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About this week’s show:
- July 1st, dollar debacle?
- Bloomberg identifies new bond risks
- Manipulated markets: risk compounded
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Kevin: You know, Dave, I’ve been with the family company for 28 years and it seems like every year there is someone who picks a date and they say, “This is the drop-dead date. You’ve got to do everything you’re going to need to do before this date,” like Y2K, and I think of other dates that have come in the meantime. We’re getting a lot of calls about July 1st, and I need to know, is this the date that the dollar dies?
David: For many, there is a growing concern about the collapse of the dollar sometime around July 1st, this year, 2014. What’s the issue? Well, FATCA, which stands for the Foreign Account Transaction Compliance Act, has certain requirements which are slated for implementation on the 1st of July, and the story goes that this will precipitate a dramatic decline in the dollar.
Here’s our view in a nutshell: Don’t panic. You have FATCA. It was brought into existence in 2010 as a part of the higher legislation. We discussed this extensively when it was introduced, and wondered why foreign holdings and income were factored into the legislation, sold to the public as a jobs promotion.
Kevin: It’s like every other bill. It’s amazing how they just build everything into it, isn’t it?
David: Yes, because it was originally legislation to offer incentives to hire new employees and invest in equipment, giving some substantial tax write-offs for businesses that did so. Well, that is, as you say, the way Washington gets things done.
Kevin: But this actually looks like it has capital controls in it. It is limiting the flow of dollars in and out of the country, isn’t it?
David: FATCA, the Foreign Account Transactions Compliance Act breaks the financial world into two camps. You have the good guys in the financial world that do the bidding of the U.S. Treasury as proxy, unpaid collection agents, and then you have the bad guys that don’t comply with the Treasury’s expectations. The good guys have until July 1, 2014, to have a system of reporting income and they have to have that operational by July 1st, so they will be withholding agents of the IRS.
Kevin: So they are reporting to the IRS, foreign accounts, basically.
David: Well, beyond that, on any income that is generated in those accounts, they are automatically withholding 30%.
Kevin: Oh, thank you. Well, it saves you the trouble.
David: Right. Well, those institutions which intend on participating, have been in the process of compliance prepping since 2010, and they are either ready, or they are nearly ready, at this point.
Kevin: So Dave, July 1st really is the drop-dead date for that?
David: Well, the U.S. government has extended the compliance deadline to January 1, 2016, 18 months more for those who are making a good faith effort, but aren’t quite done. Then they’ve got the other category. No grace is extended if the good faith effort can’t be proven. So there’s no reason to panic. No one is dumping the dollar on July 1st. What we have with FATCA are countless reasons for FFIs, which are Foreign Financial Institutions, to move on down the road, and rather than comply and set up a system of accountability with the Treasury, simply open accounts with non U.S. persons exclusively. Exclude all U.S. persons and you don’t have to comply because there is nothing to report to the U.S. Treasury anyway.
Kevin: And you can talk personally about this, Dave. It has affected the company, it has affected you personally. There are businesses that you have had in Europe that you have had to change based on how the foreign banks and institutions look at Americans.
David: It’s just not worth the hassle to comply, for many smaller institutions. By smaller institutions, you may be talking 30, 40, 50 billion dollar financial institutions, as opposed to the 150-250 billion dollar financial institutions. So, how has it affected me? Even with a business in Switzerland, we were asked to leave several years ago. Nobody wants a liability relationship with the U.S. Treasury.
Kevin: Well, the fines are huge.
David: And then shortly after HIRE [Hiring Incentives to Restore Employment Act of 2010] was implemented, we were also asked to leave a Dutch bank in Brussels where we operate a branch of our precious metals business. We’ve been in business for 40+ years and this is a part of our supply chain. These are accounts that are disclosed, these are accounts that are reported, and they are part of our everyday supply chain operations, yet FATCA has made it virtually impossible to operate that business overseas. Today we work with a French bank and they are large enough to care about FATCA compliance. They will voluntarily be one of those good guy banks, and they will play ball with the Treasury, even as resentment grows over the costs that they bear to do so, so who can blame them for feeling a little upset about it? So what we have as a consequence, starting in 2010, was really an unofficial, but for all practical purposes, an implementation of exchange controls.
Kevin: We have interviewed Harold James and he has talked about how as tensions build in a world economy, exchange controls are a big part of that. Your being able to trade with other countries breaks down, and in a way, that is sort of what this is. It’s a back door approach to exchange controls.
David: It means that you can’t take money around the world, as you once could. It’s almost a revival of the capital controls of the 1980s and 1990s in Europe, where funds could not flow freely from one place to another. No, the U.S. Treasury is not limiting the outflow of U.S. dollars to the world, it’s just that they have sufficiently bullied the world into a position where it doesn’t make sense to take any inflow of U.S. dollars. So what are the unintended consequences? Try to operate a strong dollar policy when less and less people want to bother with the currency at all.
Kevin: Is this why China, Russia, India, and Brazil are starting to find ways around the dollar?
David: And frankly, I think this is a part of the official position on our currency. You can talk strong dollar, but the actual implementation and the ramifications of FATCA and other things legislatively that are being put through reveals, I think, the official position on our currency. By managing the dollar gradually lower, you keep the financial system from panic. The frog stays in the warming pot and we get to pay off our debts at a discount over time. This, again, is a part of the consequence. It is, in all likelihood, the last straw of dollar imperialism. And I think we should expect some degree of reserve currency repudiation.
Kevin: We’ve talked about that often. That seems to be the direction that we’re going, but as far as picking a date and just panicking on the date, I think that can cause people to do things that they would regret later.
David: No. Let me repeat. One day, July 1st, a supposed day of reckoning has already been postponed. We mentioned that, January 1, 2016. Kevin, here, in-house, we try not to sensationalize or operate on the basis of fear. Is it a real problem and threat to the U.S. dollar? Yes! Is it a drop-dead date for dollar-holders, after which point you are doomed? I suppose that works for a few newsletter writers who are trying to get you to re-subscribe, so, sorry Porter, if that happens to be the case. I do think that long-term reputational damage is being done to the U.S. financial system and the U.S. dollar. I do see the marginalization of U.S. assets, U.S. stocks, U.S. bonds, along with the U.S. dollar, and I do see U.S. persons, along with that, in the world of money and banking, being moved out. We’re no longer as relevant or as important to the world of tomorrow. We belong to the world of yesterday.
Kevin: And this is part of the dirty little secret that nobody really wants to talk about, and that is, you go into debt, 17-18 trillion, continue on up from there, but you pay that debt off with ever-declining currency, and as long as you keep people from panicking and calling it inflation, then you’re fine.
David: This really is a story about financial institutions learning how to minimize, or limit, their exposure to the U.S. Treasury, by eliminating, or limiting, their exposure to U.S. persons. They don’t want that liability, they don’t want to be in a lawsuit, they don’t want to pay fines, they don’t want to be in a place where our rule of law somehow extends itself, on a supra-national basis, into their territory. And yet it does, because the flow of funds somehow justifies it. And the verdict is still out on this, but we do know there are some consequences. We do know that this will end up further concentrating power in the hands of a few financial institutions. It’s going to make systemically critical banks even more systemically critical. It puts them in line for future bailouts, and maybe that puts us in line for future bail-ins. I don’t know. But I repeat: Don’t panic. Just remain thoughtfully engaged on the FATCA issue.
Kevin: This has been a theme the 40-some-odd years that the company has been in business, and that your dad has written in the newsletter: Stay thoughtfully engaged. You don’t have to panic if you’ve already thought things through ahead of time. I think sometimes just watching a YouTube video just scares the heck out of people. Yes, it can go viral. The problem is, it causes people to do things that may be correct in the long run, but they do it too quickly, and then they regret it. I’m thinking about your dad’s newsletter. For years he has tried to inform people ahead of time so that there is no panic.
David: The funny thing is that for years nobody even knew we were in the gold business. He has written this newsletter for 38 years now, and there were decades that people would read the newsletter and say, “Oh, I never knew you were in the gold business.” Well, we have been for 40 plus years.
But something, I think, to look forward to in July. I read my father’s July newsletter last night. Of course, I get the pre-copy, if you will.
Kevin: We’re talking about the McAlvany Intelligence Advisor…
David: McAlvany Intelligence Advisor, July 2014, and I have to say, my dad’s latest newsletter, not even off the press, is one of the best I’ve ever read, and he’s been writing it for 38 years. The man, to me, is amazing. If you don’t read it, if you don’t study it, if you don’t pass it along to ten people that you care about deeply, I don’t know what to say, I can only assume that you don’t care how the world works, you don’t care about our future, your future. Maybe it’s this. Perhaps you’ve adopted that Buddhist idea that pain is an illusion, right? Because honestly, if you don’t read the letter, I can only assume that you groove on the pain that will be in your future.
Kevin: Okay, it’s not off the press yet, but do you think the listeners could maybe get a copy free, if they call. The newsletter has a price to it, but if they call us here, we’d be happy to send it to them when it comes out.
David: Sure. Request a copy. Request ten copies. Listen, if you want multiple hard copies, send us something, pay for them. I’m not asking my dad in the newsletter business to front the cost there. But hey, get a digital copy and send it to everybody in your address book. There is no out-of-pocket expense for us to mail them to you, to print them, and everything else. Get a digital copy. Send it to everybody in your email address book. I’ve never been more impressed by my dad’s writing than in this latest missive. Don’t miss it.
Kevin: David, sometimes it’s easy to lower your guard in the summertime. People are taking vacations, life is not necessarily normal, it’s beautiful outside – I know it is here in Durango. But if you look at the markets, oftentimes the volumes drop slightly in the summer. What’s happening this summer? Volumes are just, they’re gone.
David: From Bloomberg this week, they’re talking about the bond market, not just these summer months, but really, the last 6, 9, 12 months. The bond market continues to see a very steep decline in volumes, with wholesalers – folks that take on large quantities of these bonds into inventory for future sales – their inventories are thinner and thinner.
Kevin: That affects liquidity. If a lot of people wanted to sell bonds, they’re not taking inventory right now, are they?
David: It just means that nobody’s really buying and selling the bonds, themselves, because it’s actually the use of derivatives in the form of futures contracts, which is multiplying rapidly. In other words, the buying and selling of actual bonds, including treasuries, is slowing down, while investors are opting for futures contracts on the bonds instead. What does that do? That increases leverage, and it allows less money committed to an investment thesis to create a large fixed income exposure.
Kevin: Let’s talk about derivatives and futures contracts. In a way, they are sort of the phantom of the actual investment. They don’t really exist. It’s like a phantom. You’re leveraging yourself if it goes up and leveraging yourself if it goes down, but it doesn’t actually hold the substance of the investment, does it?
David: No, it’s one step removed, and it has to be said that when leverage is in the equation it takes less volatility to wipe out the leveraged investor’s capital. I guess it’s a good thing then, that in this context, right now, volatility is declining as a consequence of central bank-administered markets, because without that the volatility in this market would wipe out those who are now speculatively entering into the bond market. There are a lot of over-extended investors who are taking too much risk. They are searching for yield without respect for the risks that come associated with it. We will learn a lesson or two about how quickly money can disappear. I think there are a lot of lessons to learn in 2014, 2015, 2016. Mean reversion is the theme over the next two years, both for equities and bonds, and I think those lessons are going to be the painful ones for the unexpecting investor.
Kevin: You mentioned something a few days ago about Japan. Japan is a very large bond market. In fact, it is the second largest in the world. Yet, the trading in Japanese bonds sometimes can go hours without a single bond being traded.
David: And that’s the changing dynamic that we see – less and less participants, less and less people buying the actual bonds in the marketplace. Japan has a total of 9.6 trillion dollars of debt in its market. There were two days last week where no paper traded – no buys, no sells – until noon, until mid-day. This is the second largest bond market in the world, and you had no trades until mid-day, twice last week. And, oh, by the way, 70% of the Japanese bond market, the stuff that is sold, 70% of it is gobbled up by the central bank, the Bank of Japan.
Kevin: So the markets don’t even seem to be existent anymore. You know, David, it reminds me of when you walk into a shop, and you hate to see it, but you just know is going to go bankrupt. Nobody is there, nobody is buying the product. There’s really nothing happening. The owner has that look on his face like, well, I’m going to bide my time for a couple of more months, but there is really no business. Well, the bond market, and other markets, seem to be doing that right now. The central banks are buying everything up, but the markets – where are the markets?
David: Look at trading revenue at most of your Wall Street concerns, and their proprietary trading in bonds has dropped considerably. The revenues from fixed income trading have fallen off a cliff, while 70% of the debt is sold to the Bank of Japan, in Japan. The same is true here in the United States. We’re no different. We’ve mentioned this in the past, that year-to-date, we represent, that is, the Fed represents the largest buyer of U.S. treasuries. Their balance sheet continues to grow, now, well north of 4 trillion dollars. But Bloomberg points out in this article that our biggest bond dealers, the wholesalers of debt, have reduced their inventories by about 75% since 2007. Let me ask you a question. If you thought there was going to be a change in the price of the assets that you had in inventory, a negative change in price, how much of an inventory do you want to maintain?
Kevin: You’re not going to want any.
David: Right. So, the higher you see the prices go in your inventory, and the less certain you are that that sustainable trend of higher prices is in front of you, what do you do? You begin to limit the inventory or your market exposure to those assets. We have trading in Italian bonds, which is down about 57%, close to 60% in the last ten years. Meanwhile, back to that idea that people are moving to the futures market and the derivatives market for some sort of a synthetic market exposure. Italian bond futures are up 800% since 2009.
Kevin: So the actual bond buying is down almost 60%, but the futures that represent those bonds, again, the phantom…
David: The derivatives trade is going nuts. So the argument of the article is basically that liquidity is a real risk in the bond market, and we’re not talking about small off-market placements of bonds where you might have 5, 10, or 50 bonds here or there, and that’s what we’ve witnessed over the last 30 years, is really, the perfection of distribution. But the ordinary buy-back expectation, that investors believe they have, where they can get out when they want to, at the price they want – you may have a surprise in the future. And this is from corporate bonds, to municipal bonds, to sovereign debt of nations, what Bloomberg underscores in this article is the nature of the market, which in any real volume is only a one-way market.
Kevin: David, you’re talking about bonds, but look at the gold market. It looks like it’s just sideways right now, and then I go to the stock market, and there’s very little volatility. Yes, it’s rising, rising, but there’s hardly any volatility in the markets. In fact, I don’t think in my career I’ve ever seen anything like this, where the markets just all seem to be hypnotized.
David: Well, this is critical. It is like things have just gone dormant sideways, and this has gone on for a couple of years now. Right now, if you’re looking at the VIX, the measure of puts and calls, the Volatility Index, as it is known, or the fear index, as others have called it, it represents a tremendous amount of complacency. It is at levels that we haven’t seen in years, if not decades.
Kevin: You know what this reminds me of, Dave? Claude Shannon. He analyzed information theory. He worked for Bell Laboratories in the 1940s and the 1950s. He was trying to quantify the value of a message in a machine. Bell Laboratories was the perfect place to look at that because they were saying, “How much information gets through on copper wire,” or later, fiber optic, that type of thing, or even, just a communication through the air, “how much gets through?” So he learned to measure signal, and noise, and message, and he learned how to quantify that. It became very valuable, it was called Information Theory at the time, and it’s a new science, but the key is surprise. That’s where the message lies.
David: You only have new information if you have a surprise.
Kevin: Right. When you tune an AM radio, Dave, and you hear the fuzz, there’s really no new information coming in. You have noise, but you have no real signal. You have no real message. In the markets, message comes in the form of accurate prices, where you have a buyer and a seller, who agree…
David: And in their exchange it requires volatility, and there are few, if any, surprises in a controlled economy, or in an economy where price controls are in effect.
Kevin: So Dave, what it seems to be is where they are inputting money here, or inputting money there, this is printed money, it’s free money. In a way, it’s muting, or normalizing the signal to where it doesn’t have any message any more.
David: Sure, they’ve lowered volatility, they’ve nearly eliminated surprise, and it’s leading to market stagnation. Nobody wants to play in what, today, appears to be a rigged game. Does this sound familiar? Does this explain why New York Stock Exchange volumes are pitifully low? And it’s not because we’re in June because we had similar volumes 3, 4, 5 months ago. They’ve gotten mildly worse, but they started out from a fairly punk perspective. So you have P&L, profit and loss statements, which are getting very boring for money managers and hedge funds. There is nothing to trade on, except the next central bank decision.
Kevin: Yes, any time Yellen comes out and talks, or even Bernanke – he’s not even there anymore.
David: Or Mario Draghi. This is why central bank decisions have become so critical. These are the geeks in control of any, and frankly, all new information. And of course, this is sort of reinforcing the effort to control price movements beyond the money that is being spent toward that same end.
Kevin: That’s called talking the market, isn’t it? Where you can come out and actually talk the market. If the person says, “Well, gosh, is Yellen going to say we’re going to taper more, or not? That shouldn’t have that traumatic of an impact on free market prices.
David: But at this point, that is the only new information. That’s the only surprise that we have to work off of, so we are, in essence, destroying normal free market dynamics in the hope of creating an economy that only progresses, if you will. It never regresses, it never retrenches. And this is the issue that I have with the Keynesian operating model. Gone are the days of the basic business cycle. I think we will see market dynamics reassert themselves with a vengeance. That’s always been the case, but here is this period of dormancy where there is little signal, there is little real communication, little information, because there is no surprise.
Kevin: And you know, all of history of mankind, from the Tower of Babel on, basically, says that you cannot control everything all the time. So there is going to come a time when a true message or signal occurs that is outside of the control of the guys who are controlling. Now, David, how do you get people to hold onto their bonds? We talked about liquidity in the bond market. How do you get people to hold their bonds when they want to sell them?
David: This is, I think, required reading for any of our listeners. Financial Times, June 16th, this week, we have a fascinating article on the Fed considering exit fees from bond funds.
Kevin: Oh, so there’s a penalty now, to sell your bonds.
David: Yes. That has the effect of discouraging liquidations and preventing a massive sell-off from those bond mutual funds. We’re right at about a trillion dollars, which retail investors have moved into bond funds since 2009, and it has, of course, contributed to the shrinking in yield, and in income, on those investments, that we have seen throughout the world, of fixed income investing. So the discussion amongst Fed officials, what it highlights is the concerns they have about potential volatility in price and yield in the 10 trillion dollar corporate bond market.
Kevin: Ten trillion dollars. That’s a substantial impact if you can’t liquidate those bonds.
David: The Financial Times article specifically looks at their concerns over the corporate bond market. I wonder, though, if it isn’t convenient to discuss someone else’s problem while really wringing your hands over a personal problem. Say, for instance, 4 trillion dollars in mortgage and treasury notes.
Kevin: Which is on the Fed balance sheet.
David: Exactly. They have probably one of the most levered balance sheets on the planet, and any change in price, again, going back to what we were saying before, if there is new information and they are not controlling it, if there is surprise in the world of interest rates, and they are no longer manipulating or managing the price and thus, the yield, in the bond market, what happens to the value of the assets on the Fed’s balance sheet? What happens to the value? Did it maintain status quo? Well, they’ll have some creative accounting to do, which will allow them to sort of mark it to make-believe. But if you marked it to market, you would see significant losses, you would see complete bankruptcy, insolvency of that particular institution.
An inflection point of the bond market is coming. It’s coming. We don’t know when, in part because we don’t know how long price controls, directed by the Fed, directed by the ECB, whether it’s Yellen, or Draghi, or Kuroda, or Carney – how long will it remain functional? Jim Grant says this: “While we don’t know when, we do see how. Low volatility, deep complacency, perverse financial incentives, collapsing credit spreads, unslaked thirst for yield, the basic preconditions for a financial accident are already in place.”
Kevin: You have said many times, and I remember your dad saying this: “Greed and fear seem to work in market forces in the long run.” Now, we don’t seem to have a lot of either operating. It seems like the greed is being paid into the big banks right now, and the little guy doesn’t have much chance, but what happens where there is a change? Like you said, Grant doesn’t know when it’s going to happen. Just like you said, “Don’t worry about July 1st, don’t be picking dates, but it will happen.”
David: It’s almost like picking a trigger for an event, and we’ve mentioned this on the show before. We spend a lot of time in the back country here in Colorado. We’ve got a lot of avalanches here in the wintertime. Trying to figure out what the trigger is for an avalanche is really foolhardy. You need to know the context more than the potential triggers. The context is what is dangerous. Anything can be a trigger, and the trigger doesn’t have to be something that is predictable. It can be something that is very, very unexpected.
Kevin: Because everything is in place already for the whole thing to happen.
David: That’s exactly right. Listen, when we have these sorts of price controls in the bond market, they maintain control for a certain period of time. They certainly determine the course for a certain period of time. But I’m confident that the market will create – call it a work-around. When prices and volatility are controlled, market operators will continue to act with their self-interest in mind, even if that means busting up the apparent control, which is exercised by the powers that be.
Here’s an example of this. Go back to the past, Wall Street used to call these guys the bond vigilantes. So when prices were not right, when interest rates were not reflective of real risk, large investors would drive prices and yields to what was considered a reasonable balance.
Kevin: That’s called arbitrage.
David: Between risk and reward, sure, sure. So the bond vigilantes today, listen, they’re either on vacation or they’re retired, living in Turks and Caicos. But I’m telling you, someone will take their place. Maybe it’s the Chinese. Maybe it’s a series of hedge funds with (laughter) George Soros in the vanguard. I mean, somebody will say, “This is tomfoolery. This is balderdash. It cannot last. We’re going to bet against it.”
Kevin: I’m so glad you brought up George Soros. I’ll remember 1992 the rest of my life, because in 1992 we had a lot of investments with our clients in something called the exchange rate mechanism over in Europe, where there was control of interest rates and currencies in Europe, and everyone had just become accustomed the fact that none of these European countries would let their currencies fluctuate more than 10%. Well, George Soros, I don’t know how he knew it, but he knew it was going to break, so he bet against the pound, and he made several billion dollars while that exchange rate mechanism broke down.
David: What is interesting, Kevin, is that he made a bet that was obviously contrary to popular belief. And it was something that if you said, “According to the conventional wisdom, you’re going to lose.” Certainly, if you’re sort of marking it up to democratic vote, folks in the market would say he’s a fool. “Listen, this is the system that works. This is they system that will continue to work.” He took an unpopular bet…
Kevin: Yeah, he shorted the pound.
David: And actually was willing to sit with it long enough for others, if they had known it was him, to offer criticism. He did it quietly enough that no one really noticed, and ultimately, it was very profitable, into the billions of dollars on that trade. Listen, the IMF, this week – what does it do? It lowers full-year growth estimates for U.S. economic growth. They are now right in line with the World Bank, which, last week, dropped Q2 numbers, that is, the second quarter numbers, as did at least a half a dozen Wall Street firms during the recent past. It is interesting, Kevin, because we have the explanation now that the winter weather was what threw off the first quarter growth.
Kevin: Right. That was an excuse.
David: But since then, we haven’t gained momentum back, so second quarter growth is going to be worse than hoped for because we don’t have momentum, thrown off by the winter weather. This sounds like so much ridiculous song and dance. But listen, everyone is still hoping for a strong finish to the end of the year, it’s going to end considerably better. That’s what the pundits and Wall Street desk jockeys have to say.
Kevin: I think about when they were blaming the winter. Now, being in the second quarter, it’s a little like saying, “Gosh, this snow in June is just killing us.
David: It is killing us. Listen, it’s every GDP release that I kind of have to shake my head. No one, still, is accounting for inflation adequately, so when you understated inflation you overstate GDP growth. That kind of gets in my craw and I can’t get over it, because no one else seems to acknowledge it. When you do a comparison, economic growth in the macro, to economic growth in the micro, you think of company earnings. At least a third to half of improvement in company earnings comes from inflation. And yet, economic growth on a macro, instead of a micro level, doesn’t have to have real inflation factored in against it. It can be some made-up number, what we call the deflator, and it can be understated? It’s aggravating to me.
Kevin: You know what it reminds me of? They find any way to count something as growth. They just wrote growth into the GDP last year and then expenses and investment. What is that? When I spent money, I’ve spent money. But when they spend money, when the government spends it…
David: It’s called an investment, it can be recategorized.
David: Right. And we’re not talking about small figures. 560 billion dollars’ worth of expenses recategorized as investment, to goose our growth figures last year, which is not odd, I suppose. Look at the Italians in recent weeks. This is particularly odd. They decided to include prostitution and drugs as a part of their total economic growth figures. (laughter)
Kevin: Anything that will boost the GDP.
David: Anything goes here. What stays in Italy … never mind. Why was this rationalized? Basically, the Netherlands, of course, have legalized these activities, and they have larger GDP growth, and the Italians are assuming this is why they have larger GDP growth. So they want to keep up with the Joneses, so they are now including prostitution and drugs in their GDP statistics. Italy, they don’t want an unfair comparison, so they’ve taken, frankly, economic goosing to a whole new level.
Kevin: And I think you have to just eliminate what the government says is the gross domestic product and look at figures. Bill King was talking about lumber. Lumber is a good thing to look at. Copper is another. You look at those types of things because if there is growth, you’re going to see use of lumber, copper, etc.
David: And that was our friend’s, Mr. King’s, point. You look at a recent chart showing lumber futures. They’re falling off a cliff. People are betting against the use of lumber in the coming months, and yet homebuilders have soared.
Kevin: The stocks, you mean.
David: Yes, the homebuilder stocks have soared. So we ask the question, can both sets of investors be right? You have bullishness on homebuilder stocks, which is consistent with a strong recovery thematic, while on the other side of the equation you have to move lower in lumber futures, which is suggesting a decline in demand for lumber, and that’s either a speculative short position in lumber, or frankly, the producers of lumber are shrinking their hedge positions, and they’re not expecting as much demand. So you have this divergence between bulls and bears and it is pronounced enough to take notice.
Kevin: We were talking about new information in the system, and things did sort of go into a quiet hypnotism for a while, but there is new information coming into Iraq right now from the Syrian side, and I think it’s worth talking about a little bit. What is going on with ISIS right now, and Levant, and the threat, and the effect that we could probably expect?
David: Is it any surprise that without a strongman in the country, they are moving back toward civil war? This is where, when we had a conversation with Bernard Lewis at Princeton a few years ago, we set the context for what was happening 300 years ago, 500 years ago, 700 years ago, and frankly, 1924 is a standout date. When Kemal Ataturk took over in Turkey, he basically moved toward a secular state, and took the religious state, which had been known as the caliphate, and said, “It is no more. It is no more.”
Kevin: And a lot of people don’t realize, the wars that we have been fighting against Al Qaeda and Taliban and Osama bin Laden – that was all about caliphate, re-establishing this centralized control system of the Islamic faith.
David: Re-establishing a religious-based political system, and with that being said, you are back to the old conflict between Shi’ites and Sunnis, and the Shi’a, sort of the last bastion of concentrated Shi’ite control in Iran, and then you look at most of the radicals today… By the way, who was funded in Syria by the U.S. government, and by our allies, here in recent years, to fight the Syrian government, to fight Assad? But the radicals, which are Sunni, and they are now bleeding into northern Iraq, and what do they want to do? They want to establish the old caliphate.
Kevin: And it’s strange bed partners, because now we’re talking about allying ourselves with Iran. It’s very, very complex, it’s a tangled web, but Dave, it really is, if you think about what you just mentioned, this pie chart. You have three elements in a society. You have an element of chaos that is controlled either by the rule of law, liberty, or a tyrant. And if you take the tyrant out of the way, you’d better have the rule of law, otherwise chaos fills the gap. Same thing with liberty. You take liberty away, chaos will fill the gap until the tyrant replaces it. Saddam Hussain was no good man.
David: No, he was a tyrant, and there certainly was no rule of law.
Kevin: But there was stability.
David: But it kept chaos from reigning. Now you don’t have a tyrant. Now you don’t have the rule of law, and you don’t have freedom based on the rule of law, and therefore you have chaos in Iraq.
Kevin: A vacuum is filled with chaos.
David: It’s that simple. So, in the absence of a dictator, it is chaos. Freedom rooted in the rule of law – it’s not possible in the region, there is no history of the rule of law, and without a supportive context, when freedom is granted, it will typically degrade into one of the other two political and social expressions.
Kevin: You do an awful lot of national televised interviews, and the calls that have been coming in this week have been, “How does this affect the oil price?” The market shows are not focusing, necessarily, on the political. They want to know what the price of oil is going to do. Do you see it sky-rocketing? What are your thoughts?
David: Brent crude has been on the rise, primarily Brent crude. If you look at how much Brent has risen compared to West Texas crude, you will find that the U.S. markets are not as vulnerable to this sort of geopolitical repricing. So Brent crude – could it see $120? It could, it could. But the militants are in the north. They would have to drive south and compromise the export terminals and the refining capacity there, and to date, the extremists, again, funded by the U.S. and Syria, are only in the north, and have only affected a few hundred thousand barrels of daily oil production. Again, just for comparison, let’s say it’s 300,000-400,000 barrels. That sounds like a lot of oil. But OPEC, which is only 40% of global supply, they are providing 30 million barrels per day.
So in terms of what has caused a rise in the price of oil here in the last week, it is mainly headlines, because there is not enough supply that has been taken off. They would have to move well into the south, compromise those terminals, and not allow for the growth in OPEC production. A lot of that growth in OPEC production has been predicated on Iraqi production coming back on stream. All of that would have to happen before you had real pressure in the oil price. Until then, it’s headlines. And I don’t think we have a lot to worry about here in the U.S. in terms of the consumer, consumer spending being hurt. Why? Because we are really talking about pressure on Brent crude, and you are likely to see the spread between WTI, that’s West Texas Intermediate, and Brent – you are likely to see those prices separate out as Brent goes much higher, much faster, than WTI will.
Kevin: You were talking about staying up north. Our friend George Friedman of STRATFOR talks about what the rational players are doing. Even though these jihadists are radical, he said it’s very important to understand what they are doing. This is a rational strategy to re-organize the caliphate. And he doesn’t see them coming down into Baghdad any time soon. He says they are going to keep those areas that they can control and gain power so that they can take Jihad elsewhere. So from an oil perspective, Baghdad is really pretty critical, isn’t it?
David: I was trying to explain this to my boys last night, because we played Risk for the first time. This is the first time they’ve ever played. Of course, I’ve been playing since I was probably 5 or 6 years old, so it seems about the same time frame to introduce them, one is 8, and one is 5. It was interesting, they overextended so many times. Once they won one battle, they wanted to fight another, and win again, and fight another, and win again. And at the end of the game, we still have tonight to play, but it will end very quickly, I can tell you, (laughter) because I’ve concentrated. I’ve concentrated in Europe, I’ve concentrated centrally. My borders are protected. I have 15-20 armies ready to expand wherever I want to go, at this point, and everyone else is spread thin. I think that the folks there in the north of Baghdad, obviously to the north of Iraq, are doing the same thing. They have money, they have resources, they have absolutely no reason to go pick a fight they can’t win. They will pick the fights that they know they can win. And so to see them concentrate and hunker down for a bit – kind of expected.
Kevin: Dave, you were talking about weighing risk out. Sometimes it’s important to weight the risk, nondependent on the signals coming in, or the message coming in, and the European debt markets, you and I had shows just a couple of years ago where we were talking about radically high interest rates because of radically high risk. At this point, you can go buy just junk, garbage, European paper, and still get less of an interest payoff than you can on a U.S. treasury.
David: So just in principle, here’s how it operates. When rates are extremely high you have an indication by market participants that the underlying asset leaves something to be desired. High interest rates are like a red flag, waving and warning, “High risk is here, there are plenty of inherent risks.” That’s what you should see when you see high interest rates. So when we see low rates in Europe we should assume the opposite, right?
Kevin: No risk.
David: Well, quite to the contrary. In this case, rates no longer offer the information that they used to, that is, on credit quality, or for the lender, having surety on being repaid from the borrower. Now what rates are reflecting is the gigantic central bank footprint in the marketplace. Add to that the regulatory shift in Basel, Switzerland, that is the Basel III agreements, the convention that they have come up with is radically altering the debt markets in Europe.
Kevin: This would be a good time, Dave, to probably ask again, what is Basel III? How is it affecting these markets at this point?
David: The Bank of International Settlements is more or less the central banker’s central bank. What they’ve come up with in the Basel agreement is something that banks voluntarily, to sort of be a part of the in crowd, will submit themselves to. The Basel III agreement, at this point, that I’m particularly critical of here, on, again, interest rates and what they are telling us or not telling us, Basel III conventions have assigned a zero risk weighting to the sovereign bonds from any OEC member countries. You remember we had Bill White on our program a few weeks ago, a few months ago. He was at the Bank of International Settlements after leaving the Bank of Canada and the Bank of England, and after the Bank of International Settlements took on a job in Paris at the Organization of Economic Cooperation and Development – that’s what OECD stands for. You have 20-30 member countries from around the world. This includes countries like Italy, Spain, Greece, Ireland, Portugal, Mexico, Hungary, Iceland, Estonia, the Czech Republic, and there are many others. What this means is that European banks can buy the sovereign paper from these countries – they can buy these assets – and they don’t have to put any capital against them.
Kevin: So they don’t have to have any reserve, whatsoever.
David: No skin in the game. Not 10% down on the purchase, not 2% down. They represent, basically, a buyer with unlimited credit. Contrast that with more of a standard banking practice, where the bank wants to create income. You can do that either from investing in these kinds of pieces of paper from other sovereign countries and collect the interest, so you are putting money out there and collecting the interest income, or you can make a loan to a business, and you’re putting money out there and collecting the interest income.
Kevin: Either way, the bank, still, is taking some risk.
David: Well, with the bank loaning money to a private individual or business, they have to hold some money back. In other words, they have to have a capital base. Let’s say, for instance, they’re loaning money to me. They loan me a million dollars and they’re going to say, “Well, if Dave goes sour on this bank, we want to at least have in our capital reserves, let’s say, $250,000 to $300,000, so that’s not an outright loss. We have reserved against a loss on that loan. But you don’t have to do that if you are, again, buying sovereign paper. You do if you’re loaning money out into the business community. This is one of the reasons why they are having a hard time making loans to small businesses. And it goes along with – you remember last week we talked about the ECB wanting to make 542 billion dollars’ worth of loans to small businesses. It’s because they have set up perverse incentives. Basel III has set up perverse incentives to encourage banks to buy this paper. Maybe it’s an unintended consequence, maybe it’s an intended consequence, I don’t know.
Kevin: Well, it’s a simple answer, Dave. If I say, “Do you want free money, risk-free money, or do you want to go take a risk for the same amount of money?” You’re going to say, “Risk-free money.”
David: Right. So this is the interesting point. Sovereign paper is assumed to have no risk. A bank can load up with Spanish or Portuguese bonds with zero money down and collect between 2½ to 3% with virtually free money that they are getting from the Fed, the ECB, and the Bank of Japan. Can anyone tell me, does this sound healthy? Does this sound sustainable?
Kevin: And this amazes me, because you could own German bonds, which, of course, are much safer, and still have no risk, or you can own Portuguese bonds and Spanish bonds, which are much more dangerous, and still have no risk.
David: What banks have to be assuming is that this is a freebie to them. It’s a freebie to them to help rebuild their balance sheet. If something goes wrong we have interest rate volatility, or we have major fiscal concerns, again, with those peripheral European countries where interest rates begin to start rising, for any reason, guess who is going to take it on the chin? Guess who is going to pay the bill?
Kevin: We are.
David: The taxpayer.
David: The taxpayer there. If it happened here in the United States, the taxpayer here. There are limits to leverage for these banks with other assets, but it would seem here in this case, with the sovereign paper that they can buy, the sky is the limit for banks owning sovereign debt.
Kevin: And this only works as long as the controllers can continue to maintain control.
David: We’re talking about bonds that two years ago had interest rates of 6-8%, and in many instances, are now priced to yield less than U.S. treasuries. Let that sink in. We are talking about last week: Spanish 10-year treasuries trading at lower yields than 10-year U.S. treasuries. If something doesn’t stink here, you have factory fatigue, you have some sort of fatigue, but you may not be paying attention. This is extraordinary, unprecedented, ultimately unsustainable, and if somebody is not scratching their head, again, you’re not engaged.
Kevin: This is that control element that we’re talking about, but the problem is, it creates an enormous amount of risk that will catch people off guard. I’ll give you an example, Dave. On climbing and not really understanding the risk, I’ve read stories of climbers, very experienced climbers, who just subconsciously tie themselves in each time with the equipment that is their safety, and they have fallen before, and realized, unfortunately too late, that they did not tie in, which is one of the most common things to evade risk.
David: Whatever the normal information flow is, today in the marketplace we have the perception of risk which is disappearing. No one assumes that there is risk, and price distortions, again, are basically increasing risk. I look at it this way: When I was 18 years old and fairly sure of my climbing abilities, I would go out to Joshua Tree and there were a number of climbs that we would do without ropes. Again, I assumed that there was no risk, because I had overconfidence in me. In this case, you are talking about overconfidence in the market operators. You are talking about overconfidence in the central banks that are manipulating these numbers and rates and prices to the levels, and to the extent that they have. Did it eliminate risk? Just my presence of mind and cocksureness that I would never fall, could not fall, it wouldn’t happen to me? Listen, 10, 15, 20 feet, it was no big deal. But once you get to 50, 60 feet, and you’re not climbing with ropes, my friend Gabe and I did this on one occasion, and in retrospect, it was a really stupid thing to do.
David: It was a really stupid thing to do.
Kevin: And you don’t really learn your lesson if you fall from 50 feet, you just die.
David: You just die. We didn’t have a sense that there was a risk, so we continued to take it. That’s the same thing that is happening in the market today. No one has a sense that there is risk, in part because there has been a distortion of the normal information flow. Interest rates tell you what risk is. Now that interest rates have been manipulated so low, no one has a sense of what real risk still exists. Does that make any sense, why I think this is really scary?
Kevin: Yeah, the central banks say, “Well, we’ve got your back. We’ve got your back. Anything that you do, we’ve got your back.”
David: I think that regulators have tried to be helpful. I think they’ve tried to support the fiscal issues of our day, here in the U.S. and in Europe. I think regulators have tried to jump-start lending. But the system is now full of perverse incentives. They are encouraging banks to ignore the volatility we know exists with any fixed income asset. We can only assume that this is sort of a further effort to recapitalize the banking sector, and should something go terribly wrong, the losses will be spread across a large base of taxpayers through some form of extortion or another. You have U.S. banks, by the way, if you compare them to European banks, we score the highest on the leverage ratios, on the capital adequacy ratios set out by Basel III, with the lingering problem that we still don’t fully account for all of our off balance sheet liabilities, and derivatives are not fully accounted for. But nonetheless, we do set the curve in terms of global banking on these particular tests of strength set up by Basel III.
So, just nutshell here: In summary, you have big banks that are loading up on sovereign paper, knowing that it’s a sure bet, and that it’s regulated by Basel III, and it’s promised by various central banks that they will not fail, they cannot fail. These institutions, if they are between a rock and a hard place, will be supported. Again, it comes back to Grant’s comment. The basic preconditions for a financial accident – they’re already in place. While we don’t know when, we do see how.
Kevin: So the laws of nature, and the laws of the market, have not been vetoed, they’ve just been delayed by control. Just remind the listeners that if they would like Don McAlvany’s newsletter, your father’s newsletter, the July letter, that they can call us at 800-525-9556, and just expect a slight delay because it has not come off the press yet.