GILTy? Bank of England’s Big Pivot

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• Bank of England shifts from QT to QE
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• Would China actually, purposefully devalue?

GILTy? Bank of England’s Big Pivot
October 5, 2022

“We’re in a new stage of instability. You can see it in the frantic behavior of the markets. When I see the markets this week up as much as they were down last week, I don’t see a recovery. I see a frantic and desperate desire for normalcy. The volatility in both directions is so erratic as to be dangerous. When it becomes this volatile, remember that there’s only so much volatility that these risk metrics can handle before they blow up.” — David McAlvany

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

Well, you’re a traveling family. Dave, most often, I talk about your travels and what you’ve learned, but last night, we were talking about Declan, your 16-year-old son and some of the observations he made while he was with your wife at a think tank in Austria. Would you share the thought?

David: Well, it’s fun to see them involved with this global think tank dealing with culture. My wife’s particular interest is in the arts and entertainment, and for my oldest son to see big picture conversations happen about public policy and the way that ideas filter through into communities, very, very healthy for him.

Kevin: These are influencers. What was the percentage of PhDs in this group that your son— He’s 16 years old, but he got to hang with—

David: I think 70, 75% were PhDs. So, that left our family contingent on the undereducated side, which is fine.

Kevin: But we were sitting over a Talisker last night when you brought up what Declan said.

David: Yeah, he said the macro thinkers tend to grab a beer or glass of wine and think expansively about the world, and the micro thinkers prefer a caffeinated beverage to focus the mind and bang out the details.

Kevin: That’s a keen observation. That’s true. I’m not much of a detail person when we have Talisker day.

David: No, it’s true, but we do have very expansive conversations.

Kevin: Yeah, can you believe? Okay, so we went about two years where we couldn’t meet at the restaurant that we’ve met at for years and years and years. It’s called Ken & Sue’s. It’s now called 636 Main. We’re back there, face-to-face meeting, with Talisker. Covid had shut things down for a little while.

David: Back in table 30.

Kevin: Table 30. Can you believe we’re already into the fourth quarter of 2022?

David: As much as investors would hope for an all clear from bear market dynamics, yeah, it’s hard to believe we’ve started the fourth quarter, but we had those bear market dynamics earlier in the year. What materialized through the very end of September was nothing short of ominous. The devil’s in the details they say, and there are more than a few details lurking in the realm of interest rates, interest rate derivatives, and portfolio leverage.

Kevin: Well, if we’re going to get detail oriented, in other words, caffeine rather than alcohol, we’ve got inflation still raging. Look at Germany.

David: That’ll focus your attention. Now, German CPI exceeded expectations in September coming in at over 10%, as did the broader European numbers, also north of 10%, double digit for both. Germany is now committed to 200 billion euros in government borrowing to defray the consumer costs of energy bills in the months ahead. Two hundred billion is a big number. That figure is far more significant from a fiscal standpoint if you’re comparing the 200 billion to the 2 to 3 billion in tax savings which had been proposed by the English Chancellor of the Exchequer last week. Again, it was a tax break for the rich, 40% tax rate instead of 45, and it would’ve saved them 2 to 3 billion in taxes. The Germans are spending an extra 200 billion, and that doesn’t seem to rile the markets as much as this injustice, so to say. Nevertheless, you’ve got inflation raging higher on the continent as energy costs in Europe remain really in Putin’s grasp.

Kevin: We talked last week about the space shuttle and the complexity in the space shuttle. When there is a failure, when you’ve got a million moving parts or however it works out to be, you really don’t know until the crisis occurs where there are frailties in the system. You wonder if inflation’s uncovering that right now.

David: Yeah, I think leverage is a part of that picture too. So, where and when weaknesses are first exposed is sometimes difficult to predict, but eventually, circumstances emerge to reveal design flaws. If there are engineering weaknesses, they’re ultimately revealed. So, under stress, you find the frailties of a system. It’s true of a family system, it’s true of a financial system. Under stress, you find the frailties of a system. It probably comes as no surprise to hear me say that with massive quantities of debt in the financial markets, and assets which have been geared or leveraged for exceptional returns using various tools, again to leverage up those trades, that we have these frailties emerging in Europe. So, Larry Summer’s commented that global market risk is building like it was in August of 2007, and he went on to say, “Crisis firefighters had better not book vacations.”

Kevin: Well, yeah, especially if it’s looking like August of 2007, but you have often said, Dave, that ideas have consequences. When interest rates shift, we’re starting to see there’s consequences there too.

David: Yeah, a shift in interest rates is consequential. So, we look at the progression. It’s simple. Inflation gives way to a shift in central bank policy tightening, and interest rate policies globally begin to pressure asset prices, which have universally though probably not uniformly benefited from the previous policy choices to accommodate, to ease, to kick the can down the road. So, these big asset bubbles are now being pressured by the opposite actions, quantitative tightening or financial tightening of any sort. Now, the risks are concentrated in a dangerous place: believe it or not, government bonds.

Kevin: Which is amazing because if you would think, “What’s the probability of government bonds becoming a high-risk investment?” You look at statistics. If you’re just looking at history, which is really all we have, if you’re just looking at history, you can statistically fool yourself and say, “Oh, look, that’s so many standard deviations off the main chart.” I mean, there’s just no way that— That’s too far from the curve.

David: Things run in long cycles. If you go back to an earlier part of the US interest rate cycle, US government bonds were affectionately known as certificates of confiscation. That’s what they were called. Last week, gilts, right? That’s the name of the UK or the British bond market. Next week, bunds, the German bonds. This month, perhaps it’s Treasurys. Next month, fill in the blank. I mentioned in the Commentary last week how trades are set up by speculators with risk parameters, by investors and pension funds and investment groups. You set these risk parameters, and those parameters are thought to adequately encompass a reasonable number of standard deviations. In other words, there’s enough history to cover normal circumstances, normal probabilities, normal asset price behavior. Then events emerge that were low probability given the historical range chosen. Surprise, surprise. You have a black swan.

Kevin: Yeah, Nassim Taleb wrote a book called The Black Swan talking about this very thing. It just hit me when you brought up gilts, I guess that’s appropriately named. If you actually were going to borrow money that you either didn’t intend on paying back or that the person who loaned it to you would lose a tremendous amount of money, I guess you would call that the guilts.

David: You would feel very guilty.

Kevin: The guilts, yeah.

David: Feel very guilty to walk away. By now, last week’s about volatility. If you’re looking back at the news through the weekend, you get it. We had the required central bank interventions. Everyone I think understands what happened. Fixed income assets, these were bonds within pension portfolios which were leveraged as much as seven times—

Kevin: They were crushed.

David: They had their value crushed by a rapid rise in rates. So, not only did the fixed income portfolio suffer, but it was a leveraged fixed income portfolio. That triggered margin calls. The forced liquidation of collateral, which included similar bonds, recycled and magnified the issue. As collateral was liquidated, interest rates rose even more. Prices declined in lockstep, and more margin calls were triggered. 

So, that liquidation doom loop, as we’ve called it internally, was in effect last week. That pricing dynamic was reminiscent of the 1987 liquidation cycle perpetuated by portfolio insurance. That was the name given to the structured derivative products meant to protect a portfolio from loss back in the ’80s, but under stress ended up being a multiplier of losses to the tune of 22% in one day. So, the Bank of England intervened to prevent another Lehman moment. That was last week. Bloomberg reports 1.7 trillion in UK pension strategies hedged dynamically in this way. It’s not a small number.

Kevin: No. So, if something were to happen, you said the BoE, the Bank of England, could it be the bank of interventions at this point? Do they have the guilts? I’m just wondering. You know who should have the guilts is our own Treasury Secretary.

David: Oh, so funny.

Kevin: Janet Yellen. Grandma Yellen.

David: One of my neighbors worked for her in San Francisco.

Kevin: Oh, really?

David: Yeah, when she worked for the Treasury department. It makes me chuckle that just hours before the Bank of England panic intervention, Janet Yellen was quoted as saying, “We haven’t seen liquidity problems develop in markets. We’re not seeing, to the best of my knowledge, the kind of de-leveraging that could signify financial stability risks.”

Kevin: Isn’t that amazing? And then right after that, hours after that, you had the Bank of England or the Bank of Interventions, saying that they’re going to do an unlimited amount of QE to save the gilts—or actually the pension funds.

David: Is it possible that she’s that oblivious? I don’t know. Hours before unlimited QE is announced to save the British government bond market and some systemically important financial entity from imploding—at that moment, we have our Treasury secretary reflecting on how well the market is functioning.

Kevin: Well, it’s just perfect. 

David: Yeah, just Bill King had this to say the Bank of England’s excuse to intervene is pension funds. This is a reason. Is it the reason? 

Kevin: Well, it can’t possibly be the reason because we have two other central banks that were also intervening—banks of intervention—the Chinese and the Japanese.

David: As we’ve learned from the global financial crisis, there’s always more than one roach. You may see one scurrying around as you turn on the lights, but there’s always more than one.

Kevin: Never an isolated event, is it?

David: Right. So, who was the Bank of England out to save? We’ll find out as the weeks progress. 

In less than two weeks, we’ve had three central banks intervening in the markets. If you reflect on how this year has progressed, we started with a very rocky beginning to the equity markets, and we still have that fragility lingering. It’s now clearly in the debt markets as well, strongly entrenched in the debt markets. They’re intervening in markets to bring either currency stability or bond price stability back into an otherwise vicious decline. Bank of Japan, People’s Bank of China, Bank of England, we’re in a new phase, a new phase of instability. 

The Bank of England operations—first of all they suspended the scheduled QT that was set to begin this week, and then we got the first round of quantitative easing back off the ground. The most impressive price action last week was that gold immediately moved higher. On the announcement that they were going to buy unlimited government bonds, gold responded as it should, popped higher on the implementation of QE. Larry Summers, again reflecting on the weakness in the financial markets and reminiscing, probably not fondly, from 2007, said, “Japanese bond holdings need scrutiny.” The reality, Kevin, is there’s fragmentation and pressure building in multiple spheres within the financial system right now.

Kevin: Dave, one of the things that you love to do oftentimes after we record the commentary is go swim for a couple of miles. Now, I can tell you that I’ve taken you out on the boat and taken you a long distance away and dropped you off so that you could swim back to shore. That’s a fun thing to do, but you’re always dressed, and I think about it. Nobody would know whether you’re dressed or not unless the tide went out. I think about what Buffet has to say. Isn’t leverage a little bit like swimming naked and then the tide goes out?

David: Everything’s fine unless the tide goes out. I love Buffet’s reflection. You learn who’s been swimming naked when the tide goes out. That rings true. We’ve got British pension managers buying—these are not small quantities—hundreds of billions in structured financial products, and they’re among the undressed and recently exposed. US pension and insurance managers are only different by degree. Apparently, the differentiator is not whether leverage was included in the fixed income structures for the US pension funds, just rather how much leverage was utilized. 

So, it seems that too much leverage is the approximate answer if you’re looking at the other side of the pond, going back to England. Frankly, it remains to be seen what other entities are in jeopardy. Their rates continue on a higher course set either by the central bank policy tightening or by market decree, but these are things that are going to continue to put pressure in the financial markets.

Kevin: Okay. But what’s suspicious right now? BlackRock, the giant, I mean the giant BlackRock. What is it that they’re doing? Who is it that they’re trying to protect right now?

David: According to Bloomberg, they opted to reduce leveraged exposure in those pension assets. They were among the giant firms purveying them, probably not a surprise there. So, they’re selling these structured leveraged products to pension funds, and they opted to reduce leveraged exposure to those pension assets and move to cash rather than requiring additional collateral to meet margin calls. It seems like a logical step. Seems almost like a car manufacturer. If you’ve ever gotten something in the mail like a recall notice, there’s something inherently dangerous. Inadvertently, we put this in.

Kevin: You think they’re trying to protect liability then?

David: Yeah, I mean they designed this thing, or some of this stuff, and seeing it come unwound— I think to be able to get ahead of the curve and unwind it, maybe it’s kind, maybe it’s a pragmatic gesture. Very characteristic of Wall Street behemoths, as we know, always out for the other, not necessarily for themselves.

Kevin: Philanthropists.

David: But maybe in fact this was a form of market buy off, shrinking liability as much as possible prior to the next round of customer accidents.

Kevin: Before the tide goes out. Before the tide goes out. So, oftentimes, these products are structured in a way of actually saving a portfolio. If you think about it, a lot of these structured products are to protect from downside risk, but greed has entered in through the years, and a lot of it’s because the central banks had everybody’s back. We’ve talked many times about how, when you know that you have really no risk on the downside, you’re going to increase your leverage. Do you think greed plays more of a role right now in the leveraged exposure than it would have been in the past?

David: Yeah, the mechanics for these pensions and insurance companies, I mean they didn’t have to take this risk. You’re looking at future liabilities and you’re trying to match up current assets with future liabilities, the assets that you have with the required outflows in the future. So, yeah, portfolio of zero coupon bonds could just as easily get you to the cash payouts that you need for pension obligations. Somehow these pension managers said, “On the one hand, I don’t want volatility, and on the other hand—”

Kevin: Give me more money.

David: “Why don’t I put 30% down or 40% down and have the same market exposure?” So, you’ve got pensions and insurance companies, they’re center stage due to first of all the scale of their fixed income assets and their portfolios. And then secondly, in this case, the desire for market protection. Again, you wrap in derivatives into the equation and it works well until it doesn’t. These are beautiful, dynamic, complicated PhD-type products, and they work until they don’t work. 

In this case, the cost of protection, very high, ultimately less market-protected because of the complexity required to leverage up the positions. One could argue that if you’re looking at really who holds responsibility here, clearly, the pension fund managers got themselves into this mess. Wall Street’s there just to sell you anything you want. It’s one of the reasons why my dad likes to think of Wall Street as wearing too much lipstick and way too much perfume, little bit of a brothel if you will. 

One could argue that indirect responsibility lies with the central banks, because you create the context of low yields and these pension and insurance companies need a 6% return, a 7% return, a 9% expected return. They can’t get there in a low to negative interest rate environment. So, yield seeking is a natural response to artificially low interest rates when central banks set them as low as they have in recent years. What leverage allows you to do is take a micro return and magnify it to a level supportive of your pension drawdowns.

Kevin: Yeah. See, we’re talking about pensions here, Dave. We’re talking about people that they’ve worked all of their life hoping that that pension will pay out the rest of their life once they retire.

David: Yeah. So, government bonds in the UK maturing in 2050, which just two years ago were yielding 1%. You would leverage up five or seven times to get your required pension draw, and then try to hedge the risk and use derivative products to hedge any volatility risk. This is where those parameters come in to play.

Kevin: That can be for either getting more on the upside or protecting yourself on the downside. So, there’s a variety of forms of leverage, aren’t there?

David: Yeah. Part of this is lack of imagination, where you set the risk parameters and you just don’t conceive of a world where things will be that volatile, right?

Kevin: The standard deviation, right? It’s too far out.

David: It’s the language of, “Oh, this is a once-in-a-hundred-year flood.” It just happened last year. How’s it going to happen again for another 100 years? Whoopsy daisy. So, yeah, there is a variety of forms of leverage within the financial markets. This is one version. 

We said earlier that there’s a difference between the UK pensions and the US pensions only because there’s slightly less leverage, that we’re aware of, in the US, particularly corporate pension market. $1.8 trillion in US corporate pensions are also at risk of margin calls, having used similar strategies employed just like the ones in the UK, 1.8 trillion, 1.7 trillion. You got a couple trillion dollars tied to these things. Slightly less leverage may mean that the margin calls come a little bit later, but it really depends on what happens to interest rates.

Kevin: It reminds me a little of what we saw last week with the hurricane. So sorry to see so many people affected by that. But it’s a strange feeling, Dave, when you see that hurricane coming days ahead of time, and you know it’s coming. We saw, in a way, the hurricane of these pension funds, these margin calls starting in the UK, but what you’re saying is we’ve got 1.8 trillion that could be receiving margin calls as well here in the United States.

David: That’s right. That’s right. So, I mean, other leveraged players— banks come to mind. Banks have these huge fixed-income portfolios. At least in the United States, they’re not required to mark those assets to a real time market value, and thus they’re not pressured in the short run by transitory pricing issues.

Kevin: So, you don’t really see the risk with banks.

David: No. If you’ve got a loss on the position, hold it to maturity. It’s not going to matter anyways. All will be well if you can hold them. I mentioned that a few weeks ago. If you can hold them. What if depositors are exiting? What if you look at the differential between bank deposits and money market funds, and the money market fund’s paying you 3% and your bank deposit’s paying you half a percent? Well, goodness, that means you can increase your income by six times. Why wouldn’t you do that?

Kevin: Well, see, the thing is you call that hot money when you’re looking at a bank. You look at hot money to see where it’s just going to go. It’s not loyal. It’s going to go wherever you’ve got the higher number, the higher return.

David: I would just say this, if you’re ever curious about hot money, this is something we’ve provided to our clients for years, is bank safety ratings, which is just a numeric grade on your bank. It measures a variety of things, about 17 different categories, but one of them is a hot money rating to see the kinds of clients that a bank has. Some banks are very stable, and people are not necessarily there for the money. If you paid them a quarter of a percent, if you paid them 20%, they’d still be working with you because they’re working with you. They chose you, they chose a relationship.

Kevin: You know what’s consistent? When clients call in, I’ll have clients say, “Hey, oh, I just put money with this particular bank. They’re paying this much higher in interest rates.” I’m like, “Well, you know what? Let’s just go get the bank book. Let’s look it up and see what the hot money ratio is. Because usually, the banks that are paying more are trying to attract that money in.”

David: It attracts the kind of client who doesn’t stay long anyways.

Kevin: Hello, I love you. Won’t you tell me your name? Remember that song? It’s not real loyal. Okay.

David: No, that’s modern banking except for small community banks that take a different approach and actually do have relationships, and maybe you’re not there for the money. Call us sometime and get one of the safety ratings on your bank. Look at the hot money ratio and a variety of other factors that go into an A-rated bank down to a C- or D-rated bank. Obviously, the lower you’re getting on the scale, you’re dealing with levels of competency. Do you really want your hard-earned savings in an institution that’s A, not paying you much, and B, there’s still the inflation factor?

Kevin: Do you remember the Savings & Loan crisis of the early ’90s? We had clients who were calling in for bank ratings, and it actually saved people quite a bit just by knowing the ratings of their institutions. So, it’s a worthwhile thing to do. 

Let me ask you this, though, because the government’s always been here to save all these things, up to this point. That’s the last two decades. That’s what we’ve gotten used to is the government just steps in. We were talking about Grandma Yellen. Back in 2013, wasn’t she actually talking about raising the stakes for the people who were creating these products?

David: Sure. Axios ran an article in the last 24 hours about her potentially being asked to step down at the midterms. So, that’ll be interesting to see what happens. But go back a couple years, I looked at a spider web-like chart that Janet Yellen referenced. It was in a 2013 speech when she was advocating for more skin in the game by derivatives investors, drawing attention to the need for both initial margin and what she described as variation margin for all non-centrally cleared derivatives. I thought she made a good case. Initial margin can be thought of as a reserve set aside up front for future decline in value. Then variation margin is supplemental—subsequent calls, if you will, on collateral or cash to supplement in the event of a decline past the amount originally posted.

Kevin: You climbed Mount Hood, right?

David: Yup. Yeah. Rainier.

Kevin: Well, same concept. Okay, it’s a volcano. Do you remember when we read Deep Survival by Gonzalez, the five people who were clipped together on Mount Hood? It was like a network of people, and so it reduced the risk one by one, but it also increased the risk for all five, and all five ended up falling. This sounds like a network. It sounds to me like what Yellen was proposing was clipping in and actually creating a network.

David: Well, that’s right. So, in theory, she’s right, it reduces risk, but in practice—

Kevin: It could bring the whole thing down.

David: It gets more complicated. So, I doubt that when those subsequent calls for cash or collateral come, raising cash, I mean it’s going to be a challenge. It recreates the selling dynamics we saw last week. It’s well-intentioned risk management, but in the real world can have an effect that exaggerates system stress. It doesn’t alleviate it. You want to moderate the risk in the system, and you’re asking people to put more skin in the game. All of a sudden, you’re turning a small liquidity crisis into potentially a systemic liquidity crisis. 

What I concluded looking at that chart was simple. The global derivatives market is a network with interconnections that tie hundreds if not thousands of institutions together into one giant trade. So, we’ve talked about this everything bubble. Well, behind the everything bubble is a series of layers of derivatives that interconnect all your global financial institutions. Ripples are felt by everyone in the game. What we had last week, what we still have into this week, ripples are now in motion. Contagion is built into the interconnectedness of the system.

Kevin: This morning when my wife was making breakfast, she said, “I heard on the news about Credit Suisse and that they were so close to default.” That’s part of that, isn’t it? That interconnectedness with other institutions?

David: Well, right. So, we were asking the question earlier, who is the Bank of England protecting? Because it’s not just the pension system. These are institutions that are dealing with margin calls. These are institutions that are hemorrhaging, that are getting ready to go the way of the dodo bird, and we’ll get a list. I don’t know. Is it a coincidence that SoftBank, that Barclays, that Société Générale, that Credit Suisse are currently under pressure? We will sometimes talk about credit default swaps. Credit Suisse has their credit default swaps, that’s the cost to ensure against default. It’s now more than the levels that we saw during the pandemic or even during the global financial crisis. 

What is it exactly? Is it derivatives? Is it exposure to European peripheral debt? We have not just Credit Suisse, but other financial institutions where it’s too early to say who survives or who doesn’t. But postmortems often reveal the definite cause of death. This is what they died of. But prior to that, diagnosis of disease could be tricky. We have pretty good idea of what ails the system, and then ultimately what takes the system down. Once the system’s done, then you can tell.

Kevin: Just like with the medical profession, you can intervene on a dying body and sometimes hide the consequences for a while. In fact, it can mask the ultimate outcome.

David: Yet too much debt and an excess exposure to counterparty risk via structured financial products and derivatives, that’s the easy guess about what’s ailing the system. That narrative is a little bit like the causes of obesity. The problem has been in the making for some time. It just didn’t happen overnight, and it’s gradually taking a person towards an untenable and dangerous outcome, whether it’s a heart attack or diabetes or a stroke. Now, interventions may prevent death, but systemic pressure and a repeat of acute bodily stress can only be resolved by different choices, by new habits. It’s not clear that the folks who are running or managing our global economy really care to change much at this point.

Kevin: Right. Well, maybe— Old habits are hard to break. I mean, it takes a little while and I don’t know that we’ve got enough of a crisis right now.

David: I guess that’s what I’m getting at is that we’re not far enough along in this credit cycle decline for institutional money managers to be prioritizing the health and wellbeing of the system. They’re still more interested in clever engineering. They’re still more interested in derivative products, adequate use or maybe even excessive use of leverage to be able to enhance and gain above average returns, alpha, alpha, alpha, the market’s version of binging. It’s still rife, and systemic pressers are going to take some time to work off.

Kevin: I wonder though if it’s also just a mistaken question. Sometimes you’ve got to ask the right question. I mean, you grew up on Peter Sellers’ Clouseau. You remember, and I’m going to just tear it up terribly. You might do better than I, but remember when he asks that man if his dog bites? He says, “Does your dog bite?

David: He says, no, and then he gets bit by the dog. He says, “I thought you said your dog did not bite.”

Kevin: It’s not my dog.

David: It’s not my dog.

Kevin: It’s the wrong question. Remember when ratings institutions were blamed for a lot of things.

David: Sure. Moody’s and S&P started stamping AAA on things that smelled like dog poop.

Kevin: That’s not my dog. It’s not my dog poop.

David: Doug Noland in the Credit Bubble Bulletin recalls the last round of stress in structured financial products this weekend. He says, “Investors and regulators were quick to blame the rating agencies when it should have been obvious to anyone doing real analysis that transforming trillions of risky late cycle mortgage credit into mostly top rated securities was fanciful financial alchemy. It’s the sudden loss of confidence in perceived safe and liquid instruments that sparks panics and runs.”

Kevin: Doug is an expert at economic history, but Doug would point out at this point, it’s not mortgages, is it? It’s something’s bigger.

David: What’s different this time is we’re not talking about AAA rated mortgage securities, rather the perceived liquid instruments that are causing problems. As I mentioned earlier, government bonds.

Kevin: Don’t say it.

David: Government bonds. Clearly, they remain the best credit, and this is where I’m going to sound like I’m contradicting myself. They do remain the best credit, but stretching across all maturities, an increase in interest rates has proven debilitating. So far, all we have in the financial markets as it relates to fixed income assets, an adjustment of rates has adjusted prices. We have yet to see a real implication into credit quality. Notice that the long bond has lost more than the junk bond.

Kevin: Isn’t that amazing?

David: Well, and then that won’t stay the case. Spreads will widen, and higher-risk assets will be priced accordingly as this credit cycle decline continues.

Kevin: Yeah, but people are already seeing it. They’re pulling money out of the investment grade and high yield bonds.

David: Last week was very notable. Investment grade, 10 billion in bonds, sold 3 billion in high yield. So, over 13 billion for the week. Second highest week of outflows in recent memory. But when you begin to see stress in the commercial or corporate credit markets, then you know you’ve got real big problems because it’s starting to seize.

Kevin: Yeah. Do you think what the Bank of England or the Bank of Interventions did last week is a signal to those who are wondering if there’s going to be a pivot, the big P word, a pivot with the other central banks?

David: Well, this is what’s really unhealthy about our market still, because the equity markets love the idea of a pivot. As soon as we pivot, then we’re back to easy money, and we know what to do with easy money. Let the credit flow, the dollars will go. We will have fun.

Kevin: Silly fear, silly fear, greed’s back.

David: But I think there’s another message embedded in the gold and silver markets, which is that QE is of consequence and we don’t like it. Synchronicity is a dangerous hallmark of the current market environment. The relief we see this week in the bond markets— We had the Bank of England and the QE announcement had a massive relief rally in both equities and bonds. Rates globally have moved as a single block. Whether you’re talking US Treasury yields, emerging market yields, European peripheral yields, investment grade, high yield or junk debt, they’ve all dropped off—the rates have dropped off, and prices have recovered from last week’s pre-intervention highs, talking about highs in terms of yields. All as if to say, “Look, the Bank of England today is going to be our great savior and every other central bank tomorrow.” 

So we’re getting two themes here. One is unhealthy in the context of the equities market: “Happy days are here again. Not to worry, we knew it was coming. We just weren’t sure when the pivot was coming and we weren’t sure how serious the central banks were going to be in their interest rate increase endeavors.” Gold’s behavior, recovering the 1,700 level, and silver moving up over 15% in less than a week suggest that QE is thought to be an inevitability and is dangerous.

Kevin: Well, let’s put this in perspective, too, because we’ve been doing the Commentary now, we’re going into our 15th year, but the company itself is in its 50th year. I don’t think we’ve ever seen bonds drop like they have now. So, what we’re talking about, this is the highest-risk game of all, because this is the government debt world that we’re talking about. These are pension funds. This is the last of the safe money. Have we seen the kind of volatility in the bond market in our lifetime?

David: What you say is true. Year-to-date performance at the close of the third quarter, the S&P was down 24.8%. The Dow off 20.9%, banks down 27.5%, mid-caps down 22.5%, small caps off 25.9%, semi-conductors down 41.5%. Gold finishes the quarter with year-to-date declines of 9%, silver 15. Of course, we can come back and say, “Oh, but since the beginning of this week, we’ve erased a good part of those losses for silver and close to half the losses for gold.” It’s a market that’s moving fast, but most remarkable is not that we’ve had equity market volatility, but that bonds have dropped just as much at the same time.

Kevin: That’s amazing. At the same time.

David: So again, what’s driving the volatility? It’s a tightening of financial conditions. What’s driving the volatility in both? It’s an increase in interest rates. Why do they have to go higher? Because inflation remains an issue. We have yet one more confirmation of our thesis tied to market fragility, illiquidity, and contagion, and it’s playing out in real time this week. There’s a funny cartoon that I saw, and it shows one colleague speaking to another colleague. He says, “My kid told me a riddle yesterday. Which falls faster, a pound of bricks or a pound of paper?” And then the coworker responds, “Is it 30-year paper?”

Kevin: Oh, see, that’s what I’m talking about. Dangerously close. But that’s not just here. China has had relatively low inflation during this period of time, but you talk about the credit default swap market. You watch that closely because that measures what people feel is the oncoming risk, and the CDS market in China has really rapidly increased.

David: That’s right. When you’re navigating, it’s helpful to have a compass, and sometimes you’re navigating through very challenging waters and still you get good information from the compass. You of all people could talk to that as a celestial navigator. We get information like we’re reading the compass from the credit default swap market. In uniform fashion, last week, we had Chinese bank CDS and even Chinese sovereign CDS both uncomfortably high.

Kevin: Which means risk. There’s oncoming risk.

David: It means there’s stress growing. It means there’s an uncomfortability with the current state of the financial markets in China, just as there is with the European banks we mentioned earlier. Developer bonds in China remain under pressure. No real recovery in view for that GDP growth driver. There’s a really critical element. I’m not exactly sure how this is going to play out. But I wonder if the decision has been made— maybe it’s after the next major political convention. We’re just weeks out from that. But I wonder if the decision has been made to gradually edge towards a new exchange rate level to lean into the manufacturing and export capacities of the mainland.

Kevin: Are you talking devaluation of the yuan?

David: Straight up opportunistic devaluation. If China wants to keep a larger slice of the global GDP pie, then devaluation may be a policy choice. You’ve got Germany on its back. You’ve got them wondering if they can run as many shifts with lack of available energy sources. Natural gas is a significant constraint to full-out production and exports from Germany. I wonder if China wants to keep a larger slice of the global pie. Devaluation might be that policy choice. 

They’ve preferred a stable currency, and arguably a stable currency would suggest that they favor shaping their economy in the direction of the consumer and away from that export-led growth which they’ve had, the mercantilist model, for so many decades now, but here they are pressured by the developers who were contributing over a third of their GDP growth. They’re on their back. They’re circling the drain. We had the largest of them, Country Garden, last week jumped nine percentage points. Nine percentage points! So, I think their bonds now yield close to 50%. It was the high 40s, 46, 47, 48% at the end of the week. That’s a big deal. 

But I think about their ideal growth path and how they have not really been able to get on it or stay on it, expanding the household share of GDP. They just can’t do it. They’ve tried to make it happen and it’s not happening. Property development has driven a massive amount of growth. Demand for commodities [unclear] and that’s now in reverse. If you had a certain number of strengths, maybe you’d default to your strengths from high school or college and just assume that this may not be my adult self, but at least I’m comfortable being this, manufacturer, export. They’ve got the capacity.

Kevin: They’re willing to take on some inflation because they don’t have high inflation yet.

David: Well, that’s a particularly intriguing element, because relative to the rest of the world, they’re low single digits versus double digits in the US and Europe, nearly double digits in the US and double digits in Europe. This would exacerbate inflation issues in other Asian countries, certainly if they started to devalue their currency, but it would perhaps position the Chinese for an improved position in tradable goods.

Kevin: Do you remember—I know you do, because we’ve talked about it—when the United States had enough muscle just with our worldwide foreign policy that China would think twice before devaluing against the US currency, or Russia would think twice, or OPEC? Let me ask you, with OPEC and Russia now cutting the amount of oil that they’re going to be supplying to a market in a period of time where you have a European energy crisis, what’s happened to the US as far as our ability to maneuver things? Maybe I’m missing a couple of layers here.

David: We’re in one of the best positions we’ve been in in a long time relative to the rest of the world. We’re a net energy exporter. Think about the stress and strain, and one of the primary inflation inputs, for the Europeans. It’s energy dependency and prices that are multiples of what we are paying because they have to import it. We are producers and we are net exporters of natural gas and of oil, and that puts us in a pretty strong position. I’m not suggesting that those supplies are infinite or that we’re not going to have significant decline rates in the shale patches that are today providing us with ample supplies. That I think is an inevitability. But for the time being, it explains why, both in terms of higher interest rates here in the US as well as strong energy sourcing, we do stand out as a superior economy.

Kevin: One of the things I love when you have Dr. George Friedman on is I think about the world as a chessboard after he’s on, every time. So, if I were thinking of this as a chess game— I’m not trying to imply anything. I’m just saying you’ve got the pipeline issue and the question as to what happened to the pipeline. You’ve got OPEC and Russia cutting their oil supplies. OPEC is talking about cutting the barrels. So, could it be that at this place in time, the United States is pulling out their queen and playing the queen on the board?

David: We saw last week, the UK, they make a play for a different strategy from a fiscal standpoint, and it blows up in their face. So, everyone is aware now that the markets are sensitive to the kinds of monetary policies and fiscal policies that get implemented. So, we have that with Russia and OPEC, $90 a barrel makes sense to them. They can pay the bills, keep the lights on at 90. Less than that, things aren’t as comfortable.

Kevin: The pipeline wasn’t an accident.

David: That’s the main thing is that Russia and OPEC, they’re talking about cutting production by 500,000 to a million barrels in order to maintain a high energy price, because that’s good for them fiscally. They have to, and they will, do what’s necessary to keep the price of oil high in that $90 range. Then who knows what happened with the NordStream pipeline leak.

Kevin: They originally said it was an earthquake.

David: Yeah, but the seismic stations in Sweden, Finland, and Norway ruled out earthquake as the cause of the leaks saying that their equipment registered two explosions, specifically two explosions. Now, I don’t know who does that or why.

Kevin: Well, you’ve seen enough Bond movies. You know who does that or why. They have to have a big submarine to do it, I think. Maybe I’m wrong, but isn’t that thing way under the water?

David: There’s a few people who have big submarines these days.

Kevin: That’s true. That’s true. I’m saying nothing, I know nothing, but I have watched Bond movies and my imagination runs wild.

David: But think about Russia and the annexation of Ukrainian territory. They’ve just put in place legal steps for desperate actions to follow. If we think we appreciate risk in the financial markets today, which we’ve lingered on a little bit here, talking about derivatives and leverage, have we fully accepted the external geopolitical risks in motion right now?

Kevin: Probably not yet. Probably not yet.

David: Probably not yet. Probably not yet. We’re in a new stage of instability. You can see it in the frantic behavior of the markets. When I see the markets this week up as much as they were down last week, I don’t see a recovery. I see a frantic and desperate desire for normalcy. It’s frantic and it’s desperate. The volatility in both directions is so erratic as to be dangerous. When it becomes this volatile, remember that there’s only so much volatility that these risk metrics can handle before they blow up. That is a part of what we saw last week.

Kevin: That’s that complexity you talked about, where you have no idea where the fragility is until it hits.

David: Get outside of the risk parameters, outside of the range of “possible or probable expectations,” and then all of a sudden, things start to fall apart. This kind of volatility is not healthy. 

As radical price swings have materialized across asset classes in the last week to 10 days, the most encouraging signal from all of that noise and confusion in what belongs where in terms of an appropriate price, the most clear signal for me came from the gold market. So to see normal behavior—it wasn’t moving with risk assets, it was moving against the QE mandate of the UK. To the degree that we continue to see central banks put in a similar position, where quantitative tightening has its limits because this mountain of debt simply can’t be maintained at higher and higher rates. As things continue to break and central banks resort to, as the UK did, quantitative easing straight away, expanding the balance sheet, not shrinking it, then I think we continue to have this preference for real things, this preference for inflation protection. This is the beginning of a long inflation grind. We’re nowhere near the end.

You’ve been listening to the McAlvany Weekly Commentary. 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 suitability for risk and investment. Join us again next week for a new edition of the McAlvany Weekly Commentary.