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The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

“We are moving into a period of global chaos and disunity unlike any that we have had in the post war era. How are you processing those risk-mitigation decisions today, and also planning an exit strategy? Because by the way, when gold reaches peak, which I think could be over the next three to five years, you had better have something of a reduction or exit strategy. If you’re not mapping that out, you’re missing a great opportunity.”

– David McAlvany

Kevin: Well, Dave, you called it. About three to four years ago you were talking about what would be the next step as the central banks start stepping back from quantitative easing and low interest rates. The next step, of course, in the Keynesian model is fiscal spending. I remember three to four years ago you said what we will probably see is either war – that’s a good way to spend some money and pull the economy out – or we will see a massive public works spending project announced by the next president. Well, here we go, on Monday that’s exactly what we heard from Trump, the Keynesian model.

David: That’s right. As Bill King likes to say, Keynes on steroids. Trump has gone Keynes on steroids. 4.4 trillion dollars is the budget. 1.5 trillion is the public works scheme. That is actually a pretty significant chunk of change.

Kevin: Yes, well, you can borrow money, and you can borrow money, but you still have to find people to lend it to. So today I would like to unpack that a little bit later, Dave. I know the story on borrowing money a lot of times hinges on what happens to the U.S. dollar. If you’re going to loan money to a country, you certainly don’t want to loan money to a country from outside where you know that currency is going to fall.

David: There has been this assumed advantage in the U.S. because we have the world’s reserve currency status. People have to, to some degree, have dollars in their banks and their banking system, and it gives us the opportunity to inflate away a part of our liabilities. Whether it is a 2% target inflation rate, consider yourself on the creditor side of the equation. If you have lent money to the United States and we’re deliberately paying you back with cheaper and cheaper currency over time, 2% is the stated, maybe we overshoot to 3% or 4%, maybe we fudge the number and are constantly inflating at 3% or 4% – we are taking advantage of our creditors.

Some of the things to watch for 2018 as it unfolds, first and foremost I think is the U.S. dollar. And if the U.S. dollar continues to fall as it did in 2017 there are significant implications for the funding of U.S. debt. So again, we come back to, we have spending projects coming, we have a tax deal in the works now, and that is one possibility is that the dollar continues to fall just as it did in 2017. It will affect the U.S. debt markets, it will affect the equity markets here in the United States.

Kevin: But if it continues to rise, Dave – talking about robbing Peter to pay Paul – it pulls money outside of this emerging market. Look at what happened this last week. As the stock market fell it was the emerging markets that really continued to take the hit.

David: Now, when you say continues to rise, that would be sort of in the last week, because the U.S. dollar has had not much of a bounce here in 2017. But if the U.S. dollar reversed course from 2017 where it was in freefall, begins to rise in earnest, you could see capital flows into the United States. That would be very supportive for a debt financing needs. But as you mention, in turn, it would cripple the emerging markets because essentially what you have is savings flowing from overseas into the U.S. markets. In that case, you have an emerging markets crisis, an unwind, and potentially, a full-blown global credit crisis. That is something that Russell Napier talks about in recent comments. He has been a frequent commentary guest here at the McAlvany Weekly Commentary.

Kevin: He wrote one of the best books either one of us have read, The Anatomy of the Bear.

David: If you’re looking for an investment book, a sort of a tome to study and be familiar with, I would say The Anatomy of the Bear is a top ten read. He is concerned with this question today – who is going to fund the U.S. government?

Kevin: I know there is an active discussion between you and your dad right now as to the direction of the dollar and what that means for gold. There is a lot of conversation about the dollar, and I think there is an assumption, Dave, and I think the side that your dad might be taking, too, is that if the dollar falls that is really good for gold. I think what your point right now is, that really doesn’t matter, does it?

David: If you say, on a long-term basis, say, on a 100-year basis, what is the stability of gold relative to fiat paper currencies, you could say, “Yes, we have a dollar problem, we have a euro problem, we have a yen problem, we have a British pound problem, because they are all fiat, and they are all trading lower relative to gold over a long period of time. But just because that principle applies over the long-term does not mean that it applies in the short run, as in there is some sort of axiomatic relationship – dollar goes up, gold must go down, or vice-versa.

A lot of conversation today around the dollar. I want to come back to that here in a minute, but I do want to mention something on gold because I’m writing an article for my dad’s newsletter on that topic. That’s for next month’s McAlvany Intelligence Advisor. Make sure you call and get a copy of that. It’s still a few weeks away before you could order it. But my dad argues, as you mentioned, that U.S. dollar weakness is a prime driver of the gold market. I would argue, as you suggested, that it doesn’t really matter. You have supply and demand, which are, in the near future, the prime determinant of the metals and the direction of their price.

Kevin: The foreign buyers have been not only active, but record kind of activity, though not here in the United States, necessarily.

David: The next round of buying is likely to include a catalyst which will be inspirational for U.S. investors to join the party. This is after two years, you investors have not yet come to the party. But as you mentioned, foreign demand has been increasing. Chinese demand for jewelry was up 10.4% in 2017. You think, “Does that really matter? Gosh, who really cares about who is buying what from a jewelry store?” About 694 tons was consumed for jewelry purposes in China. That is out of 1,089 tons, according to the China Gold Association, which came off the market in 2017.

Kevin: And that doesn’t really include the central bank buying. They keep that very, very secret – hush-hush.

David: Exactly. Those figures are not included. Out of the 1,089 it is undisclosed what the Chinese central bank, the People’s Bank of China, does. They don’t disclose that for long, long stretches of time. But right now there is more gold that is being imported into China, and that is likely to continue as Chinese production of gold fell last year for the first time in almost 20 years.

Kevin: So you have increasing demand and decreasing supply.

David: Right. Supplies fell by 6% in 2017. So that’s China. India numbers, according to GFMS, a consultancy, increased 67% year-over-year from 2016 to 2017 in India. That was to a total of 855 tons for the year.

Kevin: Dave, one of the things I love about the Indian buying is that it shows who is buying and the instincts of mankind. Rural buying – this isn’t somebody who is manipulating the market or buying futures contracts. These are rural buyers for the majority of the buying.

David: 2018 is expected to be a banner year for gold purchases in India, as you have state funds at the federal level, but they are being lavished on rural areas. And lo and behold, politics is the same all over the world – guess what is happening in 2019? You have the general election and so money is being tossed around, and as more money is lavished on those rural areas, it does find its way, a good bit of it, into gold. Rural demand accounts for two-thirds of all gold demand in the country.

Again, you’re talking about people who are generally agrarian, and at the end of a harvest season they have money, and they don’t necessarily want to put it in the banking system. They know what the rupee can do to them, not for them. That is a key thing to recognize. They are keenly aware of currency penalties. So what do they do? They bank themselves in gold, and they do that in the form of jewelry and other things. But again, the agrarian culture, two-thirds of it rural, that is where two-thirds of the demand in the country is for gold.

Kevin: That’s not to mention, going back to the central banks, the central banking demand. There are three countries, actually four – there is China, Russia, and Turkey – that we talk about large central bank buying – and of course, we include India in there and like you mentioned, it is two-thirds rural demand. But those are the four countries that are really hitting the gold market. Now, the central banks in Turkey and Russia, I think, we should be paying attention to.

David: I was fascinated, about two years, Ken Rogoff wrote an interesting article. While on the one hand he was arguing for closing of the financial system and a forced inclusion into the banking system so that he and the likes of Michael Woodford and other academics can have what they want, which is their way with interest rates, taking them negative, completely negative, and forcing savers to abdicate, not only the income that they would have received, but now actually part of their principle, too. Negative rates are yet one more iteration of theft from government extracting it from the people.

But he wrote something a few years ago about central banks, particularly in the emerging markets, needing to acquire more gold. I thought it was fascinating, because on the one hand he is talking about a closing of the financial system – individuals should not have cash, individuals should not have gold, but on the other hand central banks should have gold, and particularly the emerging markets should be diversifying their dollar holdings into gold. I just thought it was a fascinating commentary that goes back a couple of years ago.

Kevin: Isn’t that something we see from elitists all the time, though, Dave? It’s like Animal Farm where all animals are created equal, only some are more equal than others.

David: (laughs) That’s like Keynes being somewhat anti-free market and yet he made his fortune trading grains.

Kevin: Several times.

David: Exactly. But you’re right, the Turkish, the Russian – there are a number of other emerging market central banks which are active buyers of gold last year. So U.S. dollar strength and weakness, back to that point of contention, perhaps, with my dad and I – over the past two years it has not kept gold in check or penned it down, it has been up. Gold has been up over 30%, cumulatively, over the last two years, so two years in a row. And guess what? The dollar was trending higher in 2016 – that didn’t put a halt to gold’s rise – and it trended lower in 2017 and gold did its own thing.

So again, I see some independence there. The trend has shifted and I think that other than what you see from a daily knee jerk response, you have so many ADD traders, Attention Deficit Disorder traders, who are saying, “Wait a minute, what’s going to happen now? In the next two seconds, what’s going to happen? Dollars’ up – that means gold is down.” They’re over-thinking it, I think.

And the currency direction is not ultimately going to determine the next shift toward gold. Look at Europe as an example. Europe, I think, is a very good example. Last year, if you look at their currency, you have great demand for gold in both Eastern and Western Europe – coins, bars, ETFs. Record per capita gold purchases occurred in German last year.

Kevin: That’s amazing.

David: The euro was up considerably, so it’s not as if a currency, a critical world reserve currency moves up and gold axiomatically moves down. Whether it is the dollar, or the euro, or whatever else, actually, gold demand – were talking about the demand side of the equation here – was off the charts in Europe last year, even with the euro going up.

Kevin: And Germany, in particular. This is a country that – when Germany leads, the rest of Europe follows.

David: Yes, so I think the critical driver is not currency. The critical driver of investor interest in the metals moving forward will be financial market stability or lack thereof.

Kevin: We talked about that last week. We had a VIX, a Volatility Index, that was unmovable for a year-and-a-half, almost two years, so much so that people were placing their major bets on it never moving again. And of course, you said last week that some of those people were paid back four cents on the dollar when they had bet that there would be no volatility. So we have instability right now. Do you think possibly some money will start coming out of the equity markets on a worldwide basis, and start buying something other than bitcoin?

David: Absolutely – global and domestic equity markets. So again, all over the world, including the United States here, domestically, we are going to see the equity markets drive a diversification into metals.

Kevin: That hasn’t really happened here in the America yet, though, has it?

David: No, it hasn’t. You have supplies of the metals which remain reasonably tight overseas. You have U.S. markets, ironically, which have been very weak, lots of liquidations of metals, not very much purchasing. So in terms of gold demand and supplies I think the supplies here in the United States are actually deceptively abundant.

Kevin: Explain what you are talking about concerning deceptively abundant.

David: I say deceptively because it is very little in terms of dollar volume, which would wipe out the existing supply overhang. So we do have an overhang of supply – bullion, American Eagle gold coins, if you go to liquidate them today, they always sell at a premium over the spot price. But today they bid less than spot. That is the market dynamic today. It is something we have never seen in the U.S. wholesale market, but it is a circumstance which is very easily rectified with a few dollars flowing in. So again, we’re dealing with a deceptively abundant market where, yes, today we have too many coins, but literally, tomorrow, and a few large purchases, and they’re all gone.

Kevin: Let’s just look at this company over the last couple of weeks. Drew has been domestically buying. Of course, Drew is our numismatist. He called super-excited on Friday that he was able to pick up about 350 coins. Now, we’re talking about the older coins, but 350 coins, 350 ounces…

David: It’s a lot of coins, and it’s no coins at all. That’s one purchase, if somebody wants to write a check for $400,000 or $500,000.

Kevin: Right. But that’s how scarce it is in a market where it feels like there is an over-abundance.

David: Right. I think rest of world buying has been strong, as I mentioned, as you talked about earlier. And I think there is a reason to believe with stock investors now having to validate their current valuation metrics and their equity portfolios, there is a reason for them to begin repositioning to lots of other assets.

Kevin: And historically, that would also be bonds, but what are you thinking about bonds?

David: Maybe. I think some flow will go there, but inflation winds are already blowing, and even if it is just a concern or the expectation more than the actual inflation gauges rumbling, you also have rates which are already on the rise, so if the rate trend, in terms of rising instead of falling, is a secular trend in nature, then you have investors that have not seen a real secular bond bear market in over 37 years.

Kevin: Definitions here – cyclical is the shorter, and then secular is the longer. You have made it a point to say that usually interest rates travel in 30-35 year patterns. They go up for about that time and then they go back down that time.

David: The shortest interest rate trend in the United States in 200 years plus of U.S. interest rate history is 22 years, the longest is about 37, and we have seen 37 twice. So the average is probably closer to 26-28, but again, that is an average.

Kevin: So if Bill Gross is correct, and now that we’ve topped 2.66 on the ten-year treasury, and actually pushed close to 3, we’re now probably reversing that trend and interest rates will be rising now for – what? 30 years?

David: So the question is, even if it’s ten years, we don’t know the future beyond tomorrow, so we don’t know with certainty. But one thing that makes sense is if there is a reason for concern in the bond market, then the typical allocation out of stocks and into bonds may cause at least some of the flow to go into metals. And in the metals market I would bet on short-term weakness in the price. You have the plunge protection team which is trying to stabilize the stock market, trying to buoy back sentiment and say, “Hey look – no, no, no – this was a technical glitch, it was a VIX short trade, nothing more. Keep on moving, the economy is fine, we’re doing everything that we can.”

But starting post-summer I think we’re likely to see the gold price move past the $1400 barrier and into the price range that grabs people’s attention and signals a secular shift there. I think we’re already in that shift. We bottomed at $1,050, we’re up $300 from that level. If you’re looking for a great year, 2019 is my bet for a record year in the metals. That might coincide with an emergent U.S. recession, 2019 to 2020, and we may be in the middle of an equity bear market. It’s anyone’s guess, but I would hedge and invest accordingly.

Kevin: I want to go back to what we were talking about, Trump announcing a 4.4 trillion dollar budget, increasing by 1.5 trillion, just with spending projects. The concern is, our deficits are set to rise considerably. Everyone would admit that. And yes, they say tax cuts will put a lot of that money back into the coffer. But actually, the government spending has to be paid for.

David: The assumption is that tax cuts are neutral and the only reason they are considered neutral is because – let’s call it pie-in-the-sky thinking – until it has happened it’s pie-in-the-sky, it’s hopeful thinking, and it may turn out to be true, but right now it’s just hopeful thinking, that you cut taxes and it is going to stimulate growth in the economy such that there is a net benefit. And that net benefit will more than compensate for an increase in debt.

Kevin: In a way that is counting chickens before they’re hatched.

David: That’s true, and it’s patting yourself on the back long before you have accomplished anything. I go back to Napier’s question of who will fund the U.S. government? Who will fund the U.S. government is a particularly big deal coming into 2018 because you have three things floating which are a real concern. Our deficits are rising considerably. Yes, we have tax cuts, and that is an increase in government spending, meeting up at the same time. So, compared to 2017 you had our deficit numbers of roughly 500 billion. Now we will have nearly 1 trillion dollars in deficit spending for 2018. So we’re up by close to 100% in terms of our deficit spending for 2018.

On top of that a second area of concern is that the Fed is on tap to reduce its holdings – we talked about this last week – including treasuries, by nearly half a trillion dollars, which will have to be absorbed by someone’s savings. So add an extra 400-500 billion from that source to the supply of treasuries. And then there is the third point of concern, which is, there have been liquidations of treasuries in recent years, if you’re looking at treasury flows. Dave Burgess does this for us at our Wealth Management team, as does Doug Noland who manages the Tactical Short.

In recent years, we have seen net liquidations of treasuries. That adds to a potential supply overhang. But on that third point it is worth noting that the central bank community has done a great deal to mask the erosion of interest in U.S. government bonds, so even though we have seen, in terms of treasury flows between foreign central banks, a net outflow, that the significant shift taking place right now is that central banks are normalizing their monetary policies, they’re stepping away from the markets, they are allowing supply and demand factors to normalize somewhat – that is both in Europe and the United States – and the foreign central banks who were your chief buyers of bonds, now all of a sudden their net liquidations are going to become far more obvious.

Kevin: Let me repeat this back to you so I understand the three things that you are talking about. Our deficits are set to pretty much double.

David: To a trillion dollars.

Kevin: And the Fed is now, at the same time – who had been the buyer of last resort and first resort – the Fed is backing away and saying, “We’re not going to be buying as many.” And the general public, or whatever the rest of the market is, we have been seeing diminished interest in that for the last year or two. So who is going to be doing the buying of these bonds?

David: That’s right. If it’s not central banks, if they have a diminished interest in treasuries, if it’s not our own central bank, the Fed, which they’ve said they’re moving away from the treasury market as a buyer of both first and last resort, where are the savings going to come from which support our budget deficit financing needs. Because again, you’re talking about a trillion-and-a-half dollars old debt which has to be handed over to someone, plus another trillion dollars in debt for 2018, money has to be borrowed from someone in order to spend it.

So someone’s savings has to come into play. Someone has to lend the money. We have the petro dollar recycling of an earlier generation – it is largely over. We have the Chinese trade surplus dollar recycling, which is coming to an end. And the mirage of financial and economic functionality which is created by the Fed’s presence in the market – that’s what we have had since the global financial crisis. That mirage is coming to an end. None of this would be a concern if not for the massive deficits in play.

Kevin: I think we need to go back and look at that because if we were on a gold standard and had to settle our accounts with gold…

David: It wouldn’t be a possibility.

Kevin: We wouldn’t have that. So why don’t we just walk through what has supported the dollar for the last 40-50 years, because when I was a kid we were on a gold standard and then we basically moved off of the gold standard, reneged on that, the Bretton Woods system and said, “Yes, but we’re going to use the dollar for oil.” That was the petro dollar standard. That’s changing. But we added the Chinese. We bought 400 extra billion dollars’ worth of their stuff. And they turned around and loaned it back to us.

Now as the Chinese faded away after the financial crisis we had the central bank buying. So we started with gold, then we went to the petro dollar, then we went to the Chinese, then we went to the Fed. Now the Fed is backing away (laughs). I’m starting to feel like Wiley Coyote, about three feet off the cliff looking down. I haven’t fallen yet, but it’s like, who is going to buy?

David: Who is going to buy? That’s right. There are two sources of savings, domestic private savings – mine, yours – or foreign private savings. So again, you’re talking about private investors who, for one reason or another, want to own treasuries.

Kevin: How do you attract that?

David: I think a massive shift from stocks to bonds, including an interest in treasuries. If you could intrigue your asset managers around the world, there would be sufficient quantities of money to finance our deficits. Of course, that pulls the rug out from under the stock market.

Kevin: Right. Robbing Peter, again, to pay Paul.

David: Yes, so it’s just a shift in priorities. Do you want the wealth effect, where everyone feels happier, but there are greater political contentions between the rich and the poor. Or do you begin to see a leveling – a leveling of the rich and poor where reallocation occurs primarily through market chaos and catastrophe? Because again, if you are “inspiring” the saver to take his money out of stocks and put it into bonds, it has to be because A) there is no upside in stocks, or B) there is terror and only downside in stocks. Let’s call it an emergent pressure. It has been revealed in the last ten days with the U.S. stock market selling off 10% in a week from Friday through Friday, so actually, six days of trading.

Kevin: And the rise in interest rates – wouldn’t that be the carrot on the stick? If the dollar is strong and you have a rise in interest rates like you’re talking about, that would also be a reason to move from equities.

David: Sure. And I think that is also just a question of interest rate differentials. On a relative basis, interest rates in the U.S. treasury market would be more attractive, and that would be, I think, inspirational to your foreign investor encouraging private savings from foreign sources to come into the U.S. dollar and into the U.S. treasury market.

Kevin: Now I’m going to get conspiratorial just for a little while because you have studied the foreign politics and the diplomacy that is used with the U.S. treasury and the U.S. dollar and the control of the SWIFT system and some of the things that we have seen with countries like Iran, putting pressure on Iran, or putting pressure on Russia. Is it to the advantage of the United States, who needs foreign buyers of stable treasuries, to actually maybe allow a little bit of worldwide chaos when you can encourage it?

David: In terms of U.S. foreign policy it is intriguing that, yes, I think global chaos does underscore U.S. dollar strength. And it supports our treasury department’s financing needs as money from other non-domestic sources seeks a safe haven. Just linger on that for a minute. Global chaos, arguably, is here to stay. I don’t know of anyone who is still in the camp of “we’re on the verge of the singularity” or “we’re on the verge of a world of peace and prosperity for everyone.”

Global chaos, arguably, is here to stay. That feeds U.S. dollar strength and encourages flows into U.S. treasuries. I’m just giving you a case, one reason why you could see interest rates move lower, and you could see the continuation of a bond bull market in spite of the current price action. If there is enough global chaos and people say we have to get out of Dodge, where would you rather be? Venezuela, or the U.S. dollar?

Kevin: If we go back and look, historically, at global politics, a big part of diplomacy and politics is, actually, creating a little bit of chaos with – maybe it’s not your enemy, maybe it’s your ally – but creating a situation that would give yourself a positive boost while pulling from another country.

David: The year that I spent at Oxford I learned something about the British when I practiced snooker. Snooker is like a billiards table, only it’s a 12-foot long table, and you have a lot more small, multi-colored balls on the table. It is both a game of offense and defense and you can score points both by sinking a ball which would be sort of positive for you, but you could also score points by creating conundrums for your opponent.

Kevin: Frustrating the opponent.

David: Yes, if he cannot make a shot, you can earn points on the basis of putting him in a terrible position.

Kevin: Does that sound like British foreign policy?

David: Oh, absolutely.

Kevin: Say in India – the opium wars?

David: Exactly. I thought, “This is a game that absolutely belongs to the British.” So if you were the U.S. Treasury Department today, would you be inclined to stir the pot? That’s a phrase that my son, who is soon to be four years old, loves to use. I’ll ask him what was going on when there is a conflict with one of his siblings and he always says, “So-and-so was ’tirring the pot.”

Kevin: (laughs) ’Tirring the pot. Yes, he’s four.

David: “So and so was ’tirring the pot.”

Kevin: So, if you had a country that you knew flows of currency would come into U.S. treasuries that was maybe teetering, that was maybe on the edge of instability, and you were the U.S. Treasury, you had the ability to do that like we did with Iran, I guess you would be inclined to do that, wouldn’t you?

David: If anyone was teetering, might you give a little extra shove if you were the Treasury? I don’t know. We’ve explored the idea, which Juan Zarate popularized in his book, Treasury’s War, where today, U.S. foreign policy is implemented as much, or more, by the Treasury Department than the State Department. State Department diplomats, by and large, pose for pictures and they pretend to be the voice piece for U.S. interests. They diplomatically deliver the current party line at cocktail parties all over the world. It’s a tough job – wine and cheese and all that. It’s a little different if you’re Hillary Clinton, then the job becomes more complex. But that’s maybe just a server issue.

Kevin: You wonder, if we were to sit and try to be ethical or moral about this you would say, “Well, gosh. This is sort of a war without blood.” Is this a money buys everything, or a money buys influence, type of question?

David: That’s the point. The Treasury is engaging in a new form of warfare. They can cut off funding to terrorism. They can implement sanctions – the Treasury Department can. Treasury limits access to SWIFT. Treasury uses the flows of capital or the lack of it to buttress our foreign policy objectives in real ways, in support of some regimes, and to tear down others. So the U.S. dollar rising – that’s not a given. But if the U.S. dollar is rising, and that is what is, at least, proposed by our friend, Russell Napier, what does it do? One of the things it does is it impedes global growth. It strangles emerging market equities. And as there is chaos caused by the strangulation in the emerging market equity space you do have traffic coming into safe haven assets.

By the way, if the yield differential on U.S. treasuries is still positive, why wouldn’t you move into U.S. treasuries and into a currency which is appreciating as well? I don’t think Napier is taking the Machiavellian view that perhaps you and I have just discussed, where the U.S. Treasury is involved in foreign affairs. I do tend to see that, but again, that is influenced by reading Zarate who is not a wild-eyed guy with an opinion about what the Treasury Department is doing – he is a Treasury guy.

Kevin: If you were to look at relative stability, and let’s say, look at the last week and a half, yes, we had instability in our equities market, but boy did they have equity instability worldwide.

David: Yes, back to the emerging markets, if that’s your focus, in the U.S. we sold off last week, Monday through Friday, 5.2%. The S&P last week ended down 5.2%. The Shanghai composite was down 9.6.

Kevin: Yes, almost double.

David: Hong Kong, down 9.5%. Japan’s Nikkei 225 was down 8.1%. Germany, the DAX, was on par with the U.S. – it was down 5.3%. The French market, the CAX was down 5.3%. The KOSPI there in South Korea was down 6.4% – that was in the red. And Taiwan was off 7.8%. You’re talking about good degrees of pain in a short period of time here in the U.S. but a lot more pain in other places. If that continues you’re going to end up redirecting capital flows and I think some of it may come back to dollars.

Kevin: So does that answer Napier’s question on who is going to fund this now doubling or burgeoning deficit?

David: It just depends. Could it be that the more severe hemorrhaging in the emerging markets and overseas developed markets feeds the necessary savings flows into safe haven assets like U.S. treasuries? The flow from overseas would certainly buttress U.S. dollar strength and take away one of the two concerns a foreign investor has when moving money around. It’s like so much Jello on a global plate. You have to look at the asset that you want to own – U.S. fixed income.

But then you have to ask the question – do you want dollar exposure? Because exchange rate volatility can kill you, or it can add to your returns. Look at this last year – to buy U.S. treasuries was a double loser in 2017. Why? Well, I should say, actually, early 2018 because that is where most of the volatility has occurred. Rates are on the rise and the dollar is not necessarily helping you. Bond market has been a tough go, let’s say over the last 6-8 months.

Kevin: Just to simplify, because I, as a U.S. investor, don’t want to see the dollar sink, necessarily, but it doesn’t really affect me. If I go and buy with U.S. dollars here in the United States, a U.S. treasury, and the dollar falls, I’m still using dollars, I’m paying back in dollars, I’m getting paid in dollars. But if you’re a foreigner anywhere else, and you’re loaning the U.S. government money, let’s say, like you said, the dollar fell 11% last year. Let’s say you were making 3% on that money. You’re still down 8%, not including inflation.

David: That’s right. So yes, the direction of the dollar is critical, to Napier’s point, if deficit funding is going to be sourced from overseas. That’s the deal. It has to be an attractive proposition. Or if money is fleeing from something that is unattractive, then those flows will catalyze an increase in the dollar and that will feed on itself as an increasing dollar attracts more money into an increasing dollar trade. 2017 the currency issue did not advertise U.S. dollar assets very well. The U.S. dollar sank by 11%, you mentioned, and in certain currency terms, if you’re comparing it to the euro it was closer to 16%. So, nasty year for the U.S. dollar if you’re a foreign investor.

So imagine considering shifting assets around as an international investor. Is the U.S. dollar a value at this point after last year’s selloff? Maybe. But relative to what? Now in 2018 you have rates rising, bond prices falling, which also does not, at this point, advertise U.S. treasuries as the best way for foreigners to preserve capital.

Kevin: At least not long treasuries, right?

David: Correct. But suppose the U.S. dollar catches a significant bid, begins to move back toward, let’s say, 100 compared to the euro index. Yield is more attractive for an overseas investor, certainly if you’re in Europe, or in Japan. Would you best be compensated with maturities of two years, five years, ten-year paper? Probably. You mentioned at the beginning of the program, 2.85% – that’s up 45 basis points year-to-date. That for your ten-year. If you go to the 30-year treasury you go from 2.85 on the ten, to 3.16 on the 30. That’s your flat yield curve.

Kevin: So if you’re a foreigner listening to this program and you’re thinking that possibly this is going to happen, that interest rates are going to rise, if you’re going to buy, you want to buy the short end.

David: Buy the short end of the curve and limit your inflation risk. On the extra 20-year period you only gain 30-ish basis points for an extra 20 years of inflation exposure. No way. No way. But should the dollar rise you have to remember that there are huge amounts of U.S. dollar-denominated debt which have been issued in foreign markets since the global financial crisis. And this is where you have the potential for a massive credit meltdown, a credit crisis, in the emerging markets, starting in the emerging markets, because of the classic currency mismatch.

The source of almost every emerging market bond blowout has come from an emerging market borrowing in foreign currency terms. As they depreciate their currency, and if our currency appreciates, the hurdle to pay back that debt gets higher and higher and higher, increasing the likelihood of – yes, you’re thinking it – default. That’s a failure in the bond market, a credit crisis.

Kevin: We have been conditioned for the last ten years – you mentioned the global financial crisis – it’s been ten years now since the global financial crisis of 2008. We’re used to everything happening gradually, so much so that we got used to just betting on pure consistency of the volatility index. Now, when confidence changes we saw last week how quickly you can go from a dollar’s worth of value to four cents worth of value if you’re betting against volatility. If that confidence breaks could it suddenly do the same thing to the bond market?

David: Right, and that confidence could be based on international conflict or some hair-brained tweet that goes out from the president. Who knows what it is, but there are certain confidence issues implicit to the U.S. financial markets which could radically impair the treasury markets, too, so again, sort of a trickle out of U.S. treasuries on a net basis, which we are seeing, and we have already said, has been masked by central bank interventionism.

Could that trickle, under the right circumstances, become a flood where investors are exiting the treasury market, where rates have been rising gradually at first, as they are now, and then have their own version of the VIX moonshot? The VIX, the Volatility Index, went from 14 to 50 in a day – in a day – and yet we pretended for a long time like a sub-ten number, a single-digit number on the VIX was normal – it was the new normal – because there was no risk in the market. Of course there is no risk in the market. We know that. We’re 21st century men. We understand.

Kevin: So I’m Trump, and I’m starting to look toward the next election, and I look at who elected me before – the populists. He was a populist vote. So you had Republicans, you had Democrats, you had Independents, but they wanted something that would make America great again. But to have a great America, you have to be competitive worldwide, with some of these countries that can provide so much cheaper labor. Trump may not admit this, but he needs a weaker dollar, does he not?

David: That certainly has been the stated objective. You’re right, the U.S. populist following, on the one hand they would benefit from, perhaps, higher paying manufacturing jobs if those did come back, on-shoring, if that were to occur. But on the other hand, a weaker dollar may negate some of the benefits of a higher-paying job by having the goods and services that we all have to pay for come in at a higher price. Nevertheless, you have Trump, you have Mnuchin, the Treasury Secretary, who appears to have already set the course for a weaker dollar. The issue is, if they do, and that is the course we’re on, we will not have foreign capital flows that support our deficit financing.

And it comes back to that question of, who is going to pay the U.S. debt, if it’s not the central banks, if it’s not our foreign creditors like the petro dollar recyclers of years gone past or the Chinese or the Japanese, on a trade basis. Who is going to finance our deficits? And if we’re saying that a declining dollar is in play, in contrast to what we were arguing earlier, or presenting earlier, it’s not going to be foreigners. Foreigners don’t step into a declining currency with glee. That’s not good news for them.

Kevin: If you’re listening and like me your head is spinning, and you’re thinking, “Oh my gosh, there are so many ramifications to both a weaker and a stronger dollar, deficits, spending,” really, if you want to simplify this program, just call it “between a rock and a hard place.” Right? Because in a way, a stronger dollar has merits. And it has consequences. Bad consequences. A weaker dollar – the same type of thing. Yet, we are increasing our deficit and we have to find someone who will loan us the money. This is the problem that we’re stating.

David: The weaker dollar impacts inflation trends, and I think it underscores interest rates moving higher, as they have moved, and are likely to move higher, it reinforces the outflows from U.S. equities. It reinforces something of a trend into the U.S. bond market for the U.S. investor.

Kevin: What we are talking about here is economic. We’re not talking about the financial markets. Now, one of the things that Trump criticized before he was elected was this bubble in the stock market. I’m not trying to take a shot at Trump but he started taking responsibility and credit for a rising stock market. That could really shoot him in the foot.

David: Huge tactical error. Huge tactical error on his part. He should have stuck with the economic improvement meme, he should have left the stock market performance out of the mix. If anything, he should have moderated expectations. Because in life, as in relationship, you understand that a part of your success deals with how you live into expectations, or shape them, or understand them and, again, live into it.

Kevin: Don’t promise what you can’t deliver.

David: Since the election he has tweeted at least 58 times taking credit for the rise in the stock market, which implicitly, will also credit him with the fall, as well. Notice that he tweeted last week, “I can’t believe this, the economy is going great, we’re doing everything that we can, the stock market is falling. That doesn’t make any sense, does it?”

Kevin: Well, what did he used to call it? He used to call it a big, fat, ugly bubble until he took over.

David: That’s right. When he was in his campaign voice, on the campaign trail, and he was saying, “Look at what Obama has done. He has taken funny money (and those were his literal words), he has created a big, fat, ugly bubble in the stock market.” I think you step into the presidential oval office, it probably gets the better of you, and now you own the bubble. And as long as it’s going up, you’re like, “Hey, this is because of me. Look at me, this is really impressive.” I think he should have stuck with the economy because financial markets are likely to be unkind to him. Even though the economy is fine, financial markets are likely to be unkind to him heading toward a re-election bid, even with the economic tailwinds helping him.

Kevin: You talked about Russell Napier. One of the things that Russell told us a few years ago was that we had better get used to command and control dynamics, in other words, forced investing, forced monetary management – the Rogoff cashless society. I noticed on Monday that China is now calling on companies, mutual funds, large investors, to go in and buy their stocks. Do you think that there would be pressure from the White House, or from the Federal Reserve, on some of these larger passive management funds like Vanguard, where there is pressure to go in and buy these treasuries and actually become the source for the funding of this deficit?

David: You know, you say calling on – it’s a very small difference between being called on to do something, and being mandated, or it being legislated.

Kevin: À la command control.

David: Yes, go back to the language which we used in 1968 when the French started taking gold out of Fort Knox, and we called on friends of America to settle the liabilities in greenbacks and paper currency, and not to take gold out of Fort Knox. Now, of course, we weren’t demanding that they stop – that happened in 1971 when we closed the gold window.

Kevin: We just strongly suggested that if you ever want to have a favor from America again…

David: If you want to be in the friend category. And what is implicitly the other side of that? The enemy category. You choose what camp you want to be in, but please, do as you are so inclined. So there is a difference between, but not very much of a difference between, being called on, mandating, and ultimately, having it legislated. If you were the President, if you were the Treasury Secretary, under certain circumstances, who would you keep on speed dial? Again, I think this goes back to what has been popularized as the plunge protection team, which is technically and officially known as the President’s Working Group on Financial Markets. You need to make sure that you have speed dial to your top ten asset management companies.

Kevin: Isn’t there a huge concentration of a lot of assets just in a few companies?

David: Yes, in the top ten asset management companies in the U.S. you’re talking about control of over 25 trillion dollars. So BlackRock and Vanguard are both north of $5 trillion apiece, and that is a lot of Jello that can be shifted around the plate. So you start thinking in terms of political pressure, regulatory pressure, anti-trust pressure – any kind of legislative requirements for a more passive management behemoth – what if you need an allocation to favor treasuries?

Kevin: Look what happened a couple of years ago when you saw favor toward treasury money markets. They were allowed to set their share value at $1.00 a share, but if these money markets invested in anything else they were not allowed to do that.

David: Right, it changed the risk metrics for the investor, and the investor was given the freedom of choice to move to someone that was investing in commercial paper, which gave them a higher return, but the buck could trade above or below a dollar value, net asset value, or a treasury which gave you the guarantee of a dollar return on your money. You weren’t taking risk in a money market fund as long as it was treasury-backed.

Kevin: Even though those treasuries fluctuate just like commercial paper do, they just showed favoritism.

David: Yes, that’s exactly right. So, after all, it is somebody’s savings that have to fund our deficit. So the question is, where does it come from? This is why the whole conversation today, ping-pong back and forth between dollar up or dollar down is important. It’s not as if we have a crystal ball, but if the dollar goes up, there are implications, and if the dollar goes down, there are implications, right? So you should watch the dollar. It’s not foreign central banks any longer that are going to finance the U.S. deficit. It’s not the U.S. Fed, at least as stated at present. So in sum, you have Napier that argues that U.S. dollar strength, if we do witness that, will reveal global liquidity weakness.

Keep that in mind, U.S. dollar strength will reveal global liquidity weakness, and that is very much like a replay of the 1997 emerging market crackups. We had Thailand, we had many of the Asian tigers hitting the skids. Ultimately, it rocked most of Asia and Russia, and you can tie that to too much U.S. dollar-denominated debt and not enough liquidity. So there is a paradox between having debt as money. You have high quantities of money-like assets, that is debt, but on the other hand, very little money to make payments on the debt when capital flows begin to shift.

Kevin: Again, that is only a problem when you are a deficit country. Back when we were on the gold standard that wasn’t a problem because if you didn’t have enough gold you had to have it before you could pay your bills back. Now the question is, what is debt and what is money, or are they both the same?

David: So, that’s U.S. dollar strength. Then you move to the other hand. On the other hand, Napier argues U.S. dollar weakness creates a domestic funding issue where U.S. investors are likely to be the funders of our deficit. And that is resolved by a nasty bear market in stocks, where you see a capital flow from stocks to bonds.

Kevin: With that being said, you said you are going to be writing an article in the McAlvany Intelligence Advisor, your dad’s newsletter, looking at these issues and saying, “Look, as far as gold is concerned, a weak dollar or a strong dollar, that is not really the question here.” And so, for the listener who wants to see that particular issue when it comes out, can we give that for free if they give us call, Dave?

David: Absolutely. But it is worth noting that when you look at the political left going apoplectic about the “breakdown” of the liberal world order, these are the trends that are driving gold demand internationally. We are moving into a period of global chaos and disunity unlike any that we have had in the postwar era. Globalization brought us a great deal of benefits and blessings. De-globalization, globalization in reverse, what we talked about many times with Harold James who wrote a book on that topic where he argues that we are, in fact, moving into another era of de-globalization.

So whether you like it or not, and I’m certainly no champion of global instability, we are sitting ringside here, coming into 2018, and ultimately, into 2019, one of those years which I think will be a banner year for gold. That means you have to have your strategy lined out. Where do you go from here? If you don’t own it now, should you own it? In what form?

How are you processing those risk mitigation decisions today, and also planning an exit strategy? Because by the way, when gold reaches peak, which I think could be over the next three to five years, you had better have something of a reduction or exit strategy. If you’re not mapping that out, you’re missing a great opportunity.

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