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Pound Collapse: “I Just Can’t Wait to Be King”
September 28, 2022

This week is unbelievable. Uncertainty. What the folks at Foreign Affairs describe as the age of uncertainty, what we exist in now, this is an amazing week to 10 days. The rapid deterioration of financial conditions. There are a few times in our professional lives where we see the rapid deterioration of financial conditions happen so quickly.” – David McAlvany

Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick along with David McAlvany. We were just talking to the person who does the editing and recording of the show, and he’s a pilot. I agree with him. He says, “Flying is hours of boredom interrupted by moments of sheer terror.” It reminds me of the Lenin quote, and I know your dad likes this quote, “There are decades where nothing happens and weeks where decades happen.” Look at this week.

David: Yeah, in one week period, can you recall so many macro events unfolding all at once? There are financial dislocations everywhere and most disturbingly, the dislocations are moving to the core of the financial system. You’ve got government debt and your largest governments, the G7 currencies under immense pressure. Reuters defaulted to something very dramatic describing it as a macro tsunami.

Kevin: Well, England lost their queen of 70 years. What is it? 70 years, seven months, seven days. I can’t remember exactly how that works, but I heard this morning that that’s almost a third of American history with one single queen. So you have the loss of the queen, and I know that that’s a big deal in Britain, but you also have the breakdown of the British pound. I mean, do you remember when the pound was two or three times the value of the dollar? At this point it’s just about the same?

David: Yeah, In fact, it was at one time four to one, and then it made that cataclysmic crash to two to one. And now we’ve seen it move basically to one to one. British yields exploded higher, and that was followed by European yields across the periphery if you’re talking about Greek and Italian, and Portuguese, pound reached a record low surpassing the levels that forced the Plaza Accord in 1985. So dollar strength in 1985, of course, we had the Volcker rates, which attracted a lot of foreign capital into the US. And the dollar strengthened and strengthened, and strengthened, to the point where you had a collection of countries gather to figure out how to, in a coordinated fashion, devalue the dollar so that they could relieve the pressure on those other major world currencies. So balance sheet losses right now for the Bank of England are totaling to over $215 billion from the increase in interest rates. Billion with a B. And they’re, of course, just in the next week to 10 days scheduled to sell off assets, reduce the size of their balance sheet, and add more surplus, add more supply, to the bond market at exactly the wrong time, when there’s not much appetite for the British gilts—what they call the Treasurys.

Kevin: And just like Dorothy was no longer in Kansas, we’re no longer in 1985. I mean the dollar, what is it, 20 year highs right now with the dollar’s reaching. Maybe it’s going to go even higher than that. But you look at what’s going on now, we’re not about to try to save the rest of the world by devaluing the dollar at this point. It sounds to me like Powell is fairly committed.

David: Whenever you’re looking at markets and there’s big moves, they tend to gain steam and move towards sort of the parabolic at the tail end. So the most dramatic moves and the most ground is covered in the shortest period of time just as the market is getting ready to tank.

Kevin: You think that’s going to happen with the dollar, another spike up?

David: We’re here at a 20-year high. On our asset management side we’ve raised cash the last half year to a year and a half, and that’s had its merits. Now, we contemplate how much higher the spike in the dollar will go. We suspect it could be a generational high water mark, which is very significant if you just let that sink in. And the dynamics driving it now are somewhat self reinforcing. So sure, we’re at 114, 115. Could we see 117, 120? Is the top already in?

Kevin: Well, are we going to try to save Germany? Are we going to try to save Britain, Japan, the other currencies by laying off on this interest rate increase?

David: We’ve got inflation on the one hand, which we have to fight, but on the other we have another rotation into safe haven plays in the US dollar, and the US Treasury market would to some degree be considered a safe haven still. So when we see the more severe expression of a bear market in global equities, which I think is here, I truly believe it’s here, then I think you see another push higher in the US dollar. We’re almost there. Maybe we’re there. Maybe we’re almost there. But I think really when you begin to see the weakness in the equities markets and the decomposing nature of the equities markets, the fragility within the derivatives markets, we’re ready for one last push, one last push in the US dollar. And again, I think it’s going to be a generational high water mark. 

It is different than 1985. We’re unwilling to depreciate our currency at this point in the aid of France and Germany. It was West Germany at the time, Japan and the UK. This is not the Plaza Hotel. This is 2022. And US politicians have the lens of self-interest in hand. They look at the world and see that they need to take care of themselves. And in that case it is do whatever you have to do to bring inflation down and hopefully not crash the system in the process. 

We all, each individual country around the world, have inflation problems, and we’re all raising rates. In some instances it may be too little, in which case the market punishes you as we saw with the UK. I think 50 basis points was not enough for the bondholders in the UK and globally who hold British paper. It wasn’t enough set next to the double-digit rates of inflation that are already there. Maybe 75 basis points, a heftier lift would’ve helped. But the bond market moved rates embarrassingly as the Bank of England took a soft approach. And of course this was happening at the same time the Chancellor of the Exchequer announced a large fiscal shift.

Kevin: So we have enter stage left basically the bond vigilante. And when the central bankers lose control, and we no longer talk about what Powell is doing or what the central banks are doing, but what the bond vigilantes are doing. That’s when we get free market again. But boy, that can be painful.

David: Yeah, that’s right. And that’s the hint of vigilantism we’ve been waiting to see.

Kevin: Right.

David: Discipline, or shall we say punishment, if your policies don’t correspond to reality. Now in reality, with a debt to GDP figure of 95% according to the IMF—this is the British—and 86% on another measure based not on an estimate, but an actual GDP figure with an adjustment for purchasing power parity. Somewhere between 86 and 96%. They actually have the latitude to do what they suggested. So the reaction of the bond market is actually very telling. You compare them to Japan. Their debt-to-GDP figures are in the range of 250%, Greece near 200. The US sits between 120 to 130% depending on—

Kevin: So they’re sending a message through a country that can actually probably survive this.

David: The Brits have the latitude for deficit spending in tax cuts.

Kevin: Okay.

David: No, it may not be the best strategy, but the violence of the market reaction suggests that other concerns are in the mix. Maybe it’s that inflation has ramped up north of 10% and that is not being taken seriously enough. The fear that inflation as it ramps becomes embedded in the economy becomes very difficult to resolve. Maybe that’s it. 

What we saw with the 30-year paper, the gilts, they moved 41 basis points in a day. It was the largest one-day gain in British history. The two-year UK government bond yields moved 110 basis points. 1.1% in two trading sessions. Two trading sessions. We’ll come back to this in a moment. But for now, suffice it to say the derivatives market is at risk on moves that are that extreme.

Kevin: You’re talking about bond yields, but— So a yield on a bond is really a measurement of the potential for default, or the danger of holding that long term. That’s what it measures. You just now said that the largest one-day gain in history on British gilts. Well, that’s interesting because think about before the Battle of Britain, the threat that Britain was under, there have been other times when you probably would not have wanted to buy British bonds, and yet you’ve got rates rising quicker than ever. 

So let’s take the geopolitical look for a second. Let’s look at Ukraine. We are hearing, again, the things that I heard as a child. When I was a child in the 1960s, we were told on a continual basis that Russia was a nuclear threat to the United States. Now, my kids haven’t really heard that because my kids grew up in a period of time after the fall of the Berlin Wall.

David: See, I was right in between.

Kevin: Okay, you remember the ’70s?

David: Well, one of our family movies— I don’t know why we watched it as frequently as we did. Well, there’s probably a reason for that.

Kevin: Red Dawn.

David: Red Dawn.

Kevin: Red Dawn, that’s right.

David: The invasion of America by the Russians and all of the hubbub about—

Kevin: It didn’t sound ridiculous back then, though, Dave? It did during the last generation behind us.

David: Sure.

Kevin: But now we’re hearing Putin talking about nukes. He’s got a plan. America has said, “We’re not going to fight Russia.” So what Putin is basically saying is, “Okay, that’s fine. We’re going to annex four compartments in the Ukraine. We will fight in the Ukraine.” So what does that mean? Are we poking a bear? Literally?

David: Is he determined or is he desperate? I mean, Russia is moving to increased deployment of troops. They’re ramping up conscription. They’re testing the resolve of their citizens in doing so. We’ve seen a mass exodus. Every seat booked exiting Moscow from the airports.

Kevin: But they had elections.

David: Right.

Kevin: Mock.

David: So a series of mock elections. That serves as the pretext for those Ukrainian territories being annexed, being considered sovereign territory of Russia, and thus defensible with everything up to and including nuclear weapons. So if there is US or European aid to the Ukrainians in these sovereign states of Russia, then of course they’ll have— Again, are they determined or are they desperate? We look at, “we have nukes and we’ll use them.”

Kevin: That’s not very subtle, is it?

David: It’s not much of an icebreaker. It’s like, “Oh, nice to meet you.” 

We’re accustomed to North Korea’s nuke talk. Right? But it’s been 30 years since Russia played that card. So Putin I think is somewhere between determined and desperate. It can’t be as easily discounted as his Korean pal.

Kevin: Well, and some of the people who know Putin, who are not part of management in Russia—entrepreneurs and some of these businessmen—they’re like, “You’d better take Putin somewhat serious because—” I read one quote that said, “We all in the West should be praying for Russia to win because they won’t lose before using nukes.”

David: Yeah. On the other hand, you look at how negotiations take place. And the person who has the ability to walk away, or the person who actually has the power, will he use the power? Will he use it? China manages the North Korean nuclear threat. And it’s not clear to what degree China manages the Russian nuclear threat. It’s a different geography. The geography at stake is certainly less consequential to the Chinese, but consider this. Global economic activity tends to suffer in a nuclear winter.

Kevin: I guess. Yeah.

David: So maybe a country like China, dependent on exports, still cares about its friends. And friends don’t let friends use nukes—or drink and drive. 

But here into this mix we’ve got Medvedev’s suggestion that NATO and the West would not respond to the use of nukes because they would protect themselves and wouldn’t want to be embroiled in something— They’d just move to a self-protective state.

Kevin: What is he forgetting there?

David: I think he’s forgetting that if Russia feels free to nuke its distant relatives in Ukraine, well then why wouldn’t they use those same resources on non-family members?

Kevin: They have delivery capability within just a matter of minutes just about anywhere in the world.

David: Yeah. Medvedev has forgotten that precedent. Precedent is something that has to be managed, and so, do it once and all of a sudden you’ve basically opened Pandora’s box. Not only for Russia, but for the Koreans and for any other nuclear aspirant in the world. So they realize that that’s a leverage that you want at the negotiating table, every negotiating table, and you will play the card as often as is necessary. So would there be no response? Oh, I think there would be a heavy response. Up to and including a like-kind exchange.

Kevin: Yeah. That’s the thing about poker and bluffing. It can become very dangerous if the bluff is nukes.

David: Well, coming back to the difference between determined and desperate, this is where I don’t like underhanded state-sponsored behavior. And I’m going to suggest, and this may be controversial, but this is sort of the odd news out of Russia this week. It doesn’t appear to me to be a coincidence that last week’s school shooting, with the perpetrator wearing a giant swastika on his shirt— I mean, again, this is 24 Russian kids killed. Perpetrator is wearing this almost cartoonish swastika on a shirt. That perfectly dovetails with the state’s narrative and the depiction of Zelensky as a Nazi threat to the motherland. So the Russian state is, in essence, whipping up support, I think for something big. Nationalism is always something that you buoy. I’m not suggesting this is morally correct, but nationalism is always buoyed, and the state granted more permissions, when you start rolling out the murder of children, the rape of women. These are the bases of real focused xenophobia or reactionism. And so, again, this is now an existential threat. You can see it in the news. It’s the Nazis. Zelensky’s a Nazi. We have the moral authority to do whatever it takes. It’s a very interesting—

Kevin: It reminds you of the Reichstag fire. It reminds you of 1939 in Poland, when the Nazis went into that radio station and they just basically dressed up as if they were Polish, and they killed the people in the radio station. That was all put together so that people would go, “We have to fight the communist threat.” “We have to fight the Polish threat.” Whatever it is. So the game is old. I’ll tell you something that’s really getting old, though, is the mistreatment of women in Iran. And look at the protests. There’s a high price to pay in Iran if you don’t necessarily agree with the leadership on the religious side.

David: There’s so many things going into this moment of turmoil and tension. Because just like the Arab Spring a few years back— You could look at the price pressures and the inability of vendors to take care of their families and the self-immolation of the vegetable and fruit vendor. He was just frustrated and ready to make a statement to the world. Iran’s in turmoil after the murder of a girl in her 20s taken into custody by the morality police because her hijab was not properly worn. So they bring her in, and she’s unbruised before being detained. The last visual you have of her is with tubes in her nose and mouth, with a swollen face, blood coming out of her ear, in a coma from head trauma, and now she’s dead. She’s calling from the grave for the end of abuse and the mistreatment of women, the end of what some had called the gender apartheid in the Middle East. Iran, already suffering from massive levels of inflation, social and political destabilization is only kept in check by brutal police and military suppression. The last time—this is just a few years ago—they had an uprising, 1,400 people were killed very quickly. It was like a weekend slaughter. But this is how power that’s desperate hangs on.

Kevin: And these protests are not isolated. It’s across the board, isn’t it?

David: That’s right. It’s every province in Iran—which I think is 31 of them. It’s 140-plus cities. It would be nice to see the US media put more attention on the topic. Unfortunately, it complicates the Administration’s push for a nuclear deal with Iran. And it just reminds me of the number of double standards that exist today. And what it suggests is that power—maintenance and the taking of power— over people has become a priority. And of course, truth is the first thing to die. 

I think in the raw pursuit of power there will be a huge price to pay for state-supported dehumanization. I almost imagine it as sort of a cosmic boomerang. I can’t believe the insincerity of the US news media. You get to see coverage of this crisis in Iran from your overseas news sources. They’re much more open to covering it. But we have political motive to either report things or not report things. And in this case, on the heels of the Me Too movement, I cannot believe that this doesn’t get more air time than it has. But again, it’s a result, I think, of the prioritization of power over people.

Kevin: Yeah, Dave. We could also talk about the Ukrainian-Russian thing also as to who benefits and where and why. It gets to be very convoluted, but let’s go back to the cost of debt because really we’ve been running the world on debt, a little bit like printing money years ago was a way to inflate. Now, you just basically go further and further into debt. And last week virtually everybody had to raise rates. Now, how many basis points, if we added it all up, what would that come to?

David: Yeah, it’s the theme of financial tightening the world over. So the collective tightening of central banks around the world lifted rates by 700 basis points last week. So this is a global squeezing of credit conditions. My colleague Morgan put those numbers together. I think as you’re looking at the squeezing of credit conditions, you’re talking about a precursor to recession. We know that banks are loaded with government paper, and fortunately for them they don’t have to mark those assets to market, or else the move in rates this year as we’ve seen a tightening of financial conditions and increase in rates, it would’ve severely impaired bank capital. They only have to realize losses on their huge government bond and mortgage backed securities portfolios as deposits leave and those bank securities portfolios have to be sold off and shifted back to cash for redemptions.

Kevin: So we talk about leverage. The derivative market is much, much larger than any market that it is connected to. So what are the comparisons? I mean, aren’t the majority of derivatives out there debt-based?

David: Yeah, and this is I think one of the key things to keep in mind when you start talking about UK government bond volatility or US government bond volatility. There are parameters that traders set, and they use past studies, historical studies, to say, “Okay, well what is a range of possibilities and how are we going to hedge ourselves from the most probable outcome?” So they’re dealing with assumptions about past behavior. And every once in a while you get surprised by something that shows up as a 50-year flood, a hundred-year flood, a 500-year flood. 

And my other colleague Doug Noland likes to talk about, it’s easy to sell flood insurance in the context of a drought. Right? And that’s a lot of what’s been happening. People assume that there will never be another flood. So they keep these tight parameters in terms of risk profile. 

When you begin to see massive volatility in the currency markets, when you begin to see massive volatility in the fixed income markets, you blow past the expected standard deviations, the expected measures of risk, which people have hedged for, and then you begin to see real-world losses on a magnified basis. Our friend Bill King discusses the importance of the OTC derivative market in this environment. As of May, the Bank of International Settlements estimates that the OTC, that’s the over the counter, derivatives are at $606 trillion of notional value—its value if the derivative goes into the money. 4X derivatives comprise 93 trillion of that. The largest category by far is interest rate derivatives at $454 trillion.

Kevin: So let’s look at those numbers again. Out of 606 trillion, 454 trillion of those derivatives is interest rate derivative.

David: That’s right. 93 for 4X with miscellaneous included. So you want to know what a $10 trillion problem looks like? A $10 trillion problem is this simple. Let 2% of contracts exceed your risk model thresholds and you’re talking about a $10 trillion problem.

Kevin: So we’re going to have more than that.

David: 2%.

Kevin: We’re going to have more than that. Now, I know you watched—

David: What if it’s 5%? I mean, now you’re talking about, what? A 20, $30 trillion problem. And this is where you can go literally in one night, one day, one fraction of a second, from a functional financial system to a financial system— it’s almost nuclear in itself. All you’re doing is counting radiation. Now, it’s just a question of toxic exposure. And this is why gold does so well in environments like this because when it gets to the point where you’re counting toxic exposure, this is your counterparty risk. Everybody wants to know that they have something to hold onto. And I’ll tell you what, physical gold in that context is unparalleled in its value in a portfolio.

Kevin: Well, and I may sound like I’m repeating myself, but if you just look at gold versus the British pound or the yen or the euro, gold is up this year. So the dollar strength right now, I know we’ve said this each week the last few weeks—

David: Strongest in 20 years.

Kevin: Strongest in 20 years. And so gold is down relative to dollars. And it’s not down much, but it’s down relative to dollars. But it is up. 

So you also watch credit default swaps, though. Okay. So we talked about derivatives. But credit default swaps are a way that we can see whether people are worried about coming volatility.

David: I love it. Doug has brought so much order and discipline into our weekly conversations, and part of it is because he is the king of the spreadsheet. We go through 120 different indicators. I mentioned our indicators starting to go nuts last week with no news flow. And that trend accelerated through Friday with actual news flow beginning to give more of a substantive reason why things were changing. This week is a strong continuation of that trend. Credit default swaps are increasing across both US and European banks. You now have sovereign credit default swaps which are also on the rise. Many of those default swaps are now priced—get this—beyond the March 2020 levels. This is when the markets fell out of bed as a result of Covid. And some, a few, are stretching to heights not seen since the global financial crisis in 2008 and 2009.

Kevin: Here in Durango—and we’ve got some of our friends and clients coming to visit us next week—we’ve got a train, as you know, that runs three times through town, the Durango-Silverton Narrow Gauge. The way we all know to get off the track is we hear the whistle. That’s it. We don’t have crossing gates. We don’t have any of the other stuff. We listen for the whistle. They just assume we’re going to get off the track, as the roads, they all go across that track. But that’s what a credit default swap is. And last week you said there was really no news, but Doug was pointing out that, “Hey, I think I hear the whistle.”

David: Something is going on. 

Kevin: I hear the whistle. 

David: Let’s pay attention.

So we had Chinese sovereign CDS and Chinese bank CDS, which vary significantly, on the radar. And you might remember our conversation on the RNB. Again, this week is unbelievable. Uncertainty, and what the folks at Foreign Affairs describe as “the age of uncertainty,” what we exist in now, this is an amazing week to 10 days. The rapid deterioration of financial conditions. There are few times in our professional lives where we see the rapid deterioration of financial conditions happen so quickly. We get the Bank of Japan defending the yen, to no avail. Very fascinating to see the yen hit 145 to the dollar. They intervene. It pops to 140, and within two days it’s back to 145. To know—

Kevin: It doesn’t sound like it’s working.

David: The PBOC is intervening in the Chinese currency markets. Also to no avail. And that is what you have to keep in mind. This is a significant dynamic. Currency interventions have not prevented a 10% decline in the Chinese currency. And that seven-to-one threshold, which we’ve talked about before, is a critical threshold. It was not just breached by a little. It’s been breached by a lot. Seven goes to 705, goes to 710. Now 717 and falling. And I repeat when a controlled currency like the Renminbi, can’t be controlled. It’s worth figuring out why it’s falling to pieces.

Kevin: You remember when you took your flying lessons, one of the key elements of flying— Well, everybody would say, all right, well, you pull back on the yoke to go up. That’s all you have to do. Pull back on the yoke to go up. Well, that’s the common knowledge, but you have to be trained that that doesn’t work.

David: That can kill you, too.

Kevin: That can kill you, because once you start pulling up on the yoke, you will at some point go into a stall. You will be falling. And the common way to handle that is to push down on the yoke and stop trying to control it for a while, gain some speed. But pulling up on the yoke, I’m likening this to currency intervention. It sounds to me like they’re in a stall, and it sounds to me like they’re losing altitude no matter how much they pull up on the yoke. What that makes me wonder, Dave, are the central bankers losing control?

David: This is it. Are we witness to the first significant global reconsideration of central bank prowess and power? If they’re impotent as a community, then who will save us from downside volatility?

Kevin: Right.

David: If they try and save us, will the market response—we’re talking about the currency and the bond markets in particular—will it be one of gratitude—thank you for saving us—or will it be one of discipline—no, we don’t approve—and thus some version of punishment like we’ve seen in the UK?

Kevin: So their experiment works as long as you don’t have inflation.

David: Yeah. Markets are on the edge of an abyss, and there is no reliable rescue squad for the first time in decades.

Kevin: Yeah. But think about it. If you knew you could print money without creating inflation, or create more debt without creating inflation, you can get away with what we actually got away with since 2008.

David: But this is a real time experiment of the market’s response to Modern Monetary Theory. Somebody is going to say, “Oh no, no, no. The guys in the UK, this is all about supply side economics, and give them a break.” No, the argument is: We’re not going to worry about inflation. We can create more debt, and it’s not going to be a problem for us. Part of the reason we’re going to resolve that—or the way we’re going to resolve that—is by stimulating growth in the business sector, and we’re going to do that through tax cuts. I understand the rationale for it, but the bond market has just said, “No.”

Kevin: That’s not going to work.

David: “You do not have permission to increase debt. And I don’t care what your justification is for it, supply side or otherwise, you do not have permission to increase debt.” So to the other point, what about inflation? What about just running the printing presses?

Kevin: Right.

David: And I think the answer is decidedly no on that front too. So you’ve got an entire central bank community that is trapped, and a market that is becoming more and more vocal and intolerant of the policy choices—the limited policy choices—of the Fed, the BOJ, the BOE, the PBOC, the ECB, all of your central banks, all of their go-to options.

Kevin: All you need to do is sit down with an old German like Klaus Bucher. We’ve talked about Klaus. All you have to do is sit down with an old German, and he’ll say, “You know what? This has happened before.”

David: Basement full of vodka.

Kevin: Basement full of vodka was the only way they got through. But the Germans, it’s amazing what’s happening in Germany right now, Dave, because the Germans have been the ones who have been screaming, “Avoid inflation at all costs. Avoid inflation at all costs.” Remember when the euro was coming together?

David: Sure.

Kevin: The Germans were the ones who were saying, “Let’s don’t do anything that would create another inflationary catastrophe.”

David: Now, inflation figures in Germany recall the last century’s historical periods of runaway inflation. And there are a few significant differences, very significant differences. But on the surface, PPI, producer price index, in Germany up 7.9% in August, one month, putting the number 45.8% higher from the same time last year.

Kevin: That’s amazing.

David: Makes it seem like the ghost of inflation is back. And this is one of the differences: Unlike the teens and the ’20s, there is no Havenstein cranking out the printed mark notes.

Kevin: Yeah, but does he have to? I mean, do we do inflation the way we used to do inflation?

David: No, and that’s a fair comment. He thought that illiquidity in the market could be resolved by producing more paper liquidity. Now, if there’s illiquidity in the market, we create credit liquidity. So what we do with credit, he did with ink on paper, and that’s really the only difference. 

But Germany has a unique cocktail served compliments of Putin, Gazprom, the Russian leadership. In Germany, energy prices were up 20.4% from July to August, 139% year over year. If you break that down, electricity rates year over year are up 175%. And now you can begin to see the pass-through of those energy costs to the consumer, with durable goods rising 10.9%, non-durable goods up 16.9%. These are crippling to Germany, and ultimately detrimental to the EU as a whole. Obviously, the acute nature of their inflation is energy driven, and with any resolution on energy supplies should subside dramatically, falling at least in line with the rest of the world—which is still in an eight to 10% range. And we’re not dealing with the ravages of Russian energy pricing, but we still have eight to 10%, and that’s fairly uniform and universal.

Kevin: Well, and what makes it different too is, remember the days when Germany and Japan, they were the great exporters? So what that meant was, they sold people everywhere around the world more goods. And so they ended up having surplus, currency surpluses and trade surpluses. And at this point, they’re a deficit country like the United States, but they don’t have the reserve currency, Dave. They can’t just print.

David: I’m not Mr. Mechanical, so I don’t remember the full details of this conversation, but over the weekend, a young man was talking about the quality of manufacturing. He loves Toyotas, and he talked about the Tundra. I don’t know if it was the drive train or the transmission, something or other, but he said it’s basically built for a truck twice the size of the Tundra. And it doesn’t break because it’s over-engineered. So part of the thinking ahead and creating a name for yourself, the Germans and the Japanese created better products, and thus took market share from everybody everywhere.

Kevin: They were surplus countries.

David: Exactly. So as they exported their stuff, they ran surpluses, right? German trade surpluses, so typical for a massive global exporter, are now deficits—joining with Japan, who last month ran the largest one-month trade deficit on record, nearly $20 billion. These are two of your export powerhouses. But the main point is this. There is no easy relief for the euro in decline and under pressure. There is no easy relief for the yen in decline and under pressure. These are really dynamic circumstances which are going to cycle and continue to keep the vice grip, if you will, on both of these currencies and these economic regions.

Kevin: They’re in a stall, and they’re pulling up on the yoke and it’s not working.

David: No easy escape from an aeronautical death spiral or a currency death spiral. The first currency intervention by the BOJ—think about this—last week, the first currency intervention by the Bank of Japan in a quarter century, and it gave them latitude to breathe for less than 48 hours. Two trading sessions. What a telling week. Again, we talk about a fascinating macro backdrop. 

They recognize— It was just the week before that in our wealth management meeting we were talking about the yen and how the intervention was coming soon—it had to—and they would have to make a choice between one or the other. We’re talking about the Japanese government bond market. One of the reasons why the yen is under so much pressure is because they’ve been propping up the price of 10-year Japanese government bonds. They can’t ultimately have it both ways. Price controls in the 10-year Japanese government bond market and a robust currency—not compatible. Nope. Can’t have it. 

So choose one or the other, but the yen will weaken in line with the bond market interventions or rates will rise to reflect the new reality of what for the Japanese is a fledgling inflation in the island nation. I think it’s over 2.8% and rising. Frankly, it’s the highest inflation rate they’ve seen in decades. I think that figure is understated. But even at that level, if you’re capping yields at 25 basis points, a quarter of 1%, and inflation is running at 2.8, it means they are still working with hyper stimulus, just like we did in the US and Europe. And just like we did for too long, working off of deeply negative real yields. Again, now it’s in the [unclear] Covid recovery. We did it for a variety of reasons, and I think they’re priming the pump for a lot more Japanese inflation.

Kevin: Yeah, we talk about how Japan and Germany, it’s different now. They’re deficit nations, but they were also producing their own stuff and exporting it. They’ve offshored a lot of their own—Japan has, anyway—offshored a lot of their own exporting to other countries. Now, these people are being paid in US dollars. The dollar is up, what? 20%.

David: Well, think about it this way. If they once had an advantage, I mean ordinarily a currency decline like they’ve had in Japan helps an exporter’s trade competitiveness because now you’ve got basically greater purchasing power with your trade partners. And if the US dollar is strong, and I’m looking at a weak yen, I can buy more car for less money than if I was buying something in US dollars—in the US dollar market with US dollars. So more car, more product, for less money. That’s how it kind of works. 

I think the temptation has been for— And the Financial Times had a good article on this last week. It was like a 19-page article. To some degree, Japanese firms have fallen prey to the temptation of labor arbitrage. And they’ve set up camp elsewhere. They’ve built plants elsewhere. And much of manufacturing Japanese firms have migrated offshore over the last 15 years. So there’s really not a lot of benefit accruing to Japanese firms from the decline in the yen. And the benefit that is there is largely erased by higher import costs. So kind of an interesting thing because I always assumed that, “Yeah. Well, the Japanese or corporate sectors have got to be loving this.” Actually, it’s not really doing them much good at all.

Kevin: When you look at what to put safe money in all your life, Dave, all of my life I’ve heard, if you just want to keep it safe, put it into 10-year Treasurys, 10-year Treasurys. That’s the safe money. I guess maybe what we should have been going into are junk bonds because 10-year Treasurys are down how much? And junk bonds. I mean is the world upside down, where junk bonds themselves have fallen less than 10-year Treasurys?

David: The 10-year Treasury was often referred to as the benchmark for the risk free rate. I mean, just think about that. In the US, the 10-year Treasury’s on track for its worst year in history. Losses of nearly 15%.

Kevin: Wow.

David: That’s 10-year. Long bonds, longer data maturities, close to double that figure in terms of losses, 28, 29% now.

Kevin: Wow.

David: Investment grade, which typically have stretched maturities to match corporate investment cycles, they’re set to pass the 20% loss mark this week.

Kevin: This is the safe money.

David: So when you reflect on the relative outperformance, this is really a fascinating insight. When you reflect on the relative outperformance of junk bonds, only down 14%, 14.3, versus the 10-year Treasury being down 15. Junk versus US government debt?

Kevin: Wow.

David: You can be reminded that the crunch in the fixed income market thus far has been tied only to an increase in interest rates. There is a second shoe to drop in the fixed income markets. When you start focusing on credit quality and become more concerned about default rates, then all of a sudden there is a differentiation between junk and US Treasurys.

Kevin: And that’s coming.

David: That’s right. Likely three to six months out.

Kevin: So we hear the train whistle again.

David: In the distance, though, and that’s when the losses on junk debt go way past your superior quality investment grade and US Treasury paper. So the problem with managing an economy with tools that have an impact lag of 6, 12, 18 months is that by the time the effects are fully felt, you’re now in a position to overcorrect. 

This is where they want to be data dependent. Good luck with that. Reminds me of my dad messing with the thermostat on a cold day. He’ll crank the heat to make the cold go away, and by the time the space is heated, it’s a veritable inferno. And then the temptation is yet another exaggerated correction to his self-induced purgatory.

Kevin: Turn that baby back down to 50.

David: So room temp is inconsequential set next to economic temperatures, right? But Josh Brown, runs an advisory firm out of New York, questions the price stability apparatus of the Fed. He says, “If in any given year you find yourself oscillating furiously back and forth between stimulus and austerity, perhaps it’s time to stop and reevaluate. It might be the data you’re using or the way in which you’re using it. It might be your instincts. It might be a combination of things. The pendulum should swing, just not all the way in both directions all the time. That’s not a cycle. That’s a circus.” 

That is a little bit of what our central bank community is feeling like. A little bit circus-esque. I’m not sure I’d say Powell is running a circus, but his resolve to tighten financial conditions are certainly new-era entertainment. And so in this new era, the markets are unaccustomed to follow-through. And I think that’s what we’ve seen in the last week or two is the volatility in equities, it’s playing catch-up. It’s catching up to this new reality of, in fact, Powell is going to keep the pressure on. As we’ve said before, interest rates increase in a leveraged economy. Doing that, it’s like eliminating oxygen from the room. It’s going to hurt your previous functioning. And you might even say it eliminates the margin for malfunctioning. Tolerances are tightened and mistakes are magnified when, in a leveraged economy, interest rates are on the rise.

Kevin: So we’ve talked about how much has happened in a week. Just stop for a second, Dave, and pretend. This will be hard for you. Pretend you’re King Charles. King Charles, the new king. What a week to be the new king in Britain right now. I mean, think about it.

David: Think about him. Yeah. There were decades where nothing happened.

Kevin: Definitely with him. Decades where nothing happened. Right?

David: Decades where nothing happened.

Kevin: And weeks.

David: And weeks where decades are happening.

Kevin: Yeah.

David: So look at the mess that [new Prime Minister Liz] Truss and the new king have been handed. The pound came three pennies from parity with the US dollar this week. It’s traded down, and yields on British debt have soared in a reaction to fiscal policy deemed unsustainable by the markets. Lower taxes, higher deficit spending. But think about that. The pound, in our lifetime, has never been this low. It got to 108 in 1985. We traded to 103.5, and will likely hit parity—a one-to-one relationship never before seen between what once was the world’s reserve currency— 

And again, we can go back in time and say, “It was four to one when they were something and we were nothing.” And this is not comparison in contrast, “Oh, look at how special we are.” That’s not the point. The point is we are seeing shifts and volatility in these markets, and it’s not as if we are immune to them either. What today is being served up in the gilt market may just as easily be served up in the US Treasury market, and certainly the ECB is priming the pump for their own version of volatility.

Kevin: Dave, in physics, there was an absolute bombshell because classical physics for several hundred years under Newton, and the physicists who were looking at large scale physics, they were able to predict so precisely that they could use Newtonian physics to actually get us to the moon. Literally, it’s all you really needed was Newtonian physics to get us to the moon. That’s an amazing thing. 

But when they started looking smaller and smaller, Einstein came along and he started to recognize not only relativity, but he recognized something even smaller. Then you had Heisenberg come along, and he said, “Wait a second. The smaller you get, the more uncertain it gets.” Then you had Schrodinger come along, and he said, “Well, not only does it become uncertain, but really you don’t know the outcome until it’s observed.” And that’s why the cat always ends up dead. Schrodinger’s cat always ends up dead. You just don’t know when.

David: I feel like there’s a parallel with interest rates. They get smaller and smaller and the complexity gets more intense. I just don’t know what the dead cat is in the interest rate world.

Kevin: Well, have we gone from classical central bank manipulation and management to this world of uncertainty? You were talking about Foreign Affairs. The cover of Foreign Affairs says “The Age of Uncertainty.”

David: Yeah.

Kevin: Yeah, what is certain right now?

David: That’s the title that graces the most recent cover of Foreign Affairs magazine. The cover states a simple and accurate truth. We are in the age of uncertainty. Absolutely. But the contents are more convoluted. The issue covers the topics you would expect. You’ve got China, you’ve got Russia, you’ve got Ukraine. You’ve got hubris, you’ve got paranoia, you’ve got race problems, of course, very boldly—you would expect nothing less—prescriptions for a new and better world order—surprise, surprise—with no recognition that the mess that exists today is tied to the idealism of the existing world order. 

But none of the high-minded prescriptions take into account a catastrophic reversal of fortune. As the pendulum swings from credit excess and infinite growth to a world of constrained growth, and with the bill coming due on decades of projects layered in by global governments that were unaffordable in the best of times, we find each government scratching and scraping for more money to spend. Maybe this week’s canary tweeted its last in the UK. Maybe the bond vigilantes are truly back, and here to say, “Enough is enough. Not a penny more or we will extract our pound of flesh.”

Kevin: You’ve been listening to the McAlvany Weekly commentary. I’m Kevin Orrick, along with David McAlvany. You can find us at, and you can call us at 800-525-9556.

This has been the McAlvany Weekly Commentary. The views expressed should not be considered to be a solicitation or a recommendation for your investment portfolio. You should consult a professional financial advisor to assess suitability for risk and investment. Join us again next week for a new edition of the McAlvany Weekly Commentary.

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