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- 3.2 Trillion in leveraged bets to unwind this week
- Gold in relative terms up 50% vs Bitcoin, up 20% in Yen
- Powell’s Rock and Hard Place question: Implode or Inflate?
Market Horror: Three Witches and a Slice of Fruitcake
June 14, 2022
“You do have this growing probability not only for a significant market decline from here, but a whole adjustment phase, where if we are in a new cycle where inflation sticks around and interest rates have to go a lot higher, we haven’t even begun to see the extent of adjustments to take place in the stock and bond market. Do you want liquidity, which is a form of optionality in that eventuality? The answer’s a solid yes.” — David McAlvany
Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick along with David McAlvany.
David, I love our listeners, and sometimes it hurts a little bit. I’ve got friends who listen and they’re like, “I listen to the show every week, but you guys are really missing it in this area or that area.” I don’t want to hear that too often, but I want to listen to him. One of them, one of our listeners, he contacted me. He says, “You’re not getting the whole story across with Ukraine. You guys are reading just a little bit too much of the media.” Now I had an idea that maybe he was right, but now the Department of Defense is admitting something that was just conspiracy theory two weeks ago.
David: Well, right. I mean, I think this is where if you have studied Elliott Wave or studied the ideas related to socionomics, there’s a sociological and a psychological impact when you get to the end of a credit cycle. It starts showing itself in weird places, like the length of a skirt, the design of a car, the kind of lies that are told and how boldly.
Kevin: And how many biochemical labs or what bioengineering labs are in Ukraine.
David: That’s what I’m getting at because the lie factor, the deception factor doesn’t matter if you have an MD or a PhD, or you’ve got some other three letters as an acronym that should justify yourself as an authority. So where do we start today? How good of the Department of Defense and the Pentagon to admit not six labs, what they originally denied, but 46 bio labs in Ukraine.
David: 46 bio labs. Peaceful cooperation, it’s all straightforward scientific stuff. You wouldn’t understand, but just move along. It was Russian fake news until the admission this week at defense.gov. Then we wonder why the DOJ, the CDC, the DOD just mentioned, and every other extension of government is having credibility issues. Let’s not forget the quasi governmental as well, the Fed, also three letters. All of these could be four letters, frankly. But it’s telling when your reputation is doing the toilet dance and the best an administration can come up with is Department of Homeland Security is to partner with big tech and refine the narratives and the news feeds on everything from election rigging, climate change, and anything else that doesn’t fit a prepackaged storyline.
Kevin: This is why you have to seek the truth yourself. You had mentioned all of the misinformation, but sometimes you can coat over truth if you can just print money and get away with it. Jim Grant is somebody that we’ve had on the show a number of times. We’ve read his books. You take his letter called the Grant’s Interest Rate Observer and to be quite honest, for 10 years, Interest Rate Observer should have been Interest Rate Tranquilizer, Interest Rate Bedtime Read because interest rates, even though this sounds like a very boring read, but interest rates actually tell you the cost of the risk of money. It was coated over, a little bit like the Department of Defense lack of admitting what they knew, for about a decade. That’s changing this week, Dave. I mean, it’s been changing, but it’s really changing now.
David: One of the reasons we spend quite a bit of time on price action and things that happen in the markets is because it does get us away from more controversial topics, which can be subject to interpretation. What is the meaning in the message? Do you have the correct method of interpretation? Do you understand what’s happening or do you not? Are you informed or are you misinformed? Price action—it is what it is. So you’re right. The frustration there, for a good long time, was that the signal coming from the market really wasn’t a very clear signal because you had central banks defining it by suppressing interest rates.
Kevin: It was like a sedative. It was like a sedative to the interest rates. They just went to sleep for about a decade.
David: Well, the interest rate markets, and again these are generally not the conversation that you have or cocktail party conversation starter, but activity in the last 10 days in the interest rate markets has been more active than what you’ve seen over say a two or even three year period. We’ve also had equities volatile, moving lower as well. Cryptocurrencies volatile, moving lower as well. Economically sensitive commodities also under pressure. If you look at the early part of this week, even gold was sold earlier this week in a mad dash to cash.
What stands out to me is the universality of it. There was nothing that represented a safe haven. If there’s one takeaway from Friday, really Monday, this week in particular, there was no place to hide. You’d think, okay, well, stocks are under pressure, go to bonds. Certainly government bonds. No, no. There was almost the same lashing, the same kind of whipping post experience in the bond market as there was in the stock market, and gold was punished as well. So the indiscriminate nature of the selling, it brings a beloved seasonal tradition to mind. Beloved for some. It’s revolting to others. You brought it up last night in conversation, fruitcake.
Kevin: No. Yeah. Fruitcake. Not my favorite at Christmas time, but what brought up fruitcake was, back in 1987, I had only had a few months in this industry. I had come from being a toy store manager and your dad hired me. Then he predicted that the stock market was going to fall in October of ’87. He really did. A lot of people try to take credit for that. He actually did because I remember his August newsletter in ’87. But what no one understood initially was why did gold stocks? Gold stocks? Isn’t that where you go when things crash? Gold stocks were the second worst loser. They lost about a third of their value in 1987. I was told that it’s like fruitcake. When there’s a need for liquidity, you get a little bit of the cherries. You get a little bit of whatever those fruits are that are green. The colors, I don’t know on fruitcake, but green, red, whatever. You get a little bit of the nuts. But when they take a slice of fruit cake, it’s the everything bubble that rises turns into the everything pops and is sold, right? It’s like cutting a piece of fruitcake. The good, the bad, and the ugly all gets cut at the same time.
David: You’re right. My dad called it in ’87. He did not, like Peter Palmedo who was working the derivative desk at Morgan Stanley, short the market with out-of-the-money puts and retire early. So he knew what was happening. He could see it.
Kevin: He didn’t profit for it.
David: But there was a decisive action which was lacking. So, yeah. The decision, to your point, the decision to de-risk and deleverage, it’s like the slice of fruitcake. You get a little bit of everything in there. It’s the slice of fruitcake in the market. So the taste of fruitcake in June 2022 also suggests that leverage is coming out of the market, and it’s by groups that are way too over-leveraged. All sorts of trades are being unwound. You may be tempted to drive towards conclusions on a particular asset class. I wouldn’t. I would look at the trends that have been in place, and have a more fruitful conversation around what is happening, again, not on a day, but over the last several weeks, months, and even quarters.
Kevin: So have a more fruitful conversation, is a pun intended. I’m sure you intended that. But what you’re saying is so important because in 1987, stocks did come down. I’m talking gold mining stocks now. Gold actually did rise at that time, but gold mining stocks took a huge hit. It cracked me up because I had just come out of the toy industry and the number one losing stock was toys. The number two losing stock was gold stocks. I had just come from toys. Now I was in gold. It’s like what’s going on? But here’s what happened. The gold stocks rallied back very quickly because the trend was up at the time. 2008, remember that? Same thing.
Kevin: Gold came down what? 25, 30% and then it rallied back because the trend was up.
David: Finished the year up 6% at the end of the year. So November was horrific, October to November. By the end of December, it had rallied back to positive territory.
What trends are in play? Long term trends, there’s some short term, intermediate term, trends which are more compelling than Monday’s market implosion. It followed a long weekend, lots of brooding over the Friday nightmare performance following the CPI number. We had the Consumer Price Index number come out last week. Nobody liked it. It’s pretty typical. You have a terrible Friday, even a terrible Thursday, Friday, and a tough follow through on Monday because again, it’s just like, oh, what does this mean? Where are we going from here? A lot of agitation builds, and all of a sudden Monday continues on the downside.
Kevin: Plus you can hear a train coming, right? I mean, isn’t this triple witch week?
David: Think about this week in particular. It’s Friday. You get expiration of stock options, index options, and futures. What they call the triple witch occurs quarterly, so four times a year, and this Friday there’s $3.2 trillion in expiring leveraged bets. That’s this Friday. We have one of the most important Fed meetings, with public comments due, Wednesday.
Kevin: Could it be the most important ever?
David: Maybe the most important ever. We know that the global tone in the markets has already shifted, and we may be looking at a brand new cycle, different kind of cycle than we’ve seen in 30 or 40 years. But it’s shifted given the inflationary surprises, both the surprise in terms of duration and severity of the inflations, which are unfolding. I say inflations because it’s a global phenomenon.
Central banks have been forced to respond by tightening policy and therefore tightening financial conditions. That’s why this looks and feels so different than other periods in the last 40 years. In essence, the central banks of the world are just playing catch up to conditions that the market are already bringing into play are forcing. That’s what we talked about last week. You get these huge moves in European bonds. By the way, they continued this week to numbers that we haven’t seen in a decade. Real problems are going to emerge as a result of Italian debt getting north of 4%, Greek debt getting north of 4%, German bunds now above 1.6, and US Treasurys above 3.6 with a 2-year at 3.4. Again, trends have been in play, and they’re telling a fascinating story.
Kevin: Well, and on that note, I mean story versus just event is, let’s say you’re watching a story, and it’s Star Wars, let’s say. You’re making your decision as to how the movie will go by a single event. If you’re changing your portfolio by event, by event, by event, you don’t get it. The overall storyline is what you have to ask yourself.
So just going back to gold, Dave, the storyline, Jim Deeds has taught me this. Jim says, what’s it going to look like in two years? That’s the question he’s asked himself since he was a teenager, and it’s worked out really well for him through stocks, bonds, gold. We’ve worked with him. He continues to keep in touch with us in his 90s. He says, what is happening long term? Then make your adjustments based on two years out. Wouldn’t you say that’s probably wise right now? When you’re talking trends versus just sudden events, let’s say gold goes down 10 bucks. Is that a trend?
David: No. I mean the unwind of excessive speculation, that’s what we’re seeing happen on a grand scale. It’s happened starting in 2021. We talked about indexes starting to face resistance on the upside and then technical divergences and breakdowns starting as early as the first quarter of 2021. Then earnest price action to the downside in the fourth quarter of 2021. Of course, that’s been the story for 2022 as well. So it’s not the last 10 days, and it’s not the last $10. But cryptocurrencies, you now have a poster child for Ponzi dynamics and sort of the get rich quick enthusiasm around an asset class. It’s down 50% amongst the largest offerings, and 100% in your less fortunate offerings. Some of the less fortunate have seen market values of 30 to 50 billion. So we’re not talking about something insignificant going to zero, but to have a value of $30 billion and go up and smoke in a matter of days.
Kevin: Yeah, but the equity market’s different. Cryptocurrency, that’s an experiment that’s about 13 or 14 years old. That is a speculation, but equities have been around for a long, long time. The trend is down on equities as well.
David: And the question is whether or not this is a cyclical or secular downturn. Cyclical being shorter term, it’ll be over. We’ll be able to move on. We move back to a growth thematic. What argues for it being a secular trend is that interest rates are shifting and inflation is shifting. These are shifts that we have not seen in 40 years. So the probabilities of this being a secular bear market with many years ahead of stagnant growth, no real positive returns, disappointment amongst your equity investors. That argument is growing. That it’s not just a short-term cyclical correction, but it is in fact a longer-term secular one. Right now, the S&P is off 20% year to date. NASDAQ is back to its low levels, negative 30% for the year. But again, if you’re looking at the unique aspects of this market environment, you’d ordinarily see stock down, bonds up, but US Treasurys are down 25%. Just pause and think about that.
Kevin: That’s the safe money. That’s where you go when you want to be safe, right?
David: Granted I’m talking about 20 to 30 year bonds, right. So they’ve got a little bit more interest rate in inflation sense too.
Kevin: But they’ve lost a quarter of their value.
David: Right. Investment grade debt, nearly 18% down for the year. High grade— high yield, not grade. It’s anything but high grade. High yield, nearly 15% with a lot of catch up on the downside in the junk market. So we’ve had a few days of acute pain. For investors, it brings out the question of how far will these declines go? How soon will the central bank cavalry arrive to provide relief because that’s what has happened time and time again. Yes, from a technical standpoint, we’re oversold. Rallies are natural. We’ve again got games that can be played between here and the end of the week for options expiration and even beyond that, as we move towards the end of the month for quarterly performance games. So delivery on the third official mandate, that is what will be in play between now and the weekend and now and the end of the month. The third unofficial mandate is market stability.
Kevin: Okay, but how do you do that? How do you really do that? We’ve talked before. You give the Federal Reserve a mandate, market stability. Then you tell them their mandate is employment. Then you tell them their mandate has something to do with greening up America.
David: Well, I mean, to be clear—
Kevin: How do you that?
David: —it’s price stability and employment, which are their explicit mandates. That third is implicit and one that they’ve taken on voluntarily.
Kevin: So try to keep the stock market [unclear].
David: That’s right. It was never given to them. Our conversation with Paul Tucker was really related to, Stay in your lane. You’re not supposed to find a way to solve climate change or any other issue. Just focus on the two things that you’re supposed to focus on, price stability and employment. They can pat themselves in the back for the 3.6% unemployment numbers. But if you look at a chart of the US dollar, since it was freed from gold, “freed” from gold, because that is the perspective of the central bank community, it was boat anchored and unable to travel.
Kevin: It’s like you remember the Lost Boys in Peter Pan? They were freed from their parents. Okay. Look how that worked out for them. The Fed is like the Lost Boys.
David: Yeah, no. So this is the rub, the dilemma, the Catch-22 if you will. Inflation rages, and places the first official mandate of the Fed in focus, price stability. Again, because well, whatever they’re going to do to save the market from additional pain, the stock market and the bond market from additional pain, is complicated by the CPI release last week. It’s elevated. This week PPI—again, mildly better, 10.8% year over year. Mildly better than the last one. Meanwhile, CPI moved the wrong direction. Beat expectations, 8.6. This is the rub.
Kevin: Well, yeah. They need to be ahead of it. They need to be ahead of it. William McChesney Martin, he was in the ’50s, right? Fed chair in the 1950s. What did he say about taking the punch bowl away before we get to this?
David: Before the party gets started. So a muscular series of rate hikes, they’re needed to try and catch up, but there is a price to be paid. If you look at Friday and Monday, you could say, well, the price is being paid already. Leveraged bond traders are experiencing pain. Equity investors are experiencing pain. If you’re on the wrong side of an options trade, you just got obliterated. It’s not just here in the US. Globally, bonds are melting down. Greece is over 4. Italy’s over 4%. Bunds over 1.6. Treasury stretched to nearly 3.63 yesterday.
The fear here, again, why would they consider stepping in to bail out the financial system when the man in the street is being crucified on a cross of inflation? How can you possibly consider intervening in the stock and bond market? Well, you have $610 trillion in total derivatives exposure in the marketplace. That is complicated by volatility. Up till now, we’ve been dependent on central bank interventions for the viability of the derivatives market. When financial markets come under extreme pressure, you know that you’ve got the ECB, the BOJ, the PBOC, the Fed there to smooth things over. Two thirds of all of those derivatives are interest rate-related. So when we see the kind of volatility that we’ve seen in the bond market over the last two, three, four weeks, this is killing someone, right? There are entities that in recent days have blown up. As Bill King asked this morning, the only questions are who and how many.
Kevin: So let’s say Jerome Powell is a guest on the commentary today. What in the world is he going to say, because Dave, can he even admit that interest rates are going to have to be three, four, five, five, six, seven percent higher just to stop this inflation? I mean, remember Volcker? I mean, pretend like we had this commentary going on about 1979, ’80. Volcker would’ve said, “You know what, I don’t care. I’m not going to save the markets. We cannot have the kind of inflation that we have.” Guess what, Dave, we have the kind of inflation that they had, now, that he went in and intervened when he raised rates so dramatically.
David: Yeah. The problem that Powell has is he’s got three different audiences to appeal to in his comments. He’s got the bond market, which needs to hear one thing, and that is that he’s going to remain credible and his actions are consistent with the credibility thematic at the Fed. The stock market, which could care less about the Fed’s credibility. They just care about being coddled to and taken care of. The consumer just needs to know that the pain’s going to end. Yet, ending the pain for the consumer, it runs at odds with what the stock market needs to hear. The bond market, again, I think the consumer in the bond market are probably closest to having compatible needs.
Kevin: Well-controlled inflation.
David: Control inflation.
Kevin: Let’s say the guest isn’t Powell. Let’s say the guest is the consumer. The consumer’s like, you know what? How many millions of people did not pay their energy bill?
David: There’s over 20 million people who are late on their energy bills. So this is what we anticipated last week, was the CPI number end of week. Then the University of Michigan Consumer Sentiment Report, which was the lowest reading in terms of consumer sentiment and the history of the report. So think about that. Employment’s great. 3.6, pat on the back. Well done.
Kevin: Yeah. So nobody’s hearing, I’m going to lose my job. They’ve got a job that can’t pay the bills—
David: Right, and that’s with—
Kevin: —because of inflation.
David: And that’s with pay raises. So everybody’s seeing a bump in pay, but it’s not enough. It’s not enough in real terms to keep up with an increase in costs because CPI understates real-world inflation anyway. So the consumer’s experience of this whole saga is an experience of desperation. The consumer needs to know that the pain is going to stop. But for the pain to stop, you’ve got to be willing to trigger a recession. You’ve got to be willing to take interest rates arguably above the 2-year, and really even beyond that, above the level of inflation. Which is why we talked about last week, they’ve got 200 basis points, 240 basis points of catch-up to as much as 700 basis points of catch-up raising interest rates to that amount. And—
Kevin: Does the market have the imagination for that? I mean, can it even factor that into their future? Imagination is sort of, what is that, a future memory, right?
David: The stock and bond markets like the imagination for those kinds of moves, and central banks like the stomach for creating that kind of pain. You have Mohamed El-Erian, who was lamenting this week on CNBC how unnecessary this was if the central bank community had led and not followed.
Kevin: Taken the punch bowl away.
David: Right. You do it preemptively, and you’re not particularly popular. But again, that would require seeing inflation for what it was. My opinion is it remains too smug and dismissive with their economic models, and after all, who wants to be that guy? Taking away the punch bowl at the party, not particularly popular. “Hey, Hey, Hey, bring it back.” So El-Erian’s point was simple. Earlier would’ve been more effective. Late action, even if it’s the same action as you would’ve taken earlier, is less effective action, which raises the question of how much more muscular the rate hikes and condition tightening will need to be to tame the inflation beast.
Kevin: Okay. So are we seeing the markets this week brushing against reality for maybe the first time?
David: Yeah. We’re only 200 basis points behind on one measure, 700 basis points behind on another. If we just catch up to the 2-year, that means 240 basis points increase in the fed funds rate. That’s nowhere near the inflation number, of course, but now the market is assuming and building into its equations that we’ll be at 3.4% on fed funds rate by year-end. That is a 2.4% increase.
This is going to get dicey. That kind of a move on interest rates puts a stranglehold on the stock market for sure, and may in fact be one of those additive factors in terms of recession. This week’s volatility, your question, is that the first real brush with reality? I think the reality that the Fed does face is this unfriendly dilemma. Let the markets go. Don’t support equities and bonds, and choose to instead address the consumer nightmare of rising costs. Or ignore inflation to a degree. Act, but not too aggressively, and provide the moral support for the leveraged speculator, who is currently hemorrhaging. This week is pretty darned interesting because the stakes are so high.
Kevin: Well, and the stakes are high because people don’t buy things with dollar for dollar. If you’ve got 100 bucks, you don’t go out and buy $100 worth of something. If you’ve got 100 bucks, you leverage it, right? The Fed’s got your back. So if you’ve got 100 bucks, go buy $1,000 worth of something. Bet high, bet low, bet long, go short, whatever. Somebody’s got your back.
David: Options and futures is the rage. $3.2 trillion in leveraged long and short bets.
David: They’ll be unwound this week, and there’s got to be winners and losers. But wait, there’s more—as if I’m selling Ginsu knives. But wait, there’s more. Expiration is not the only relevant time-stamped date with a tremendous amount of hope attached to it. The end of the second quarter’s two weeks away. It’s end of month and quarter. So quarterly, made your performance. This casts a shadow into the rest of the year in terms of how you’ve done. Performance games, what happens is you entice massive manipulation from heavy handed traders that have far more than a P&L statement in mind.
Kevin: These are large hedge funds. Are they all going to make it? Are they all going to survive this?
David: At this juncture, you have hedge funds on the edge of extinction. That’s the trading that we saw Monday of this week is near extinction events. The fruitcake slice of everything gets sold. You reduce risk by X, and do it proportionally across the portfolio. It’s not a discriminant selling where you’re picking and choosing your winners, getting rid of your losers. I think you’ve got a few macro hedge funds that have done well year to date. Like us, the risk management, the siloed opportunism has paid off with massive relative out-performance, not on the tank by 20%.
Kevin: You guys have been doing great.
Kevin: I mean, just holding your own is really— that’s the idea when everything else is down 20 or 30%.
David: We’re not digging ourselves out of that hole. But like many others, you’ve got losses that are mounting, bad quarter-end numbers may bring out a little bit more fruitcake. So broad market liquidations with money going back to investors as we’re actually seeing franchises close for good.
Kevin: Something that keeps hitting me, Dave, we’ve talked about this with inflation. Inflation was always isolated to various countries up to this point. At this point, we’ve got worldwide inflation. This may be the first generation in world history where you can say you’ve got a worldwide event going on. I remember even 1987, the stock market collapses. Yes, they were transitioning as the sun rose in different parts of the world, but there was a delay. There wasn’t this interconnectedness, and this— At this point, are we not leveraged to the world? We have a world crisis, not an isolated crisis.
David: What I think is interesting, if you go back to the gold standard, we had globalization, one of the great periods of globalization 1860 to 1914.
Kevin: Yeah. That’s when the parents were home, the Lost Boys had their parents home.
David: Basically meant that everybody was using the same currency, gold, but it forced country by country settlement of foreign accounts. So trade deficits might cause a surplus elsewhere. Then all of a sudden there’s a rebalancing as cash flows from one country to the other. It creates mini recessions here and there, but it’s a constant rebalancing on a natural basis.
Kevin: Well, and mini recessions, you’re talking about micro recessions.
David: Mini, M-I-N-I not M-A-N-Y. In fact, they were many, M-A-N-Y. They just weren’t that severe.
Kevin: They were small because you had to balance your payments.
David: We’ve got the tinkerers involved now, and they didn’t want to have mini or many recessions. They thought we could do better with a fiat currency. In some senses, we have done better. But then when we have corrections, they’re not mini, M-I-N-I, they’re catastrophically large and global in nature.
I think what was interesting then is you had individual economies, even though you had globalization, even though you had an endorsement of free trade and no tariffs and capital flowing, you had individual countries who were managing their own affairs. Now you’ve got coordinated central bank policy. Coordinated central bank policy has made for a uniformity of effect. Believe it or not, we have almost, not quite, but almost universal inflation around the world—anywhere you’ve seen money, supply growth, which is almost everywhere.
Kevin: Which means we also have universal rates rising at this point, right?
David: Well, that’s right. So there’s a new cycle in play, and it didn’t start last week. It may have been reinforced over the last 10 days, but rates are screaming higher, not just in the United States where we would be siloed and on our own, but they’re screaming higher globally. The implications for leveraged balance sheets, whether it’s household balance sheets, corporate balance sheets, governmental balance sheets, they’re huge. They’re huge.
Kevin: Well, and we’ve talked about this easy money period of time. We knew there’s something to pay for easy money. It could be brutal.
David: Two weeks ago I mentioned going to Dear Evan Hansen, and we actually sat in a box seat, which was kind of fun. It’s not every day that you sit in one of those old-fashioned box seats. Well, to sit in a box seat here and witness the transition from decades of easy money to a totally different regime, you can see it play out in front of you. You’re a little bit removed from it. It actually provides a little bit of squeamish excitement. I was 15 and on a trip with my dad to Asia, sitting ringside in Thailand as two kick boxers took to the ring. Each kneeled in their respective corner, preparing for what came next. I only learned this after the fight that they were praying for the death of their opponent, and the inevitability of one party walking out and the other party being carried out either half dead or actually dead. I had never seen anything so brutal.
Kevin: So are you saying that Wall Street right now, there’s a brutality there like that? Are they praying for the death of their opponent, Dave?
David: That’s probably not happening on the corner of Wall and Broad, but I think the brutality is a factor that’s entering the fray, and particularly for the leveraged betting community. So if you’re talking about hedge funds, there will be massive losers, maybe a few winners, but the implications are significant. Implications for market makers who are having to match trades and make sure that everything balances out, and that they can continue to operate and provide buying and selling, what we consider to be a normal market function. Hedging strategies that keep the markets relatively in balance are something that we take for granted.
Kevin: Well, so I wonder about the Plunge Protection Team because I first read about the Plunge Protection Team in 1987 after the October crash. They came in and literally intervened. I think it was $4 million. They picked a particular index to hopefully save the market that Tuesday. We had the horrible Friday. We had the horrible Monday. Then that Tuesday, I remember being in a staff meeting with your dad, and the market had fallen another couple of hundred points while we were downstairs, because we were on the fourth floor of the First Colorado Bank and Trust building.
David: Not too high to jump.
Kevin: No, that’s true. We were meeting on the third floor in the conference room. We knew the market was down almost 10%, but they came in, the Plunge Protection Team came in and bought— This is the government. It’s the government, we’re here to help. Do you think there’s going to be, like with Vanguard and some of these gigantic people? BlackRock? Do you think we’re going to see that kind of intervention?
David: Well, I mean, we started out with acronyms, and there’s no doubt that in the months ahead, we’re going to get schooled on a new set of acronyms, all the SPVs, which is not something you catch. It’s actually done for you, not to you. SPV, special purpose vehicles. That is the way that they solved the problem in 2008 and 2009. You create an entity and sweep all the garbage paper into it and then just let it sit. We had Maiden Lane I and II. We had varieties of—
Kevin: We socialize the risk. Yeah.
David: Socialize the risk, and the taxpayer to some degree over time pays any price. I mean, when we come into periods of extreme market volatility, the actual name is not the Plunge Protection Team. That’s kind of how it’s referred to but actually the President’s Working Group on Financial Markets is there to brainstorm how to keep markets liquid and continuous. Most of the time they can do that. It just requires a little bit of muscle applied in particular ways. So if it’s the various heads of corporate entities, like a Citi Group, a J.P. Morgan, a Goldman Sachs, or you’re talking about regulatory bodies, they just put their heads together and figure out best way to keep the markets liquid and continuous.
Our conversations this week have included the possibility of the easy to buy, not so easy to sell structure of the ETF having to be purchased by the Fed—particularly investment grade bonds, high yield bonds, and a number of other products where you’d look at BlackRock, you’d look at State Street, you’d look at Vanguard, and they’ve put together these products. They manage the products. They make a good bit of money off of those products. But they don’t have to maintain the products for continuity within the marketplace. In fact, that might be a role that the Fed has to play to make sure that liquid and continuous are the terms that still apply to the market. We don’t have to see a market accident, but I guess what we’ve concluded on the asset management side of our business is the odds are increasing that we do get one. So we see the de-risking and de-leveraging in a time when central banks are constrained in their actions, and that raises unique possibilities and dangerous circumstances for the markets, which are accustomed to being delivered, being delivered. I mean, that makes me think of a speculator looking at the 23rd Psalm. Yea, though I walk through the valley of the shadow of death, I shall fear no evil for thy balance sheet and printing press will comfort me. That’s the speculator’s look at the 23rd Psalm.
Kevin: Well, and see, that ties into what do we put our belief into? The true 23rd Psalm says, yea, though I walked through the valley of the shadow of death. I will fear no evil for thou art with me. The creator of the universe. That’s a pretty good thing to believe in. But Doug— I read Doug’s Credit Bubble Bulletin last night, and he said, yeah, this may feel like 2008. This may feel like 2000, but, he says, what it really feels like is 1987, when everybody said, yea, though, I walked through the valley of the shadow of death, I have insurance. It was insurance on the markets in 1987, October, that just crushed everybody. Remember Richard Bookstaber, who’s been a guest? He wrote a book called—
David: A Demon of Our Own Design.
Kevin: —A Demon of Our Own Design, and it has to do with that. So when we put our belief in something that really is not the rock, what happens? So have we put our belief, have the markets put their belief in central bank intervention?
David: Dynamic hedging strategies are supposed to be a form of insurance which allow, in the context of a market decline, for you to be adequately covered on the downside. We’re talking about one step beyond that, where dynamic hedging strategies are beginning to not keep up and fail. Again, “for thy balance sheet and thy printing press will comfort me.” That’s what we’re accustomed to. But here we are in a different context haven’t been here for 40 years. How does the central bank deal with this particular problem? The markets have had the benefit of central bank interventions repeatedly through recent years—through decades. The belief that markets are liquid and continuous, that’s fundamental for the leveraged speculator positioning long and short. What makes the current environment more intriguing than even 1987 is that you have the same kinds of portfolio insurance bets in play, but you have a constrained Fed. A constrained Fed.
Kevin: Because of inflation?
David: Yep. With inflation being more than a boogeyman, how does the Fed step back into the role of buyer of last resort? Right? You’ve got emergency circumstances which may bring them back into the fray. This is what they’re having to balance out. It’s why this week’s meeting is really critical. What messages are they sending? Who are the three audiences that they’re communicating to the bond market, the stock market, the consumer? How convincing are they in their messaging? Right?
Kevin: Do you remember the argument? Well, let’s just look at the yen. They were able to get away with it in Japan for decades. Yes, Japan has sort of stayed in a still state of recession for years, but the yen held up until just recently. The yen was used as an example, Dave, for central bank policy that we’ve seen over the last seven or eight years.
David: Right, and where there won’t be any consequences, you can just continue to abuse the system, the currency, what have you. Well, I mean, if the Fed is brought back into the fray, if they do have to bail out the stock or bond market with extreme market volatility, you’re talking about something that could wreck the dollar like no other time since the end of Bretton Woods. I think the yen is a good exhibit A for this kind of an argument. They’ve made the commitment. Kuroda has made the commitment to hold the yield on 10-year paper at 25 basis points. That’s on Japanese government bonds. That has triggered a major decline in the yen, since the beginning of the year, to levels that we haven’t seen in 20 years, actually September of 1998.
David: So we’ve got an exchange rate hovering around 135 to one. Things are bad, and Kuroda is close to being hoisted by his own petard, blown up by his own interventionist devices. So first comes the pain, then comes the loss of credibility. That’s where I’ve actually seen a number of articles written asking Kuroda to step down. So here we are.
Kevin: Well, 1997, ’98, you just brought up the late ’90s. That was the Asian contagion, wasn’t it?
David: Right in that range, 1997, the Asian financial contagion, a slide to 150 on the yen exchange rate. All that does is layer in another kind of instability into the global marketplace. Not only do we have leveraged speculation in fixed income and other asset classes, but you borrow from one place and go invest it elsewhere. So you’ve got these carry trade dynamics, which make cross-border connectivity a dangerous element, too. So again, I think of the yen. We’re not at 150, but a slide to 150 and you really have gotten to a place where you could expect the worst, à la the 1997 Asian financial contagion.
So here in the US, we’re the beneficiaries of a strong dollar this year. We price things in dollars. Not the case, obviously, in Japan for 126 million people. They’re pricing assets in yen. Things have gotten more expensive. Gold. Gold is up nearly 20% year to date, priced in yen. For the US investor who invested in gold, you’re off $10 for the year, less than half of 1%.
Kevin: Even with the dollar up 10%?
David: Well, this is what’s remarkable. Dollar’s up nine and change, almost 10%, at levels last seen in 2002. Okay. So keep this in mind. 2002 gold was at $310—
David: —with the dollar at the same level. All things being equal, not bad. It’s a bit of an absurdity when we start talking about currencies and fiat currencies, comparing one against the other. The dollar is not purely dollar strength on an absolute basis. It’s a reflection of euro weakness. It’s a reflection of yen weakness. So that we’re up 10% is as much a story of the yen being down as it is anything else. That’s the nature. That is the nature of a fiat currency system.
Kevin: Relative strength.
David: All you have is relative valuations. In reality, the US dollar is less weak than the yen, but still vulnerable.
Kevin: Yeah. It’s a little bit more alive than the other dead currencies. I mean, it reminds me of Monty Python and the Holy Grail. You remember the bring-out-your-dead scene? And there was this whole cart full of dead people who had died from the plague. There’s this one guy on the cart who goes, “I’m not quite dead yet.” I hate to say it, but he was stronger than everybody else on the cart.
David: There’s the dollar. Absolutely.
Kevin: I’m not quite dead yet.
David: There’s the dollar compared to the yen. Well, I think the great equalizer between the yen and the dollar is monetary policy going forward. So the dilemma or the trilemma, however you want to see it—we’re looking at the Fed’s mandates, two official, one unofficial—is where they lay out the defense. Are they going to protect price stability? Well, that comes at a cost. Are they going to protect the markets? That comes at a cost. Are they going to protect their credibility? That comes at a cost. I mean, all of these things, it’s now very tough sledding.
Kevin: Okay, but I have a question for you. Going back to the analogy, I’m not quite dead yet, right? I’m not quite dead yet. I love that scene. But the truth of the matter is, we are a reserve currency. And there’s a lot of talk on the internet, and just in people’s minds, and mine included— how long do we keep the reserve currency status? What’s your thought?
David: Yeah, we’re not quite dead yet. I mean, I think we have that status for the foreseeable future, if not decades into the future. The argument is simple, and it ties to Kuhn’s observation in The Structure of Scientific Revolutions. Number one, there’s no viable replacement. I think you break that down into two particular themes: A) A viable replacement has to have depth of capital markets, and there is no deeper capital pool in the world than the US. The second part of sort of having a viable replacement is, we continue to be the largest consumer in the world. Our currency is therefore the default currency for trade settlement. Is that being eroded? Yes, it’s being eroded, but something that is eroded is not falling to pieces quite yet. The second thing that goes into maintaining reserve currency status globally is the power to maintain that incumbent advantage. In this case, it includes military spending.
Kevin: Kinetic warfare sometimes keeps monetary policy intact, huh?
David: Yeah. It’s true. It’s true. I mean, we have an enforcement arm for our monetary policy, and it’s called the US Navy—well, and army and air force and everything else, but we spend more than the next 10 countries combined on our military. So consider how this takes shape after the Ukraine incident with Russia, and how military spending’s going to be viewed, because the decades since the fall of the Berlin Wall have allowed for this massive reallocation of resources towards other public policy initiatives. We reduced our military spending, which again is still more than the next 10 largest countries combined.
Kevin: We reduced it, but we got this peace dividend because we weren’t having to build up mutually assured destruction.
David: Right. So the peace dividend, reduction in military spending, that’s gone. You’ve got a veritable arms race, which is back. You’ve got a refortification and an intensification in military spending, which would be a global phenomenon for at least a decade. The US, seeing no other challenger to its position as current global hegemon, will spend accordingly to keep the position of influence and power. So if we’re in a ramp up mode in spending, again, we come back to no viable replacement and we’ve got the power to maintain that incumbent advantage.
Kevin: Logical arguments, all of them. I’m with you, Dave. Logical arguments.
Kevin: Except crisis. Crisis has changed the world a number of times. I remember I’ve got a couple of books by Velikovsky, who was a friend of Einstein’s. He said gradualism in evolution is a lie. It’s catastrophism. Everything changes in a moment and that moment often is a catastrophe. Remember when we’ve talked about catastrophe math, where—
David: Oh, yeah, sure.
Kevin: —it builds and builds and builds. It’s like a bridge that doesn’t collapse until it does.
David: No, you’re right. Crisis compresses time. Economic crisis is not on our doorstep yet, but if you’re looking at the consumer’s response last week to inflation, if you’re looking at credit card data and revolving credit surging over the last several weeks, if you’re looking at unpaid electricity bills, certainly you can make the case that economic crisis is looming. Not here, but looming. Remember that recessions are usually backdated. So we’re already into it before the time we go back and say yeah, but actually it’s been here for a while. So we’re not talking about economic crisis. We are really talking about financial market crisis. And it’s already unfolding, with investors hoping that the worst is behind us, that the Fed put needing delivery now will be sensitively attended to this week, Wednesday—immediate attention. But that brings us back to the Fed’s trilemma.
Kevin: They’re trying to keep three balls in the air. Four actually, but three, for sure.
David: Well, managing employment, keeping prices stable. These are the two official mandates of the Fed. Providing support to financial assets, that’s become the third unofficial. That’s where we get the trilemma. Without Fed support, the markets must find a fresh justification for not only current levels and valuations, but what’s going to drive future price increases. Otherwise, you’re going to continue to see downward pressure in the markets. If your reference point is the last 20, 30, 40 years, then we’ve already had the worst behind us because 20, 30, 40% correction, we’ve cleaned up this mess and now we’re ready to move forward. But believe it or not, with the corrections we’ve already had since the beginning of the year, since fourth quarter of 2021, we’re just back to the excessive levels of the year 2000. We’ve corrected massively excessive overvaluation down to merely excessive overvaluation.
Kevin: So we were massively overvalued. Now we’re down to, would you say, excessively overvalued like the year 2000 before we had the tech stock bubble blow up? But wasn’t that due almost completely to the need for loose monetary policy?
David: Right. So the requirement in recent years has been for growth to be buttressed by loose financial conditions. That’s helped stocks and bonds to perform as they have. It’s maintained the upper trajectory. It means that every time we get a little bit of a correction, it’s cyclical, it’s not secular. When you take away central bank market support and the markets have to learn to operate without a central bank boost, it’s tough.
Kevin: Okay. So pretend, like I said before, Powell’s here in the room with us right now. Jerome Powell. Does he do what Volcker did, or does he even come close?
David: There’s shoes that you really don’t want to be in. I mean, Jay Powell’s shoes this week. 50 basis points won’t cut it. You’re not taking inflation seriously enough. 75 basis points is stronger. You’re communicating to the bond market that you understand inflation is a real issue. You had already taken 75 basis points off the table.
Kevin: Does he do 1% to shock the market?
David: Nope, because then you have a major panic in the stock market. Coming into options expiration on Friday, you get a major panic, you could have a 1987 meltdown. So he may want to get muscular to the degree of 1%, but the toll taken within the financial markets and the sort of negative daisy chain events within the derivatives complex, it’s too great. You can’t risk that havoc. You’ve got way too much frailty, way too much frailty. So the Fed has to care about that.
Again, a disorderly unwind of 3.2 trillion in bets, frankly, it’s a possibility this week looking at Friday’s triple witch and the setup that we have. Likely keeps the Fed from too much in the way of tightening. 50 basis points is the easiest. It’s pre-announced. Everybody’s absorbed it. But with a stronger inflation print on Friday and the PPI not really moderating much at all this week, he’s got a lot at risk. So it seems that you could make the case for a more muscular 75 basis points without really causing the destabilizing effects into the financial markets. Powell has to consider these things because the financial markets, they’re a little bit like the internet. It’s transnational to a degree. Contagions are not limited by the imaginary lines on a map.
Kevin: I think this is a good time to maybe go to what we talked about last night. You had said, what are your clients saying? I’ve heard several times this last week disappointment in gold not going higher. Dave, just a few figures, if we just take things in relation, okay, so the dollar is up 10% this year, and gold’s down, what, 10 bucks. But if we take things in relation to all these other markets, okay, so gold is up almost 20% against the S&P 500. It’s up 15% against the Dow Jones industrial average. It’s up 30% against the NASDAQ. It’s up 50% against Bitcoin this year.
David: So my view of gold is, I really don’t want to see it go very high in price. I’ll be honest because if we get to $5,000 on the gold price, I’m going to have to give up a huge chunk of that to Uncle Sam. I would much rather see the world get cheap and me be able to make a lateral move—
Kevin: So the rest of the world fall when the gold stay.
David: If I just maintain value, I’ve got zero tax bill or a lower tax bill and I get to maximize the lateral move into other asset classes that have just gotten inexpensive. The value exchange diminishes, and the appeal diminishes when I give up a third of my gains or more, because at some point the higher the price—
Kevin: You’re holding buying power.
David: I’m increasing buying power.
Kevin: But in dollars, you’re holding buying power to a degree, and then you’re increasing buying power in everything you would’ve bought with those dollars.
David: That’s right. That’s right. So I’m not unimpressed by gold. I’m happy that it’s holding its own. There’s a real pressure point building where, could we see it drop 100, 200 bucks? Anything’s possible because, again, the dynamics we have in play are straight out hedge fund fruitcake liquidation. I’m not talking about the hedge funds being fruitcakes. I’m saying their portfolio. You take a slice and everything goes. De-risk to a certain degree and you’re reducing all exposures by X percent.
Kevin: Yeah. Gold is one of those nuts or fruits in that fruitcake. So granted, if you need to liquidate something, but think about it. 100 bucks or 200 bucks, you just said, we’re only talking five to 10% here in markets. Treasuries, Dave, US Treasurys.
David: Down 25%. Down 25%.
David: So there is a highly probable sequence of financial market disarray followed by the forced interventions of the Fed. If I play this out in my imagination, I don’t want to get too far out on the horizon because things can change on a minute-by-minute basis or day-by-day basis. But if I said, look, we’ve got some sort of financial market accident, which is more probable in the next 30, 60, 90 days, maybe 30, 60, 90 minutes—
Kevin: Who knows?
David: —I should check the market.
Kevin: Compression of time. Yeah.
David: Yeah, but that forces intervention by the Fed. In that event, forced intervention of the Fed, you have a reversal of QT, quantitative tightening, a reinstatement of QE, re-expansion of the balance sheet, the dollar falls out of bed just as the yen has. Kuroda has given us almost a play-by-play of what happens when you fight market trends and you do something that really is not that smart. Defending JGBs at 25 basis points yield is a bad idea. The currency is telling you yeah, that’s a bad idea. So metals in this scenario where the dollar falls out of bed, metals move into the next gear for a period of time. They outperform in an absolute terms and not just relative terms, and the verdict on Fed credibility is out. The currency, as we discussed last week, that’s one version of a no confidence vote. So this is a fascinating market to be in. It’s one of the most complicated, complex and challenging markets to manage money in.
Kevin: But wouldn’t you say, keep your powder dry? Your dad used to say, keep your powder dry. Keep your powder dry. But the way you do that is gold, I’m thinking.
David: I imagine a barbell where some part of your liquidity is fiat and foolish, and another part is bullion and basic. You balance out the two, very uninteresting, frankly. But what you gain in having a higher allocation to liquidity is this ability to step in and buy things at a discount. You do have, again, this growing probability, not only for a significant market decline from here, but a whole adjustment phase, where, if we are in a new cycle where inflation sticks around and interest rates have to go a lot higher, we haven’t even begun to see the extent of adjustments to take place in the stock and bond market. Do you want liquidity, which is a form of optionality in that eventuality? The answer’s a solid yes.
Kevin: 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 You can call us at (800) 525-9556.
This has been the McAlvany Weekly Commentary. The views expressed should not be considered to be a solicitation or a recommendation for your investment portfolio. You should consult a professional financial advisor to assess your suitability for risk and investment. Join us again next week for a new edition of the McAlvany Weekly Commentary.