Both sides are in reflux. On the macro policy side, we are seeing powerful social reactions to the extremes produced by The Refrigeration Mode. These extremes are feeding into the political economy. Whether it’s the ‘Tax the Rich’ dress at the Met Gala, politicians and celebrities at climate change marches around the world, or bipartisan support for China containment, the challenge to the status quo is clear and present. The COVID crisis merely poured petrol on it.”

Thermodynamics VIII: “It means fiscal policy is back in the driver’s seat - just as central banks put an inflationary bias into their reaction functions. Future bailouts are coming via Main Street, as much as Wall Street. And when monetary and fiscal policy combine, policy becomes more directly inflationary in CPI terms, not simply in asset price terms.”

Thermodynamics IX: “On the China side, the model is pivoting. Common prosperity in its ‘dual circulation strategy’ shifts the emphasis from a reliance on exports to a focus on the domestic consumer in regional markets. A digital currency will be presented as a haven of stability, while other economies appear to be debasing their own currencies. Deleveraging is a goal - so more defaults will be allowed. Profits will take precedence to export market share. So expect to see China continuing to export more goods priced at a premium, leaning against commodity price inflation. Taken together, all these changes transform The Refrigeration Mode into its reverse: A Heat Pump.”

Anecdote: “To prepare for the future, we must first reimagine the past in a manner that central banks won’t,” said the CIO. “So, what is it that central banks can’t imagine?” he asked, rhetorically. “Can they imagine being both right and wrong? Right that the inflation potential of the system is low due to the persistence of deflationary forces that are now well known, but wrong because their actions - based on this belief in deflationary tendencies - unnerves depositors sufficiently that they want to get out of the currency,” he said, the S&P 500 still within a few percent of record highs, home prices surging, used car prices too. “And can central banks also imagine technology being both deflationary and inflationary?” he asked. “Deflationary for all the obvious reasons - just ask the shoeshine about artificial intelligence and productivity – and inflationary because social media can amplify inflationary fears, while financial technology enables more and more depositors to switch out of dollars at the tap of a button,” he explained, countless buy and sell orders from a whole new generation of day traders, addicted to Robinhood, swirling in the cloud. “It could be the currency equivalent of a bank run in the 19th century when the mere rumor - true or false - of a bank losing its gold reserves, could set off a run,” he said, a student of the rich history of financial booms, busts, panics. “So, can these two paradoxes combine to take out a reserve currency?” he asked, concerned less by the immediate market risks, but rather, what happens when the next big equity market decline forces the Fed to ease policy while inflation remains robust. “Perhaps this will be how our story ends. A run on the dollar takes hold, the world’s reserve currency collapses,” he said. “It’s the explosive ending central bankers can’t imagine.”

Good luck out there,

Eric Peters

Chief Investment Officer

One River Asset Management

Disclaimer: All characters and events contained herein are entirely fictional. Even those things that appear based on real people and actual events are products of the author’s imagination. Any similarity is merely coincidental. The numbers are unreliable. The statistics too. Consequently, this message does not contain any investment recommendation, advice, or solicitation of any sort for any product, fund or service. The views expressed are strictly those of the author, even if often times they are not actually views held by the author, or directly contradict those views genuinely held by the author. And the views may certainly differ from those of any firm or person that the author may advise, drink with, or otherwise be associated with. Lastly, any inappropriate language, innuendo or dark humor contained herein is not specifically intended to offend the reader. And besides, nothing could possibly be more offensive than the real-life actions of the inept policy makers, corrupt elected leaders and short, paranoid dictators who infest our little planet. Yet we suffer their indignities every day. Oh yeah, past performance is not indicative of future returns.