Formerly Free Money Now Getting Very Expensive

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• Companies weaned on easy credit now facing bankruptcy
• Milton Friedman warned you can’t fight inflation without loosing jobs
• China facing credit crises, high yield debt at 24.9% yield

Formerly Free Money Now Getting Very Expensive
July 12, 2022

“During the worst of the pandemic, if you go back to the spread between high yield and Treasurys, it reached a thousand basis points. If you go back even further to the global financial crisis, it was 2000 basis points. That is a tough environment to survive. So, of course, bankruptcies proliferate as the spread to Treasurys passes a series of key thresholds. We’re not there yet, but there are good reasons to believe that we will be before too long. When we get to the Chinese numbers, I think you’ll fall out of your chair.” — David McAlvany

Kevin: Welcome to The McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany. 

It’s funny, my family’s from Texas, the Panhandle of Texas, that’s where my dad grew up. I spent every summer there. I ended up going to school at North Texas for a while, but you know, I’ve never been to San Anton. I would love to go visit the Alamo and just, what is it called? The River Walk. You sent me pictures the other day. You and Miles were there in San Antonio. You went over to the Alamo. And just looking at that, I think back as to what a small place that building was, the Alamo, yet small places can change very, very large points in history. Can’t they?

David: For sure. We sat with a gentleman who was there to guide and answer questions. And I asked him, why are you here, of all the places that you could be, of all the things that you could be doing? And he gave me a short history of his great, great grandfather. Maybe it was great, great, great grandfather, I don’t remember. But it was basically the history of the Tejanos, and these were Mexicans in the north part of Mexico, and they weren’t getting the benefits of being a part of the nation, but they were expected to pay taxes and everything else. And so they were like, nope, this isn’t working for us. So they were in support of this revolution, right, that happens at the Alamo. They’re fighting at the Alamo against the Mexican government.

Kevin: So you, in a way, because you’ve talked often about how the financial leads to the economic, which leads to the political or the geopolitical, when it gets political, it starts to get bloody. That’s where the blood flows, right? It’s not the economic, but it can lead to that.

David: That’s right. Now, the tragedy was that after the Alamo, they were Mexicans and the Americans didn’t trust them. And the Mexicans didn’t trust them either. So they were at the losing end. At least this is the story that I was told while at the Alamo.

Kevin: Didn’t you get to the bar where— Okay. I don’t have a lot of first edition books, but I do have a first edition Rough Riders by Teddy Roosevelt written in the last couple of years of the 1800s.

David: The Menger Hotel is where he rallied— shots going off through the roof. You don’t want the room right above the bar. That’s for sure. Not in those days. But, yeah, Roosevelt rallies the Rough Riders at the Menger Hotel. And so to sit and have a beer sitting there where he was decades before was fun. 

One other really fun thing from the San Antonio trip was a Commentary listener approached me. We’re just at a breakfast spot meeting with a client of ours. And he says, “Are you are David McAlvany? I’ve been listening to the Commentary for years.” Anyways, it was really— It was a special moment for me. And I went around to say something to him later on, and he’d already left. Again, breakfast spots, people come and go pretty quick, but that was a highlight from San Antonio to run into a Commentary listener who’s been a part of this for years and years now.

Kevin: Well, we love you guys, all of you who listen to the Commentary on a regular basis. 

Well, going back to small things leading to large things, there’ve been a few things that have happened this week that I’d like to hear your insight on. The Abe assassination, and how does that tie in? And we’ve got interest rate issues in China right now. And the Fed— The question isn’t the Fed raising interest rates, it’s the markets themselves raising interest rates. And so I’d like to do interest rates. I’d like to talk about some of the geopolitical things going on, both in Japan, Taiwan, China, Europe. Let’s just talk about that because the Alamo is a symbol for something much larger.

David: When we look at the volatility of the last week or two, whether it’s the emerging markets or credit default swaps or yields within fixed income, it’s been amazing. It’s been astounding, surprising, shocking how far prices and numbers will move in one direction and then hammer back in the other direction. And so when we look at crises in the credit market, ultimately they lead to crises of a social and political nature. So, we do watch corporate and sovereign credit, knowing that they’re consequential; they’re consequential for the impact that they have in asset pricing and financial market stability. But more than that, because destabilized credit markets are, how should we say it, socially redefining. 

China is in an economic crisis driven by its credit markets, as we’ll explore in a minute. Europe is trying to recreate and hold together Shelley’s Frankenstein monster, with solutions for their sovereign debt markets now using experimental tools, and we’ll see how that turns out. But the vote so far in the currency markets is: Not going to work. 

The US has its own pressures emerging within the corporate credit arena. And of course in recent days and weeks, the dollar has strengthened against other weaker currencies, melting up essentially versus the yen and the euro. And the euro is basically at parity with the dollar. Not long ago was it was at 1.35, now it’s at parity. And I remember when I lived in England for a year, the pound sterling was between 1.55 and 1.65. Now, it’s in the mid teens—1.19, 1.18. So we’ve had a massive loss of currency value relative to the dollar. 

As the dollar strengthens, corporate earnings come under pressure—more and more pressure. And what does that suit us up for? Forward projections are going to be disastrous. So as we get into the reporting season for second quarter, you’re going to have damaged share prices coming into the third and fourth quarter as those forward projections end up being lowered, in some part—in some large part perhaps, by the dollar strength. So what does that do when you end up with share price damage? You increase balance sheet vulnerability, and, as Richard Russell often repeated, asset prices fluctuate—he’s talking about equity—while debt is permanent. And I think that’s the kind of thing that we’re going to see play out as we get into the third and fourth quarter—the further fluctuation of asset prices, and the ridiculous burden of debt, which stays as a permanent albatross.

Kevin: Yeah, so many things, Dave, to look at, and sometimes they can sound a little bit dry. And it’s like, oh, they’re going to talk about interest rates, or they’re going to talk about this or that. The truth of the matter is, we all, being human, we want to know the story. We want to know, well, what does that mean for me? And there’s an old saying that says, a recession, which we’ve been talking about coming. Some of these things are leading toward that. A recession is when your neighbor loses his job. A depression is when you lose your job. Now we’re not seeing recession yet. And we’ve talked about the leading signs leading up to it, but employment. Employment right now, we’re seeing pretty good numbers.

David: Yeah. Last week’s numbers were surprisingly good. There’s some disagreement, some disparities between the different measures of unemployment. 

But if you look at corporations and if you look at households, bankruptcies are, in the current context, they’re a rarity. So you see that shift in the context of a recession. They become more and more common. And particularly if you end up with a hard landing version of a recession, certainly bordering on depression. Now you’re talking about being littered with the dead bodies of corporate structures and households. 

So the common characteristic of the limited number of chapter 11 bankruptcies in recent weeks has been liquidity drying up. That one element. Liquidity dries up, and they’re done. It would seem we’re in the early stages of liquidity drying up, not in the late stages. So even with a severe correction in the equity and bond markets year to date, I think we are likely to experience far worse over the next several quarters. 

And then this comes back to liquidity tightening. It can be seen now in the emerging markets. You can see liquidity tightening in peripheral Europe and a factor in the ECB’s [European Central Bank’s] prettying up the PIGS, so to say—Portugal, Italy, Greece, and Spain—with a little lipstick and eyeliner. And you’re seeing it also in the lower tiers of credit, in the US, Europe, China. So, frankly, liquidity tightening is a global theme.

Kevin: Dave, you’re training for a race here in a few weeks in France. And I know you know how important oxygen is. You live at altitude. The higher you train, the less oxygen there is. And there is a point where you can’t move forward. And you look at athletes who come up, even to Colorado, to play basketball or hockey or football. And a lot of times, they’re taking oxygen, just trying to continue to function. And I think of liquidity in the markets a little bit like that. I had someone tell me, you want to know what emphysema is, put your hand over your mouth and now try to breathe hard, and try to do that all day long, every night. So, are the markets right now addicted to the oxygen, the liquidity that they’ve been given? What happens when that dries up and they put their hand over their mouth and they’re no longer getting that liquidity stream? You know what I’m saying?

David: Oh yeah. Yeah.

Kevin: What’s that feel like?

David: There’s an adapt or die that needs to happen within the credit markets. And I love the idea of adaptation at the micro level where I can train at 8,000 to 10,000 and race at 3,000 to 4,000 feet, and I have an advantage. What we’re talking about in the financial markets is training at sea level and racing at high altitude, where things just change. You haven’t adapted sufficiently, and you feel the pressures.

Kevin: Because easy money has been the theme for the last decade.

David: That’s right. So you don’t train easy and race hard. You train hard and race easy, if that makes any sense. The key here is that, as financial conditions tighten, many corporations that have been weaned on easy money policies, that have been reared in an age of quickly accessible credit, they’re going to have to adapt or die. The Financial Times reports that at the end of May, as measured by the S&P, under 3% of corporate credit traded with a 10-point spread to Treasurys. So we’re talking about the premium over the Treasury interest rate. So we’re talking about 10% or a thousand basis points above Treasury rates.

Kevin: So you’re saying only 3% of the corporate credit traded more than 10% away from the Treasury rate.

David: That’s right. So, numbers suggesting that distress and a higher likelihood of default are there. Again, very limited, 3%. Pretty small. By the first week of July—so from May to July—this distressed debt category jumps from 3% to 9%. So, some movement. Meaningful. Scaling up three times. It’s worth watching the trajectory there and seeing if it should get worse. This is the reality. High costs of capital indicate a number of things: the deteriorating position of the debtor, or sometimes even just the scarcity of liquidity.

Kevin: But do we have scarcity of liquidity right now? It seems like there’s still quite a bit out there.

David: Yeah. We’re not in an age of scarcity just yet, but some corporate organizations are being rerated. Their risk is being reassessed. And the credit that they have accessible to them is costly. And in some instances, there’s no credit available to them at all. And then I think that’s where you’re beginning to see a few bankruptcies. So in the absence of new credit to replace the old or in the presence of an immediate demand for liquidity, a margin call type thing, restructuring and creditor losses, that’s the reality. So we’ve got Revlon, cosmetics giant, bankrupt. SAS, the Swedish air carrier, bankrupt. We mentioned Voyager Digital, caught up in its collateral overexposure with the Three Arrows hedge fund. We mentioned them last week; sizable Singaporean crypto hedge fund, bankrupt as well.

Kevin: And if you look at a bankruptcy as sort of like running out of oxygen, running out of liquidity, you’ve lost the ability to pay your bills. Going back to the air thing, I think about it. There’s a way of thinking about how you can survive in the wilderness. One is, okay, so you’re not going to live much longer than three minutes without air. And they say about three days without water, they say 30 to 50 days without food. But we really do—we have certain absolute needs. And if those needs are not met, we have something that seizes. And I’m just wondering, do we have a seizure right now in like Revlon? That is an old name.

David: Yeah. Yeah. Well, did I ever tell you about the time when I had to have Mary Catherine take the wheel? I was driving and I passed out.

Kevin: No.

David: Well, so this ties to my obsession with—

Kevin: How do we know each other all our life, and each time we did the Commentary, you’re telling me things I didn’t know.

David: Well, I was practicing holding my breath, and I got to about three minutes and 30 seconds. So, to your point about you can’t do very well without oxygen, I made it to 3:30. 

Kevin: And you were practicing while you were driving? 

David: Of course. It seemed like good dead time and space to be using it.

Kevin: With how many kids in the car?

David: Oh yeah. I know.

Kevin: Yeah.

David: I know. Well, I just said very matter of factly, “Mary Catherine, please take the wheel.” And she reached over and grabbed the wheel.

Kevin: Oh no.

David: And I came back about 10 seconds later. I was like, “Oh, wow. I think I won’t do that again.”

Kevin: Was this when you were getting ready to free dive? Because you like to do the free diving.

David: Spear fishing is, well, in past years, it’s been something that I’ve really enjoyed. I haven’t gotten to do it much lately.

Kevin: So using this analogy, though, okay, these guys are driving down the road, holding their breath. If they’re not getting any credit, or if credit is costing more than they can afford—

David: Who’s going to grab the wheel?

Kevin: Yeah. That’s what I wonder.

David: We’re not yet in a place where credit markets are seizing, but we’re close. And I think this is really key. In recent weeks, the investment grade and high yield markets have struggled to issue new debt. And maybe that loosens up from here. Maybe we see something in recovery, both loosening pressure in the equities market and also a return to being able to issue new debt. But I’m telling you, in the last three weeks there’s been a couple of instances where we’ve come very, very close to those market seizing. And when those markets seize, the engine of finance seizes, particularly if you’re talking about investment grade debt. It is a strange reality, but corporate America cannot exist without a steady and fresh flow of credit. It’s a global phenomenon, right? So it’s frankly not just corporate America. But no credit, no growth. No new credit, no survival.

Kevin: This era of passive money management in ETFs [exchange traded funds], where you’ve got giant funds that are holding this corporate credit that you’re talking about, doesn’t that also restrict the flow? When credit starts to tighten up, what do you do when you’ve got a gigantic passive income fund that’s full of it?

David: Right. And we’ve seen significant outflows from those funds, from those sectors. Again, talking about investment grade and high yield, and that brings unwanted supply to the market in the same period of time that corporations need new debt for continuing operations. So the ETF structures which easily package and sell corporate bonds, they have a much harder time unpackaging and liquidating the same assets. This is just one complicating factor. I remember a gentleman from Allianz Global in their fixed income department saying, “We’re having a hard time with liquidity. It’s taking us weeks to get things done that used to take days.”

Kevin: So we’re not really talking about banks here, as much as we are non-bank lenders.

David: Back in the day, when we would have banking crises, some of them would be tied to foreign lending, and banks were lending to everyone for everything. And the larger pressures emerge now, not because banks are lending or not lending, but we’re talking about non-bank lenders, Wall Street firms. When they slow the creation and distribution of credit, then you end up with larger pressures in the fixed income market. And because they’re primarily responsible for the distribution and creation of credit— Again, talking about at this level, not— Central banks obviously are doing a lot of that too. But central to the way that economic growth has been engineered in recent decades has been this proliferation of financial assets. 

So you can combine in the financial asset category equity, debt, and then a whole host of other structured products that have a vague resemblance to one of those two things, equity or debt. And this is what enables corporate entities to leverage opportunities, to expand their balance sheet, to grow. This is mergers and acquisitions and all the rest. Behind the magic of corporate financial engineering lies central bank credit and a machine which has passed through a discounted structure to support leveraged corporate growth. And so central banks, if they’re not subsidizing interest costs by keeping them at unnaturally low levels, then corporations have major adjustments to make in the ways that they manage operations, in the way that they target growth. And I think the other adjustment that follows on the heels of this is for investors that need to make adjustments to their expected returns.

Kevin: Well, and sometimes it’s best to put it in a term, almost all of us have had or have mortgages on our house. And so not everybody listening to the Commentary runs a corporation and has the understanding of what the impact of interest rate increases are. But like with a house. Let’s just take a half a million-dollar house. What does it look like as interest rates rise, so that we can— It goes back to what I was saying before. How does this affect me? How can I relate to this, the interest rate increase, and how much more difficult it is to survive with what we’re seeing?

David: Yeah. The era we’re entering into is a new era, and corporations face higher costs of capital. That raises the question of sustainable levels of debt. So back to your example of household and a budget related to a home. You buy a house for $500,000, you put 20% down. Okay? Let’s say you borrow the rest at 3%. Right.

Kevin: Which is what we got used to.

David: We had that a year ago. We don’t have it now. But here’s the difference, right? So you borrowed 400 grand out of the 500. Borrow at three. Your mortgage with taxes and fees run around 2350. Same scenario at 6% puts your mortgage at 3,065.

Kevin: Now the pain’s being felt. Yeah.

David: Bump your interest rate to 10%. Same house. 4,200 is your monthly payment. And this is the point, is it takes a bite out of disposable income when interest costs increase. And it’s no different for corporations. If a corporation has less to show at the end of the month, at the end of the quarter, at the end of the year, how have they impacted their economic performance? It becomes obvious.

Kevin: Well, here’s the difference. Here’s the difference. I can lock on a rate for 30 years, but they don’t do that very often. Corporations are having to reevaluate at the new interest rates much more often, aren’t they?

David: Yeah, it doesn’t happen that often. Corporations— This style of rate increase, looking at debt service costs, they tend to see things a little bit differently. They don’t usually lock in debt for 20 or 30 or 40 years on a fixed rate mortgage the way— We’ve highlighted in the Commentary a few entities in recent years that have borrowed money for 100 years at very low numbers. And at the time we said, brilliant for them. How insane. Not so brilliant for the lender. This is in a period of zero inflation, zero interest rates, and you can borrow money at 2 or 3 or 4% for 100 years. Again, brilliant for the borrower, not so brilliant for the lender. 

If you look at maturity timelines, the US Treasury has about two thirds of its debt, so call it $20 trillion, with a maturity of five years or less. You can find that information at Treasurydirect.com. Not very smart. Five years or less, two thirds of your debt, it’s going to come due. You’re going to continue to issue new debt each year, so that number will grow over time. Plus, you’ve got to refinance the old stuff, right? Corporations have done a little bit better job. Their average maturity is closer to low teens, call it 12, 13 years average maturity. And that buys them a little time. It reduces the risk of a rollover calamity.

Kevin: Right. Right. But the higher interest rates that they pay, we talk about something called the price/earnings ratio on stocks. What’s the price of the stock, and how does it compare to the earnings of the company? When you’re paying higher interest, you are reducing profitability and therefore earnings, are you not?

David: Right. So at the corporate level, as interest expenses rise, it reduces corporate profitability. That’s the best-case scenario. Worst case is that you need liquidity and liquidity is not available. And then a liquidity crisis becomes a solvency crisis.

Kevin: That’s bankruptcy. Solvency crisis is bankruptcy.

David: ’08, ’09, that’s what we watched over and over again. Perfectly healthy business needs a little bit of a cash infusion. Cash infusion’s not available. And all of a sudden liquidity crisis becomes a solvency crisis and bankruptcies start to move higher. So, again, reminiscent of the global financial crisis and the quickly changing financial market and liquidity backdrop. I think there’s some similarities, and there’s also some differences. We had commodity price inflation in that ’06, ’07, ’08 timeframe. A lot of that was driven by Chinese demand for commodities, a massive boom in building. At that point it was ghost cities. Now we can see through those ghost cities. They’ve actually torn some of them down just so they can rebuild them again.

Kevin: Well, how about liquidity though? Because yes—

David: We also had a massive housing boom in the US, and that pressured commodities as well.

Kevin: Yeah. Well that boom went bust. That was amazing at the time. But the liquidity that we’ve seen printed over the last 10 or 12 years is nothing like what we saw in the global financial crisis, especially the last two or three years with COVID. So, let’s just take that, okay, the measurement of that is M2, they call it M2. What’s the comparison there?

David: Yeah. They used to be able to pretty easily extrapolate from M3 to what your future inflation number would be. And many central bankers, particularly the German central bank, the Bundesbank, they mocked us when we quit printing M3. They’re like, how do you make forward projections in terms of monetary policy without seeing what M3, how it’s trending? And for us, it was more a question of how do we obscure the data? And they had their rationale for getting rid of it. But that’s essentially what it was, is let’s just make it a little harder to connect those dots between monitoring expansion and inflation.

Kevin: It allows them to control more versus the person who needs to make the decision for themselves.

David: Yeah. You can still roughly gauge it off of M2, a slightly smaller measure of money supply. And so you had the Chinese development boom and the inflation, which was going on ’06, ’07, ’08. Of course you had energy prices moved to 140, Brent Crude was really expensive. There was a lot less money creation then as measured by M2 than in more recent years. Your maximum annual growth came in actually during the crisis as a part of an intervention to help bail out the crisis. And so this is after your commodity push in ’08, you get into ’09 and sure enough, you’ve got a 10% growth in M2, annualized rate of change 10% or thereabouts, maybe just over. 2020, we surpassed 20%. And in 2021, money supply growth surpassed 25%.

Kevin: So that’s two and a half times the monetary growth of, what would you say, 2009?

David: Yeah. So we’ve got a different dynamic driving inflation, one of the influences being monetary expansion. So this is important to bear in mind when you think about the bankruptcy proliferation of 2008 and 2009. Inflation was launching at that time, and a massive asset price deflation squashed it. So we had a little inflation, of course we have a lot more now, but I think what we have yet to see, at least in this round of inflation, the consequences, tightening financial conditions, the consequences of inflation, much of that is still ahead of us.

Kevin: When I was taking economics years ago, back in the ’80s, you had the Keynesians, you had the Monetarists—that was the Milton Friedman school—but all of them had equations. I remember the thing that fascinated me about economics when I got into my money and banking class was that you had three or four numbers. When one would get larger, the other one would get smaller, and it almost was as if economics was like a little black box. But one of the things we all know is, Milton Friedman said you can’t fight inflation without rising unemployment. In other words, people are going to lose jobs. That’s a painful equation, going back to how does this affect me. Either you lose your job or your neighbor loses his job, whatever the extension is. If they’re going to truly— If they’re committed to fighting inflation, which they have said that they are, it’s going to involve people’s jobs, isn’t it?

David: Certainly. And I think one of the painful realities for any professional economist is to see that equations really don’t capture everything that’s relevant. There’s human idiosyncrasy and emotion which don’t easily fit into equations. So there’s an element of surprise, always, in the markets. And regardless of how tight an equation is or how clear you think an axiom is in economics, be prepared for surprise. 

I think we’re at the front end of financial tightening, both in terms of the timeframes and severity at the height of interest rates, and the length of time that they remain elevated. There’s going to be some surprise element there. And that is if, in fact—if, in fact—central banks hold the line on inflation fighting. Because frankly, to do so means there’s going to be pain. And Milton Friedman suggested that there is no way of slowing down inflation, he said, that will not involve a transitory period in unemployment and a transitory reduction in the rate of growth of output. But, Milton said—Friedman, that is—these costs will be far less than the cost that will be incurred by permitting the disease of inflation to rage unchecked. 

So we discussed the difficulty of maintaining two mandates simultaneously a few weeks ago, and how unemployment is likely to rise in the years ahead, above the current 3.6% level. We also discussed the absurdity of adding a third mandate which can end up ruining all three.

Kevin: We called that the three body problem, but—

David: Like in physics.

Kevin: Yeah. And I have to catch something here. I didn’t realize that that quote by Milton Friedman used the word transitory twice. So I’m just wondering if they weren’t just copycatting the old Milton Friedman, yeah, transitory.

David: It was an homage.

Kevin: So if you’ve lost your job for a month, that’s transitory. If you lose your job for two years, what is that?

David: Yeah. Squared. Transitory squared. 

So my point is that things are pretty good now, but the conditions are being set for a pressured economic environment. And so high yield bonds averaged a not-so-high yield of 4% for most of last year, 2021. And that was after the pandemic spike, they went from 5 to 11% at the onset of the pandemic. And so, from 5 to 11, and then they spend most of 2021 with central bank intervention globally, bringing rates down to nothing, actually to zero and negative levels. US junk paper is yielding 4% now. They’ve steadily risen. They haven’t spiked—not like the 5 to 11 spike—they’ve steadily risen from 4 to 8%. And the spread, that is the gap between their yield and the Treasury yield, has increased from the 200s to over 500 basis points. This is a gradual tightening of financial conditions. The impact can be felt in the bond markets. These are borrowers who are now feeling a little bit more tension, right? And the impact can be felt in the bond markets. These are investors exiting in advance of further interest rate increases. This is a change in credit conditions overall, inflation, the whole yield curve is shifting, but we’ve not seen anything yet.

Kevin: Well, Dave, that’s what we’ve had this false paradigm, this false model. And the problem is most of the money managers out there probably don’t remember any other model except for an artificial interest rate model. So having junk bonds paying close to Treasurys the last few years, that didn’t make any sense, and having emerging market debt or European debt paying, like the Italians paying about the same as the Germans, that didn’t make any sense. But now things are starting— Mr. Market is coming in. He’s going to sew the seeds of making sense. The problem is that it’s painful.

David: Well, again, during the worst of the pandemic, if you go back to the spread between high yield and Treasurys, it reached 1,000 basis points, 10%. So we’re at 5% today, on our way to 10% perhaps. If you go back even further to the global financial crisis, it was 2,000 basis points, 20%. That’s 20%, folks. That is a tough environment to survive. So of course, bankruptcies proliferate as the spread to Treasurys passes a series of key thresholds. We’re not there yet, but there are good reasons to believe that we will be before too long. When we get to the Chinese numbers, I think you’ll fall out of your chair.

Kevin: And this is where, when we hear about a Federal Reserve interest rate hike, okay, you’ve got two factors that’ll raise interest rates. It’s either the Federal Reserve or it’s going to be the markets, and what we’re seeing in China, the markets have taken over, right? And what we’re seeing even in the high yield in corporate debt markets here, the markets are starting to take over. What it reminds me of, there was a show I watched a couple of times with my wife on dominoes. These people would set up, they’d spend all day long making these incredible designs with dominoes. This was just recently on. And I think about the domino effect of, okay, so the Fed raises the fed funds rate. Boom. And then it moves right on down until you get to some of these high yield or even junk bonds where there’s a point where the company can no longer pay the interest as that domino fault. Does that make sense?

David: It’s too much pressure. It’s too much pressure and they can’t bear it. So, yeah, you’ve got the tiered nature of the bond market. Government debt’s in the first tier. It’s the safest tier. Then you’ve got investment grade, and lastly high yield, otherwise known as junk, and at the edge, at the edge of investment grade are your borrowers that need everything to go right, and lending conditions to stay easy. And if something changes external to the company, they can easily flip to junk status. And in flipping to junk, they swell the ranks of those desperate borrowers. You can see the junk category go from being a few poor pathetic souls to the majority of debt that’s outstanding.

Kevin: That also forces some of these ETFs and funds to sell those bonds because they have certain limitations.

David: That’s right.

Kevin: Ratings limit.

David: Oh, sure.

Kevin: Yeah. And forced—

David: And that’s the structure of the ETF which becomes deadly in a decline where credit’s being pressured. Then you also have, at the edge of junk, this distressed debt we discussed earlier, which was 3% of the total in May, 9% in early July, when interest rates increased in tier one. Okay. So you mentioned the fed funds rate. Yeah. So we’re going to hear about it in the next week or two. This week, we’ll know the direction of inflation. 8.6 was the last number. Expectations are 8.8. Maybe it comes in at 8.7, better than expected—or 8.5, even better. Okay. Well, that’s not the end of the inflation story, but it does create a bit of a bind for the Fed. They’ve got to do something. Right? But you also have a few economic variables which are fading. And how do you raise rates as you’ve got an economy fading? That’s a tough position to be in.

Kevin: Okay. But think about the dominoes.

David: Yeah. So interest rates increase in tier one, government paper. Again, we’re contemplating another 50 to 75 basis points this month. There’s an impact to tier two—top-rated corporates, investment grade—and then tier three as well, with there being a force multiplier into the lower tiers. The higher the interest rates, the more precarious the position of those corporate entities financing themselves. So the Financial Times article I referenced earlier noted a $350 million loan by Avaya, this is the telecom hardware company out of North Carolina. Guess what the rate was? You want to borrow $350 million? Market rate for you: 15%. Okay?

Kevin: I remember paying 15% on a mortgage back in the ’80s. That’s hard to do.

David: In this market environment here in the States, that’s almost a hard money loan. Those are high rates, right? They have three billion in debt. They have a current market cap of 200 million. See if you can square that circle. So 300 billion in debt, a current market cap of 200 million, sharp slide over the last 12 months from $25 a share to $2.30 cents a share. They’re down 90%. Right? So, no, they don’t make the chapter 11 list today. This is my point, is we’ve had very few chapter 11 instances. But can you see how, as external pressure increases, and now all of a sudden they have to finance themselves and refinance a good part of that three billion as it comes due on very unfavorable terms? 15%? Oh. This is what I’m talking about.

Kevin: So if you had to pick anything as to what to watch right now, let’s say you’re an executive—I’m glad you’re not—but you’re an executive at one of these companies that is paying high debt. You’re going to be waking up every morning and looking at inflation. Isn’t inflation the key thing right now? Or the perception of the Fed toward inflation.

David: Yeah. In the end it’s the interaction between the central bank and the inflation number. And the inflation numbers are the most challenging aspect of how central banks will act in the coming months and years, and we’re talking about multiple decades. Up to this point accommodation for the markets at any time the markets have come under stress, that has been the understanding the market participants have had, that there’s going to be a relatively organized and a highly functional market. Even when things come under stress, you have the central bank to back your play. 

When things get unorganized, and chaotic behavior emerges, that’s when central bank policy doesn’t come through as clearly, or it isn’t easy to anticipate. And here we’ve got—we don’t know—is inflation going to increase to double digits? Just at the CPI to double digits, we already have PPI in double digits—10.7, I think, is expected for later this week. But we don’t know what that number is, and therefore we don’t know how the central bank responds. And it’s made even more complicated by the fact that financial markets are already under pressure—20, 30, 40%, depending on the segment we’re talking about. 

So the market wants crystal clarity on what the Fed is going to do. And I think you can think of that as a reliability issue. Are they going to help us? Yes. Are they going to help us under any circumstances? Yes. So what happens when they help Bear Stearns and not Lehman?

Kevin: Right. Are we too big to fail or not? Is the question.

David: Yeah. It’s like, wait a minute. So who’s next? We thought you backed our play. Yes, in some instances, but no, not in others. That causes confusion. And again, a part of this is the legacy of the market put, the Fed’s superhero, save the day, that kind of work, which is implicitly assured to be there in a severe downturn. Is the Fed’s implicit bailout capacity as readily available as it has been in recent decades? And I would say today you’ve got some uncertainty there. No one knows. No one knows.

Kevin: Well, it creates inflation when they do that.

David: That’s right. So inflation is the problem. It can now compound on itself negatively. They’ve got to fight it, but to the degree they accommodate the markets, they go back to feeding the flames of inflation. They must address inflation. Right? And they must communicate and try to do that clearly, but let us never forget Alan Blinder, I think he’s at Princeton now, former vice chair at the Fed. He said, famously, “The last duty of a central banker is to tell the public the truth.”

Kevin: Well, we just talked about that. They got rid of M3 so that we would have M2. Well, that’s partially because they want to keep us from the truth.

David: You need clear, believable communication that doesn’t necessarily have to correspond to reality. It’s an interesting world. So to address inflation for real comes at the cost of jobs, at the cost of economic activity, at the cost of demand, so that supply and demand can be moderated and price inflation pressures alleviate.

Kevin: And we’re in an election year right now. What do you think politicians want to see happen with the Fed?

David: Can you imagine being the White House today? Can you imagine being in the midyear election cycle when economics 101 says that to fight inflation, unemployment will increase? To fight inflation, unemployment will increase, right? Four months out from an election, inflation is killing you in the polls, and yet to fight it, you’re going to have to go kill your constituents’ job prospects? That’s a tough dilemma.

Kevin: Well, I hate to say it, but yeah. And there may be politicians right now wishing that they had the situation that they have in China where they can say, yeah, we’ll call it an election, but it’s not really an election. Yeah.

David: Yeah. Widen the scope of the conversation to China, and Chinese credit markets are a big deal—not just because of their scale, but also because of the intense rate of growth they’re still seeing in the credit markets. You’ve got a bubble that is still bubbling higher, even as it’s bursting. And in response to the pressure that’s building, you’ve got the Chinese government, which—they floated it last week, now it’s initiated. $240 billion infrastructure spending program this month. We’ll see what they do next month. But 240 billion in infrastructure spending, a huge bond issuance, bank lending is being aggressively encouraged for small businesses. Credit growth is still running at double-digit rates. We spoke of US junk bonds earlier, and this is just for perspective. Chinese junk debt—let’s call it high yield to be polite. Chinese high yield started the year at 16.76%. Pretty elevated, right? And then you’ve got the All Asia High Yield Index starting at 9.97% at the beginning of the year, right? So you’ve got China, and then Asia, ex-China.

Kevin: Petty much 10 to 17%, basically, if you were rounding.

David: Today, the Chinese high yield is 24.9, up from 16 and change. And the All Asia Index is at 16.68 up from just under 10. The developers, that is the property developers in China who are responsible for up to a third of GDP growth, have been circling the drain all year. But with some of them showing better resilience in the credit markets. Vanke, one of the strongest, their borrowing costs started the year at 3%. Country Garden, one of the largest, at 6.5%. And Evergrande, which has been the ever-disaster story, they started the year at 83% borrowing costs. I’ll just let that sink in.

Kevin: Wow. Wow. 83%. If it was safe, I’ll sign up.

David: So Vanke has moved from 3 to 8, Country Garden has moved from 6½ to 39.9%, and Evergrande from 83 to 139%. 139%. That sounds absurd.

Kevin: This is Mr. Market. Mr. Market is forcing this. This is not a Fed decision over in China. This is Mr. Market.

David: What’s underappreciated is how severe the credit crisis in China is, and how it’s creating political pressures domestically. So social pressure, political pressure, we start out by discussing not just the impacts between creditor and debtor and into the larger financial environment, the psychology of the markets and what have you. Solvency concerns and bankruptcy realities, what that ultimately translates into is changing social and political order that comes out of crisis.

Kevin: Right. We talked about the Alamo. Blood is tied to changing social and political order.

David: And so the only question is, whose? Right? Because is Xi Jinping, also in an election year, happy with citizen protests over bank closures and account restrictions?

Kevin: I don’t think he’s happy about that.

David: How about a collapsing real estate bubble and the negative impact to Chinese household net worth? Not that he has some sob story, heartfelt concern over Chinese households and their net worth, but he does care about social stability. And when people are unhappy—and you’ve got over a billion people, some large percent, that are unhappy—it begins to matter. Well, maybe it doesn’t. In a democracy, Xi would be toast in an election year. He’d be out. In an autocracy, it might be Taiwan or Japan that’s toast instead. 

And so this is where whose blood is spilled is a really interesting question. The fanciful art of redirection and scapegoating become a part of credit crisis dynamics. And you think to yourself, yeah, but isn’t it really just about the markets and prices, and aren’t we just talking about something as boring as interest rates? Yeah. That’s right. It’s as boring as interest rates.

Kevin: Until it’s not—or as boring as having to pay a tax when you don’t think you should, whether you’re part of the Boston Tea Party or—what was the name of the people that you were talking about?

David: Tejanos.

Kevin: The Tejanos. It turned into the Alamo. And look at what’s happened in Japan here recently. Going back to World War II, Japan has not been allowed to have a viable military. And Abe, who was assassinated this week, he was for Japan building.

David: Yeah. Yeah. And the tragedy of Shinzo Abe’s assassination— I can’t claim to know the background, what happened, why. I’m embarrassed by the US foreign policy statements that came out about, he was just ultra nationalist, blah, blah, blah. It wasn’t a respectful way of saying this was a tragedy. It’s very, very disrespectful. So that’s a saddening aspect to US diplomacy, is we didn’t even know how to send a regrets card or flowers. 

The tragedy of the Shinzo Abe assassination, though, it may be a catalyst for Japanese politicians to abandon their Constitution’s article nine. And it’s something that Abe was absolutely for, as I understand it. This dissolution of article nine—it’s been in place since the days of MacArthur. It forbids a military. You can have some form of self defense, but they’ve never really taken their industrial might and put in place what they had prior to the war, because it’s forbidden according to article nine. And so they have yet to build out a full-fledged military force. But with Taiwan at growing risk from the Chinese, and Japan here in recent weeks saying as much, that Taiwan falls and we recognize this is a direct threat—the Chinese are a direct threat to the Japanese.

Kevin: That’s another type of domino, isn’t it?

David: It is. Taiwan is a growing risk. Japan, too, is under regional pressure. Time is short to create a regional counterweight to China. From Xi Jinping’s perspective, that may accelerate timeframes. From Xi Jinping’s perspective, like most central planners, crisis is opportunity. You never let one go to waste.

Kevin: Right, Rahm Emanuel. Yep.

David: Yeah. So the transition from credit crisis to regional power grab may be lightning fast, as Xi projects a powerful reaction—a reaction to something he’s in fact powerless to keep from imploding. Here we are back to credit.

Kevin: You’ve been listening to The McAlvany Weekly Commentary. Now I’m Kevin Orrick, along with David McAlvany. You can find us at mcalvany.com, M-C-A-L-V-A-N-Y.com. And you can call us at (800)-525-9556.

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