Don’t Cry! Argentina Gets The Largest IMF Bailout In History

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• Can Bank of Japan’s unlimited liquidity float the whole world?

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

“Are we going to see the Fed walk the talk? Are we going to see the ECB step up and begin restricting and limiting liquidity? There are going to be consequences. Again, all the things that are overlooked in the short run, now all of a sudden come into high relief because – oops – everything is permissible in the world of Internet liquidity and low rates. But you do have to mind your Ps and Qs if the cost of capital is rising.”

– David McAlvany

Kevin:We’ve mentioned the smoke from the fire last week, Dave, but now we’re on day 12 of a fire that has made national and international news. What an incredible, almost militaristic, military operation on fighting a fire. The coordination, the back burns, the over 800 people who are involved, 15-20 major aircraft that are just continually working the lines. They’re not trying to put it out, they’re actually directing the fire, hopefully the direction that they want, while saving – they haven’t lost a single structure yet.

David:It is a fascinating illustration of exponential growth. We were sitting here last week talking about a fire that was 2500-3000 acres, which is not a small fire by any means, and now it is over 23,000 acres.

Kevin:A 10-fold increase.

David:A 10-fold increase. And you’re right, it is interesting to watch professionals handle themselves with skill. We have the best in the country fighting the fire and we’re grateful for them.

Kevin:Dave, we’ve just passed an anniversary, one of the most influential military operations, maybe in world history. It changed at least the 20^thcentury, the direction that the world was going in. I am, of course, thinking of D-Day.

David:I sat at the dinner table last week and my nine-year-old reminded me what day it was, and the day had nearly slipped by, there we were in the evening, and 74 years ago was the D-Day invasion onto the beaches of Normandy.

Kevin:But the 70^thanniversary, you guys went out, actually, to Normandy. You took the boys, and Tess was with you too, right?

David:No, just the boys. And it had slipped my mind last week, as I’m sure it might have for many, but four years ago on the 70^thanniversary we visited the beach in Normandy, and we walked the small towns which the U.S. airborne liberated. I think my boys will always remember that trip because we do like to eat and fix various things as a family, they often mention the rabbit that we bought at a butcher shop – the entire thing, a big guy – there in Sainte Mere Eglise and turned it into a rabbit pie.

But I hope they really remember the speech. We sat at Point du Hoc and read a speech that Reagan had given on the 40^thanniversary of D-Day. It is so well done, and it is so presidential, I wanted to include the linkfor anybody who hasn’t heard that speech. We took a written copy and I stood right there in front of the pillar and read it to the boys. We were there with some friends and we all read it together.

Kevin:It is important to remember, isn’t it? Memory is such an important part of developing a forward history.

David:I think it is important to teach our children to remember, too, because apparently sometimes we forget. So I was just grateful, this nine-year old voice asked me out of the blue, “Do you know what today is?” And I’m like, “I don’t know what today is.” He is like, “Well, this is the anniversary of D-Day.” I’m like, “Oh!”

Kevin:I’ve even noticed, as you go through the Bible, if you look at the word “remember” it is almost always tied with obedience and prosperity. And when they would forget – if you look at the word forget all through the Bible, you see that it is almost always tied to disobedience and a loss of prosperity.

But I’m going to shift to this week because we have had a free ride for the last decade, as least with interest rates, and that seems to be changing, not just here in the United States, but the European Central Bank is also talking about tightening.

David:This is a big week, not because we’re going to see something different than expected from what the Fed has told us about, or even different than what they have already done now six times here in recent years, but when tightening the flow of credit, when you do that via higher interest rates, there are thresholds that change things. And changing sentiment is a very delicate thing. Mood tends to shift and sometimes it is sort of based imperceptibly on small changes within the environment that you are in, the context that you are in. But as the mood shifts, so does the capital allocation process. And you’ve heard it in terms of risk on and risk off, the harsh, bifurcated, “I’m in the market or I’m out of the market.” And those are the facts that define bull markets and bear markets.

But we may well be at one of those thresholds this week. On the table is the seventh increase in rates and you don’t have to look too far – consider the real estate market – just to illustrate the point. Mortgage rates have risen from a little over 3% to a hair under 5%. So if you’re combining the high asking prices of real estate given supply and demand dynamics, and higher financing cost, you’re looking at affordability at this juncture which is setting records, not because it is affordable because it is almost not affordable for anyone. Something has to give. At the same time you have the ECB, the European Central Bank, meeting on the 14^ththis week, and that may be just as vital. So this is a big week.

Kevin:What if we could go back, Dave, to 2008-2009 right now, and know that the credit was going to be this easy for this long? Really, only the imagination could limit what we could have done with all the free money that was coming. That wasn’t natural. This was a gift that was given from a future generation – my kids, your kids – this gift was given to us to say, “We don’t want the recession right now. We’re going to go ahead and give you somebody else’s money from tomorrow, today.” Can you imagine if we would have known that?

David:I think, if you consider what happened in that period – 2008-2009 up to the present – look at what happened inside the mind of the speculative community, with the extension of quantitative easing, with mass monetization following the global financial crisis, all limits were removed from the imagination of the speculator.

Kevin:But it happened gradually. What if they would have known from the get-go? Really, in a way, we’ve enjoyed ten years of prosperity that really wasn’t ours.

David:And it has been building into a bonanza, but it wasn’t a bonanza on day one. Back to 2008-2009, you had equity returns trailing bond returns, you would have been better off sitting in treasury bills. And in fact, you were trailing treasury returns by about 14 years, if you were looking at just the performance of stocks at the beginning of the decade up through 2009…

Kevin:T-bills would have been better.

David:And you were down, in real terms, 50%, and that’s giving back all of the dividends you would have earned along the way. So down 50%, plus you gave back all the income, it was an absolute disaster. But what happened was fascinating, because the speculative community, and that idea of imagination taking over, it gradually came into the awareness of the speculative community, that prices can go to infinity, or close to it, if the cost of capital is zero. Now, we didn’t get to zero overnight so this was, again, part of the breaking in of this reality. What if rates are at 2%? Fine, then we can recalibrate everything. What if rates are at 1%? Oh, well, that’s really interesting. What if rates are negative? Now all of a sudden you’re talking about an infinite speculation.

Kevin:And the speculators are saying, “You’re kidding me, right? You’re kidding me.”

David:And this is a great experiment with interest rates at the zero bound and it revealed that excess speculation and increased enthusiasm only bump up against the glass ceiling of imagination. Basically, you can go as high as you want, or as far as your imagination will take you.

Kevin:Sure, because “Here’s more money.”

David:And when you’re in that kind of a market environment, valuations and fundamentals recede from the market practitioner’s concerns, at least for that period of time. So you have the introduction of the limits of QE here in the United States.

Kevin:Do you remember when they limited that back in 2014? At first there was that…

David:Taper tantrum?

Kevin:Oh my gosh, I remember watching on TV and it was like, “No, no, no, we’re not going to accept that.”

David:Right, so you have the other side of the coin, really, with the limitations of QE, the beginnings of QT, or quantitative tightening, there at the end of 2014. You have that fantasy of infinite valuations, infinite prices, running into the brick wall of reality as tightening of credit was resuming, beginning to resume here in the United States just at the margins, and really, as liquidity was being limited. So the infinity equation was no longer realistic.

Kevin:But the ECB took over the baton and the Bank of Japan.

David:The Bank of Japan had been printing money and doing QE type stuff since 1999, so they have been the longest at it, and, to borrow from the Koreans if I can, they are the ones who are in really deep kimchi. The reality is, the ECB and the Bank of Japan have allowed for a global speculative mood to continue in this interim period, 2014 to the present, because of the amount of money that they have been willing to put into the financial markets.

Kevin:And why is this important? You brought it out last week – liquidity. Perception and liquidity – those two things.

David:And the ECB has indicated that their foray into that fantasyland is likely coming to a close. Bank of Japan? Again, deep kimchi? I don’t know how long they remain committed to the open-ended, open-handed market interventions, but it may be forever until the system completely blows up on them. But liquidity is the key. Excess liquidity provides a boost to asset prices. That is a natural part of the equation. And if you start restricting or shrinking liquidity it causes those same assets to shrink in value.

Kevin:Do you think that the ECB is promising to also tighten up because of the potential drop of the euro?

David:I think you have the Fed tightening. They’ve been tightening since 2014. They are reducing what is on their balance sheet. Here in the next month or so it will be going at a 40 billion dollar a month clip.

Kevin:And that would strengthen the dollar if it looked like the ECB would continue to print.

David:Right. At the same time you have the ECB promising to do the same thing – tighten their monetary policy later this year, reduce balance sheet, etc., and it does put the ECB between a rock and a hard place because on the one hand, if the ECB remains very accommodating, very dovish as they say, then the euro is likely to take a hit. That adds even more fuel to a U.S. dollar value going higher. And what does that cause? It causes immense damage to the emerging markets. That’s one side of the equation is that the ECB remains dovish.

Kevin:I imagine the emerging markets, Dave, as you have been talking about them over the last couple of months, if you’ve ever watched the skaters at the Ice Follies where you have the people in the center who are doing the circles. Then you have the people who join a little further. And the skaters on the very outside are having to run as fast as they possibly can to join the line, and they’re the first ones thrown off. Do you know what I’m talking about – that spinning line? The emerging markets right now are so vulnerable to what is occurring in the center of that ice skating line, they’re running as fast as they possibly can, and frankly, they’re not keeping up.

David:I grew up at an ice rink and I have no idea what you’re talking about (laughs). But what I did see, because I played hockey all growing up, and my sister was a figure skater. And when people would practice you had the folks that couldn’t skate at all holding onto the edges at the periphery, and then the folks who were doing the triple axles, or the double lutzes, or for me it would have been a triple klutz, or whatever (laughs) – I didn’t ice skate.

Kevin:Actually, you became a pretty good skater, didn’t you? You were a goalie.

David:I can skate backward very well. But that was the domain of the central. You had the power skaters in the middle, and then at the periphery it was everyone who was barely hanging on. And literally, they were actually just hanging onto the edge for even balance.

Kevin:So what occurs in Europe, what occurs in the United States – and I’ll even count Japan – directly affects these emerging markets to the point where it is a survival situation?

David:I think going back to that contrast, we have the potential for the ECB remaining, accommodating. But on the other hand, if they get more hawkish, if they do restrict liquidity into the system, number one, it stabilizes the euro. That may be good for the euro. That also caps the upside on the dollar and to a large degree it extends a lifeline to the emerging markets in so doing. Probably, if you do that, if you’re tightening liquidity, even though it’s good for the euro and caps the upside on the dollar, and is good for the emerging markets in terms of stopping the bleeding, you do stir financing issues for your overleveraged banks.

And I think this is one of the things that the ECB is very concerned about. Do they care about the emerging markets? Yes, to some degree. Why should they? I guess the question is, do they care more about the banking sector? Because, if you look at globalization, if you look at the emerging markets, the strength of globalization is also its weakness.

Kevin:Right, so interconnectedness is a big deal. If a butterfly flaps its wings here, it’s the hurricane in China.

David:That’s right. So you have all these things which tie us together – our surpluses are someone else’s deficits and they match and mirror globally. What happens in Brazil, what happens in Argentina, what is happening in Turkey – all of these things right now send ripple effects into the global system of liquidity and risk-taking. And they signal either a positive backdrop for speculation or they signal a negative backdrop for speculation. And those are self-reinforcing tendencies. So yes, the ECB does care about what happens in the emerging markets because of the way it affects the whole mood of the markets globally. Again, the question is what do they care more about?

Kevin:And you talked about signaling a negative backdrop, but actually, the signal has been messed with for the last few years. You have high-frequency trading that has almost completely eliminated volatility in the market. You have the mainline news media that continually talks up whatever market they need to talk up. So, are we going to have that confused, distorted, or actually, just completely white noised out signal, where we can’t actually see what is going on? Or are there tipping points that the perception media and the HFTs, the high-frequency traders, can’t smooth out?

David:I was fascinated reading Bert Dohmen’s most recent letter, the Wellington Letter, because he is having a hard time calling the market on the basis of technicals. And of course, technical analysis is really his claim to fame. He brings in some good fundamental overlays, but technical analysis is how he created a reputation for making market calls.

Kevin:Which requires a signal. You have to have clear signal.

David:And he is hesitating to call the market on the basis of technicals due to algorithms dominating and defining trends in ways that make the charts, to some degree, irrelevant. So in many respects this is why, if you are talking about the algorithms, the high-frequency traders, which at this point are 80-90% of volume on the New York Stock Exchange, up from a 70% average a few years ago, they complement the media news cycle in a way that, really, is muting market signals, and it is reinforcing the current trend in place.

I don’t know that it can necessarily redefine a trend, but it certainly is reinforcing the existing trend. But there are places where, beyond the media news cycle, the high-frequency trading, the algorithms which kind of mute the market signaling, you are getting something loud and clear. Exchange rates add interest rates and they are carrying a signal loud and clear.

Kevin:And does that, then, force what you were talking about – prioritizing? Do you prioritize emerging markets or do you prioritize banks? We’ve seen banks in the past stick with banks. In other words, they’re going to bail the banks out first. They did this during the financial crisis. The guys who made the worst mistakes are still around because they were too big to fail. So I would imagine, if push comes to shove, they are going to pick themselves before they pick the emerging market.

David:Right. So you’re back to seeing the spreads widen between your risk-free rates, whether that is the U.S. ten-year treasury or the German bund, and things like the Portuguese, Italian, and Spanish debt. Spreads are widening, yields rising at the European periphery, and it is cracks in the current structure of finance which are appearing. So back to the European banking community, they certainly do not relish the idea of tighter liquidity or higher rates. Why? Because they are over-leveraged as they are.

Kevin:Yes. Why pay more interest for the leverage that they have?

David:Their balance sheet just doesn’t allow for it. This is, again, the revelation of priorities. As you said a minute ago, banks care for banks. And here in the middle of this we have Deutsche Bank – we talked about donuts and whatever last week – but Deutsche Bank is the worst offender by far in terms of leverage and derivative exposure, and it is getting special attention from Merkel week after week. So is the European Central Bank now on the horns of a dilemma where they have to choose between global financial market accommodation and support of the emerging markets, or the European banking system accommodation?

And my guess is, for what it’s worth, is that central banks are going to choose the banks. Ergo, emerging markets are in a very vulnerable position because it’s almost like those are long-term knock-on effects as opposed to markets being able to seize and liquidity seizing up overnight if you don’t take care of the financial institutions in the heartland. So to me, if there is anyone who is the proverbial goat to be slaughtered here it is probably the emerging markets in favor of the European banks.

Kevin:Just look at who is having to be bailed out at this point – the IMF. The largest bailout in history, in the history of the IMF, just occurred in Argentina.

David:Just this last week. You’re right. So stress is emerging in the emerging markets. Argentina is one on the list. And the IMF bailout comes in at 50 billion dollars. That’s last week. It’s the largest IMF bailout in history. There are other bailouts that have been larger. But from the IMF, exceeded anything anyone imagined.

Kevin:You would never know it looking at the markets. The markets didn’t care, they just yawned.

David:Particularly underwhelmed if you’re looking at the peso/dollar exchange rate because it continued to rapidly decline even after the announcement of that 50 billion dollar intervention to a 25-to-1 rate to the U.S. dollar.

Kevin:Well, let me ask, is this going to be enough? Is a 50 billion dollar infusion into the Argentinian situation enough?

David:With every version of fixing the system using debt, it is iteration after iteration after iteration. So it may be enough in terms of a quantity, but the terms that they put on it will probably have to be adjusted. If you go back to the last IMF bailout cycle in Argentina, 17 years ago, 2000-2001, just back up and think of this. You have too much debt, which was the cause of the crisis. And with the IMF doing then what it’s doing now, that all of our central banks tend to do, debt was the cause of the crisis, to which more debt and restrictive expectations for those bailout funds are then applied, which led to total collapse.

So the IMF bails out Argentina and they can’t live under the new pressure of the total stock of debt and it causes a total collapse there in 2000-2001, 132 billion dollars in foreign defaults. Elliot Management tried to step in and buy a lot of that paper at a steep discount and tried to make a fortune that way and they have been tied up in court for decades. But on this round we have the accumulation of 100 billion U.S. – this is Argentine debt, but the equivalent of 100 billion dollars in U.S. dollars – over the last two-and-a-half years.

Slap on a 50 billion dollar three-year deal, as if 36 months is enough to cure the issues which are deeply politically entrenched, and I think you can at best look at this and say that it is the first round, the first iteration. And eventually, that 36 months may be 36 years because the reality is they haven’t fixed the engine of growth sufficient to keep up with the old debt, let alone the new 50 billion dollars in obligations.

Kevin:We talked about the Reinhart and Rogoff book about bond defaults all through history – 600-700 years, over and over and over. We started this program talking about the importance of remembering, and not forgetting, but it seems like, as far as the debt markets go, they have a very short memory.

David:I read the Rogoff book, This Time It’s Different, on the plane ride to Argentina back in 2008 as the book had just come out, and I am reminded of John Kenneth Galbraith famously saying that financial disaster is quickly forgotten. There can be few fields of human endeavor in which history counts for so little as in the world of finance. Again, it is the permanence of greed, the shortness of memory – those things put together in the strange cocktail and the financial markets are very, very, very forgiving.

One of the things that Rogoff and Reinhart point out in their book is that contrary to what you might have thought, the Argentines, in their earlier collapses, going back 70, 80, 90 years, were the good citizens who tried to pay back their debt, as if good standing in their financial markets mattered. But you had Ecuador, Honduras, a bunch of other countries that also capitulated and made no attempt to pay it back.

And their economies recovered very quickly. Why? Because they were back to the capital markets and borrowing within about a seven-year period, and it was like all was forgotten, literally, because Wall Street didn’t have the memory for it. And so, Argentina suffered under, honorably, paying back the debt over decades, and no one ever forgot that because they were actually trying to live true to the terms that had been set versus just, “Hey, sort it out. You’re screwed. You can’t have your money back. We default.”

Kevin:That’s the definition of moral hazard, isn’t it, where the person can take as much risk as they want and really not have to pay for it. But we were talking about remembering something. You would think that these countries would remember not to borrow in someone else’s currency. That is usually what crushes them.

David:That’s right. So much of the debt issued since the global financial crisis – and this is what is amazing, because this is a short-term blunder, but it is also a classic blunder. It is what economists call the original sin, which is not the same thing as what theologians would define as the original sin. But this is when you choose to denominate debt in a foreign currency, not your domestic one. And the vast majority of debt restructurings have occurred because of this blunder. And it still persists.

Again, most of the debt in the emerging markets which has been issued since the global financial crisis has been in U.S. dollar or euro terms, foreign currency terms, which makes it that much harder to pay back in the context of currency devaluation. So emerging markets remain at risk. You have the Mexican peso which is still under massive pressure. The Turkish lira is also under pressure with a massive amount of foreign-denominated debt. That was a conversation we have had ongoing with Russell Napier. The Brazilian real remains under pressure. The Brazilian stock market is down almost 14.5% in one month – in one month.

So when the air starts to come out of the balloons of the emerging markets it comes out very, very quickly. Again, you may ask, “Why does that matter to me? I don’t have vacation plans and my portfolio exposure isn’t to any of those places.” Welcome to a world that has reaped the benefits of globalization. And it also lives with the drawbacks. Again, we come back to that issue of interconnectedness. There are no country-specific firewalls that contain, concern, or barricade off that risk-off behavior. When people start to sell, again, you may have a problem in Taiwan that is all of a sudden now a problem in South Korea, and we’re not talking political, although that could emerge. We’re talking about market transmission, which again, doesn’t know boundaries or borders.

In an age of globalization, you could even think of it in terms of some of the movies that in the late 1990s or early 2000s like Outbreak, where they talk about, whether it is Ebola or some other kind of virus, how much more quickly disease can travel in the age of jet transportation. It’s a totally different world. Go back to the 1340s when we had the Black Plague in Europe. You had 24 million people in and around the Mediterranean die of this disease. And if you look at where everyone was dying, it was all along the trade routes, because it had to deal with transmission. And you had to have people carrying – you had to be carrying stuff which carried the rats which carried the fleas which carried the disease. But it was transmission. Today we don’t have a slow transmission mechanism in a globalized financial environment.

Kevin:It’s instantaneous. Dave, you’re a mountain-climber, and I’m trying to remember, I think it was Mt. Hood where we read in Gonzales’ book Deep Survival– remember that story of the five climbers that were tied in with each other? You had five climbers, and you had the security – like globalization – you had the benefit of being tied in to five climbers, but you also have the vulnerability. If one or two of those climbers goes it pulls the other three down. And that happened, and they lost five climbers. Was it Mt. Hood? What was the mountain that you and Gabe were climbing? It was either Rainier or Hood where that happened.

David:Mt. Rainier.

Kevin:But it was the same thing. They had the security of tie-in. In fact, they took more risks because they had the security of the tie-in. But the very tie-in, itself, is what ended up pulling them all off the mountain.

David:Aggregate the weight, and no one of them can withstand that much of a burden.

Kevin:Exactly.

David:So stress in one geography is transmitted quickly to other geographies. I think that is really the issue. And it is helpful in the short run that central bank interventions can step in and calm the storm, get people off the emotional boil, and extend whatever trend is in place. In the end, it ends up being harmful. It’s harmful because it takes prices to an even less sustainable level – a higher height from which to fall.

Kevin:But we have “the experts,” the academics, and the calm grandfatherly voice of either the Alan Greenspans or the Janet Yellens. They have a tendency to come in and say, “There is absolutely nothing to worry about.” The thing that worries me is, after looking at this for three decades, when they come out and tell you that there is nothing to worry about, that is usually days before there is.

David:It is fascinating to me to think of Alan Greenspan, a guy who was at the helm for a couple of decades. No one understood what he said. Even the Ph.D.s in economics didn’t understand what he said because he spoke “Greenspeak.”

Kevin:But he could calm you down with Greenspeak.

David:That’s right, because you just said, “That sounded so complex, and he understands what he’s saying, I should just trust the guy.” So it was this defer to authority as a result of confusion and chaos, and it was 100% intentional. And we have actually lost something in the midst of using clarified and clear language from the Fed. Now we’re like, “Oh, well, they’re going to raise rates.” Before you would have been like, “I don’t know if he’s promising his first-born son, or if he’s going to lower rates, or if he’s just going to feed the dog at lunchtime.” You had no idea what he was talking about.

But in 1973, I think of all the experts – Greenspan, Bernanke, the guys and gals who have run the Fed – none of them saw a crisis coming. And it’s fascinating because you have the higher market prices at present here in the U.S., and if you think about the prophetic voices of those past central bank presidents – Greenspan in January of 1973 said, “It’s very rare that you can unqualifiedly be bullish as you can be now.” Of course, we went into a massive recession in 1974 (laughs). The stock market had started to go limp in 1968, but we were in a full-blown economic recession in 1974. And as far as he was concerned, standing on the high hill where he was standing, looking out on the horizon, all he could see is that you should be unqualifiedly bullish. And what he missed was what was going to happen next.

Kevin:The tech stock bubble, we keep bringing it up because it was such a profound thing. I remember the Super Bowl 2000, the commercials were ridiculous, because these were dotcom companies that had no profits, whatsoever. Their combined capitalization because of the stocks just going through the roof was greater than all the airlines out there, anything that actually did anything. At that same time Greenspan came out with a prediction. January of 2000 he wanted to let everybody know that things were fine.

David:It’s the same tone, from his lips, “There can be little argument that the American economy, as it stands at the beginning of a new century, has never exhibited so remarkable a prosperity for at least the majority of Americans.” Again, you’re talking about on the edge of the next major decline, the next major recession.

Kevin:Forty-five days after that, the NASDAQ just almost disappeared.

David:Down by 85-90%. That’s a big deal. Janet Yellen in 2007 – you fast forward and you think, “Well, maybe they learned something through time.” In January of 2007 she said, “While the decline in housing activity has been significant, and will probably continue for a while longer, I think the concerns we used to hear about the possibility of a devastating collapse, one that might be big enough to cause a recession in the U.S. economy, have been largely allayed.”

Kevin:And within the next year we had the GFC, the Global Financial Crisis.

David:Right. So I guess when you look at things today – the economy is humming along, prices in the stock market are just fine – prices change quickly when sentiment shifts. And sentiment shifts when liquidity dynamics change. We could point to a number of things at this point. We could point to the deterioration in the quality of corporate bonds, we could harp on the quantity of covenant-lite loans in the marketplace which far exceed what we had in 2006 prior to the global financial crisis 2006-2007.

We could talk about the buy-back schemes and the earnings games that are being played by corporations, insider selling versus insider buying. And certainly we could, and we have discussed, the overvalued nature of the market if you’re looking at Tobin’s Q or the Buffet indicator, which again, we’re at about 140% versus 150% being the all-time high, that is, the stock market capitalization compared to the total size and scale of the economy. But all of these issues are minimized, all of these issues are overlooked, until a threshold is reached.

Kevin:Yes, but can they not continue to supply unlimited liquidity? Do we ever reach a threshold if they continue to supply unlimited liquidity?

David:That’s the experiment with the Bank of Japan, and to a degree, we talked about that last week, this is what would be required, transforming the financial system that we know today to a closed system, one where they can control the inputs and outputs, the flows in and out, and require you to participate, a forced participant in the marketplace. So on that basis, you could. The Bank of Japan is experimenting with it, Scandinavians have experimented with it. They are beginning to experiment with that kind of a system in India.

But I think when you are talking about thresholds, you are talking about something that is non-mathematical, non-numeric. And the threshold ties to sentiment. There is confidence in this mix. And sentiment is driven, or buttressed, by liquidity. So I think of it as a liquidity threshold because of what is actually supporting it. But when that liquidity begins to shift, when that flips, so does the perception of everything else.

So again, today nobody is caring about the quality of corporate bonds, nobody is caring about covenant-lite loans, nobody is caring about buy-back schemes, nobody is caring about the earnings games that are being played. Nobody is caring about corporate malfeasance, frankly, and theft. But people being to care when liquidity shifts and there is not enough of it anymore.

Take the German factory orders as an example. This last month they unexpectedly dropped for a fourth month in a row. That signifies the German economy is slipping. It’s germane – not German (laughs) – it’s germane. But it doesn’t matter until the ECB starts signaling tightening. And if the ECB starts to signal that they are tightening their liquidity measures in the economy, in the market, then there is a whole litany of concerns which are going to surface, including the factory order numbers, which are going to be interpreted in a fresh light.

Kevin:You can have an awful lot of foolish investments that people ignore and actually put money into. I remember the dotcom bubble – the Pets.com sock puppet. Pets.com was a larger business than, like I mentioned before, all the airlines in America. It had more capitalization than all the airlines in America. Now, it just completely vaporized when things came down. Now we have Toys R Us bonds, we have stuff out there that people will say, “As long as they’re bailing these things out, I’ll go ahead and take some of those.”

David:Well, it was chasing yield. And Bloomberg asked the question on the 4^thof June in an article on their site. They asked, “What did Toys R Us bonds, the populist threat to the European Union, and Turkish external debt have in common? All were tolerated by market players until quite suddenly they weren’t.”

Kevin:And they turned out to be sock puppets.

David:Then the article went on to say, “The binary, all-in/all-out behavior, which up until now was relegated to the fringes of the financial markets, has gone mainstream.” And then they referenced the Italian markets and the article says, Investors are becoming increasingly manic. To us, it is a question of the internals of the market and the feeling and the sentiment which is in the collective market participants. It’s shifting, it hasn’t capitulated, but it is getting to the point where panic would be quite easy.

Kevin:I’m going to talk a little bit of conspiracy here. Let’s say that you are the ECB and you have the ability to print. We talked to Otmar Issing. He was, you would have to say, the founder of the European Central Bank. He was the head of the European Central Bank for seven years. One of the things he admitted to you, Dave, was that the weakness of the European Monetary Union was that it was only a monetary union. It was not a political union. In other words, you don’t have control over the leadership.

You have Italy out there, or you have Spain – you have these countries that may exercise some form of independence. This is where the conspiracy comes in a little bit. Do you think they sort of like having some of these countries a little bit on the defensive, knowing that their only survival is the mother ship?

David:I think it’s reasonable to recognize that politics is a blood sport. And just like Wyoming re-introducing bare knuckle fighting – it’s now legal, it’s been illegal for years. This is common in terms of the way things are done in the world of politics. The gloves are off, teeth are knocked out, and it is not the realm for gentleman – not the way politics actually is. You may have some sanitized version of it, but even the way we behave in the United States where we have both sides of the aisle and everyone defers their time to the speaker. You look at the way the Parliament in England works. These guys know how to hold a teacup and smoke a pipe and do everything in the finery and go shopping at the haberdasheries, and whatever else. But you put them in Parliament, and they start cussing each other out – you can’t get a word in edgewise. The reality is, behind the scenes, that’s the way politics works. It’s mean and nasty and disrespectful.

Kevin:So the ECB is a political organization.

David:Oh, absolutely, it’s a political organization. We mentioned this earlier this week on an interview I did on Steel on Steel with our friend, John Loeffler. The ECB restricted their purchases of Italian debt last month, more so than any other month since the 2015 program began when they were buying government bonds, when that whole thing got started. What does it feel like to be in a political and financial or fiscal crisis without the full support of the ECB? I think the ECB was sending a very clear message. “All right, you have some cracks in your system.”

Kevin:“How does this feel?”

David:“You’re going to elect a populist? Do you know what happens when your markets blow up? We’re just going to give you a little taste of that. We’re stepping back from the markets so you can feel the heat.” The ECB wanted the Italians to feel the heat so as to not do something stupid, which in the opinion of the ECB was to move away from the euro and move toward an utterly populist regime.

Kevin:I know we’re looking toward the Fed meeting this week, but also the ECB meets this week, as well. They will transform that into interest rate politics, too, won’t they?

David:The June 14^thmeeting of the ECB in Latvia, just like the Fed meeting over the next two days, may signal precisely what the market cannot handle, which is present tense limits to the liquidity game. Honestly, what do we know? Nothing. Can they do this? Do they have what it takes to normalize interest rates? To this point, the Fed and the ECB have talked the talk, but there are consequences to rising rates, and that’s what we are talking about. You get to a threshold moment and it recalculates and recalibrates everything. People look at every fact and figure differently in light of how they feel, and those feelings and sentiments are determined by liquidity flows.

Kevin:So no matter what they say, they are still buying billions and billions of bonds.

David:And that is what we have juxtaposed. On the one hand, we have the ECB balance sheet growing another five billion dollars this week to an all-time high of 4.5, 6, 7 trillion euros, and the market is calm about that – no big deal. A reversal of that trend would have consequences. And they’ve talked about reversing that trend, and if they do, there will be consequences.

Kevin:But Richard Duncan is saying, “Hey, maybe that Japanese model will work. Maybe this will work, in the long run, for everybody.”

David:And I don’t know that he is a champion of the model, he is just saying that in a system that is driven by liquidity, if liquidity is tightening everywhere but the Bank of Japan, perhaps the Bank of Japan is providing sufficient liquidity to float all boats. And I don’t know. But there is the suggestion that extreme quantitative easing undertaken by the Bank of Japan may be sufficient to keep the global asset markets afloat a little bit longer. And that is better than them falling to pieces, in Duncan’s opinion.

But I don’t know. It’s liquidity, liquidity, liquidity. That has been the theme, I think, for us for a couple of months, and as we get close to some of these dates, are we going to see the Fed walk the talk? Are we going to see the ECB step up and begin restricting and limiting liquidity? There are going to be consequences. Again, all the things that are overlooked in the short run now all of a sudden come into high relief because – oops – everything is permissible in a world of infinite liquidity and low rates. But you do have to mind your Ps and Qs if the cost of capital is rising.

Kevin:You mentioned bare knuckle fighting. When I think of Bill King and his analysis, this is a guy who has had to survive. This is a guy who trades, and he is held accountable when he is wrong, and he is praised when he is right. He is a bare-knuckle fighter and an analyst in this. It makes sense to maybe have him on in the next week or two to talk about these issues.

David:That’s a great idea. I’d like to press him for his thoughts on the markets. Of course, he always has thoughts on politics and geopolitics.

Kevin:He doesn’t hold back.

David:No. In a recent note he said, “Summer rallies in the stock market when you have low volume and extremely bullish trader sentiment with concentrated buying in just a few of the trading sardines, short-term gains, no doubt. But it gets you set up for an autumn full of pain. That’s the way the market is setting up.” That is from a recent comment of his.

You have bank stocks which are beginning to break down, and he had a comment on that, as well. “The stock market rally can’t last much longer if banks take a tumble in the coming days or weeks.”

Kevin:You brought up musical chairs. The music is still going, I’ll grant you that. The music has not stopped. We’re still going around in circles around those chairs, but there are signs that the music is going to stop and I think King is basically saying this fall could even be possibly when that happens.

David:Right. What is fascinating is, you’re seeing a growing consensus, and granted it is the bears at each of the firms, whether it is at Societe Generale, or J.P. Morgan, or even Goldman-Sachs. They may not call for chaos in the fall of 2018, but they can’t make the numbers work as you get into 2019 and 2020. So for them, we’re in a 24-36 month timeframe. Anywhere from the next two weeks to the next two-and-a-half years where we see more pain than the market can really bear.

I was reading John Hussman the other day and he says, “Look to see a 66% decline, a two-thirds decline, in the S&P from these levels. That is what we expect in the completion of this cycle.” Hussman is no dummy. He is no dummy. Definitely a credit analyst, as is our Doug Noland, and for him, I think gathering chairs would be getting into treasury bonds. For us, gathering chairs is probably getting into ounces. But fewer chairs are available each week.

The music is playing, you’re right. People are happy with that. But as we suggested last week, keep your eye on the chairs.

Kevin:I definitely want a chair when the music stops.