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The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Mortgage Rates Explode… Housing Affordability Threshold?
April 3, 2022

“The speed and ferocity of reducing a mammoth size presence in the fixed income markets that is shrinking the balance sheet, that’s what they probably tinker with. While the Fed need not worry for its own solvency, you and I have to. Others have to worry about their solvency. We get marked to market every day, and we lack the flexibility to print ad infinitum. They’ve got that going for them too. We plebes operate with a different set of rules. And so, with rising rates and the “stagging flation,” I think these are things that we have to pay attention to.” — David McAlvany

Kevin: Welcome to the McAlvany weekly commentary. I’m Kevin Orrick, along with David McAlvany. 

A lot of our stories Dave, come from your travels. I love sitting— We were sitting at Ken & Sue’s restaurant last night, again. For the first time in two years, we actually got to be live with each other instead of doing the FaceTime, because they opened up for us on Monday nights. And we looked back and we said, “Gosh, we’ve done this for over a decade.” Sat, had a Talisker, just talked about life, our family, the markets, the things we’re going to talk about. It was so nice to do that. And also talk about, again, your travels.

David: Well pretty busy between the Energy Conference in Florida to meeting with a group of guys, business leaders from around the country for a couple of days of fly fishing in Montana.

Kevin: I got the pictures. I got the pictures. Well, I’ll tell you what, I’m glad though. I’m glad that the accident that you guys were caught in, one, didn’t turn out to be fatal. It certainly could have been. It sounds like it was a terrible accident between a little RAV4 and a semi truck. And you said that the semi truck looked like it was worse for the wear.

David: Exactly. Coming back from Montana, we went straight to Santa Fe, New Mexico, and on our return trip, we were stuck in traffic and sat there for three hours. And a RAV4 and a semi, you’d think, this is not going to be a good story. No fatalities, but a big mess in a pinched canyon.

Kevin: But you adapted quickly.

David: I looked at Mary Catherine. I was like, “We could be here forever. Why don’t I go for a run?” So I ran up the road. I ran past the mess, they let me go by. And I was like, “You pick me up. If traffic breaks free, you can pick me up. I’m going to keep on running.” Kind of a Forrest Gump moment.

Kevin: Yeah. Yeah. Just, keep running. You said that your wife also brought a book to read a little of, and she ended up reading the whole book while you waited.

David: Oh yeah. Oh yeah.

Kevin: Okay. So as we look at this, I think about your travels, Dave, because you have a tendency— That’s just part of the resiliency that your family tries to build in. You wrote the book on legacy. You could also add resiliency to that. And that is, take the situation, make the most of it. 

I think about Christopher Blattman last week. You met him on one of your trips. Literally it wasn’t one of those things where you had figured out, “Oh, I want to talk to somebody about why we go to war.” I think you met him and his wife in a hot tub. You came back and you said, “I have a guest for the Commentary.” And it really, it turned out to be a very timely, a providential type of interview. I really enjoyed it.

David: Yeah. Well he said it was probably the most interesting conversation he’s ever had in a hot tub. Well, I thought, it just pays to be engaged and ask questions, and we’ve got the life story of two PhD students in east Africa trying to figure out what their future looked like and here they are. After a stint at Yale, now at the university of Chicago. Both of them still actively engaged in wanting to make the world a better place.

Kevin: We got a lot of good comments on that. And that’s the thing though. He’s looking at a situation as to, okay, why do we fight? Or Why We Fight is the name of the book. But actually the truth of the matter when you read the book, it was, what are the things that we do to not fight? And I think about the same thing, Dave, with markets. The markets are just getting decimated right now. All these guys who are making money in tech stocks are starting to go, “gosh, I wonder if it’s time to get out.” But resiliency and just a way of looking at things, you can always make lemonade out of lemons.

David: I remember Richard Russell saying years ago that in a bear market, the person who wins is the person who’s lost the least. There’s always something to lose in the context of a bear market. And we look at markets at month-end. They were anything but kind. It really looked like the RAV4 in that accident. Yet consumer discretionary stocks, which ended Friday—not for the week, but on the day—with a 5.92% loss. I repeat. That was for the day, not the week. The S&P retail ETFs, you’re talking about retail stocks, shed 3½%. The S&P real estate index gave up 4.9%. Friday was a tough day. Amazon had its biggest drop since 2006. Now down over 30% from its peak. Netflix is down over 70% from its peak.

Kevin: So you’re talking about a couple of the FAANG stocks. That’s where everybody was gathered over the last few years.

David: Well, we often referenced the concentrated positions in those stocks because it’s almost as if you have to participate. You have to own. If it’s moving and you’re not in, then clients may look and say, “Why aren’t you owning the things that are winning today?” So you’ve got concentrated positions held by hedge funds, by mutual funds, by individual investors, and they focus on just a few names. So the FAANG stocks, you’ve got Facebook and Apple [and Amazon] and Alphabet, the old Google. These are the stocks—Netflix—in just these five names, more than $1.2 trillion in value went up in smoke during the month of April. Tough month. On the earnings call, Amazon mentioned a binge dynamic catching up with them. Hiring was a part of that, warehouse building during the pandemic, it’s now impacting profits. So imagine this. Imagine losing money on a $116 billion in revenue.

Kevin: You’re not making it up in volume, are you?

David: Apparently not. There’s only tolerance for that when financial conditions are loose. It’s a challenging strategy to pull off in the context of tightening financial conditions. And I think that’s what a lot of investors have yet to really wrap their minds around. What works when credit is virtually free and access to credit is unlimited? Well, that changes when those underlying conditions shift.

Kevin: One, and it’s not just the FAANG stocks. We’re talking the Dow, the Russell 2000, NASDAQ, they’re all down right now.

David: Year to date losses in the Dow boasts to 13%. Russell 2000, smaller cap stocks, a 17% loss. NASDAQ 100 off about 21%. Semiconductors are down 26%. And you’ve got Bitcoin—not a safe haven play—now down 16.8%. It’s matching the declines in the banks, the broker dealers, and the biotechs. Roughly the same losses year to date.

Kevin: And even gold stocks, Dave. Gold stocks— And this is typical. When stocks go down, a lot of times gold stocks will go down with them but then rebound quickly.

David: Yeah. It’s interesting because you’ve got one of the best environment setups for gold in terms of profitability, margins, everything else. But gold stocks gave up 6% last week. That reduced their year to date gains to just 9%.

Kevin: So they’re still up.

David: For the year. They’re just not up as much. So same with our portfolios, our positive year to date returns, still are a contrast with the market, and we’re continuing to raise cash because we really don’t like the environment we see. So, huge cash position and we are making money. But a key question I think investors should wrestle with is, how do my investments perform in the context of an inflationary recession? What’s changing this week? What you’re seeing unfold with the Fed meeting on Wednesday is a change in the dynamics of what has made for decades of success. Not just a short period of time, but a very long, extended secular growth trend. 

So there are a few waterfall declines around the bend. We have to ask the question, with limited access to cheap credit, can companies that didn’t need to have revenue, didn’t need to have profits, can they even survive? We had Lou Wang from Bloomberg. He commented that, “the only thing that isn’t falling in the markets is the price of protection.” Of course, he’s talking about put options, and if you want some insurance on the downside, it’s coming at a higher and higher cost. I will say, also, a shout out to Doug Noland. He’s working his tail off with success, and that’s the purpose of the tactical short.

Kevin: It’s amazing how quickly things can change. I can remember just recently mortgage rates being two, two and a half percent. People were getting very low mortgage rates. We’re right around five right now. And the 10-year Treasury, we’re pretty close to three. So what does that do? When does the transition occur where people actually realize we’re moving into a different paradigm?

David: Yeah. The waterfall declines, we’re already seeing particular instances of that inequity. So of course it’s very easy for us to imagine stocks breaching a threshold and then entering a cascade type decline. Individual companies, we mentioned a few. Netflix is 70%. That’s not a minor haircut. And again, that’s widely held, same with Amazon. Is that same kind of deterioration possible with bonds as well? And actually your US Treasury, the long US Treasury bond is down more than Bitcoin, and right in line with NASDAQ stocks, 18 to 20%—

Kevin: That’s amazing.

David: It’s amazing. It really is.

Kevin: It’s called safe money. It’s not. It’s not safe money.

David: No, it’s not. This is from the Wall Street Journal last week. Fed president James Bullard says, “The bond market is not looking like a very safe place to be.” It’s like, these are the things that make me chuckle. It’s like, “Yeah, right.” Well, it’s a tornado right now, is what one investor described it as. Because it’s Treasurys it’s investment grade debt, and high yield is just beginning to kick into gear.

Kevin: Well, and it’s where you hide if you don’t want to be in the stock market, according to modern economic theory.

David: Right. Right. So is it possible that bonds have a similar type of profile? I think this really is a question of thresholds, and we may be at those thresholds. Three percent on the 10-year Treasury 5% on mortgage rates. That’s my best guess. These thresholds, I think, could define the next level of market movement in the bond market. And the movements don’t have to be orderly. They’ve been anything but orderly to date, but they can actually get more—intriguing, shall we say, in the months ahead. 

And I think these levels, 3% on the 10 year, 5% on the 30 year fixed rate mortgage, these are recalibrating levels for consumers. They’re recalibrating levels for bankers and for shadow lenders. These are the levels that begin to reorder the consumer’s life, and force tough decisions. 

And I think they’re also contributing factors to one of the worst cases of housing affordability on record. We’ve got price increases. The most recent Case-Shiller index has the single-family home, year over year, up nearly 20%. It’s up nearly 20%. So prices are continuing to streak higher. And unfortunately, so are rates, 3¼ to over 5%. 

The buyer’s in a tough spot. Rates are not great, at least compared to recent lows. For anybody who was financing purchases back in the ’80s. You remember double digits and you remember the teens, right? So it’s a lot better now, but there is a big difference in terms of affordability, moving from the low threes to the low fives.

Kevin: One of the ways that you value things, Dave, and I love doing this, is to say, “All right. How many ounces of gold is something worth?” And right now houses are worth more gold than they’re normally worth, too, aren’t they?

David: Yeah. So it’s great because price can be deceiving, particularly when your basis for reference is changing. So I want to talk about the yen for a minute because the yen has been in free fall. And it’s probably one of the most important things to be aware of in the financial markets at present. But if you’re a saver in yen, you’re getting decimated. And so you need to reference something outside of the yen or, for us, US dollars—or pick your currency. 

We do that by creating comparative values or reference values or relative values. The average new home sells for $436,700. That’s the new price, the average home for a new price here in the US, $436,700. Divide that by the price of gold, and it works out to be 235 ounces of gold. 

Okay. So that’s a pretty high number. You don’t get to see a number into the mid-two hundreds but probably once in your lifetime. What I’d like to do is consider real estate in a “back up the truck” moment, moving out of ounces into square feet, at more of a 50:1 ratio—50:1 ratio. So four, almost five times the purchasing power. And that means a slight diminishment in the real estate value and an increase in gold. It’s not a collapse in real estate, but it’s meeting those two assets, meeting somewhere in the middle.

Kevin: Do you remember when we had the client stand up at the Portland Conference a few years ago, and your dad told him back in 2005. He said, “Sell your real estate right now, move to gold, let the real estate market correct. And then move back in.” And he stood up at the Portland Conference, and he said, “Not only did that save his family’s money.” He had over a hundred properties that he sold. It was an amazing thing, but he tripled, he tripled his footprint by 2011, just coming back out of gold and going back into real estate.

David: But not only did he increase his financial footprint, but now it was not including leverage. So—

Kevin: That’s right.

David: —the debt part of the equation, the properties that he owned previously, he had debt on. When he came back in and owned a lot more properties, he had no debt. So if you think outside of the dollar price box or the yen price box or the euro price box, and price things in relative terms, these ratios are incredibly powerful for the macro management process of an individual investor. So there’s a fundamental case for housing at these levels. I’m not going to argue that $436,700 isn’t justified. It is what it is, and on the basis of supply and demand.

Kevin: Yeah. But when does that start falling based on interest rates?

David: And that’s where affordability is a big deal, because right now you’re talking about compromising the marginal buyer. Right now, you’re talking about rates increasing, and people can turn a blind eye. If you’re in the upper middle class, you just say, “It’s going to cost a couple hundred bucks more. No big deal.” But when you have real inflation adjusted incomes which can’t cope, and you’ve got inflated housing costs, rising mortgage rates, this is where 5% starts the recalibration of price. And it’s at least for the marginal buyer today. But what I’m saying is that trend is now in effect at 5%.

Kevin: My wife and I, when we got married in the early 80s, we bought a property. It was like 500 and some odd square foot apartment. 15% was what we were paying in interest at the time. It was very, very difficult to meet those, even with a small place. But we were coming out of an inflation that was just strictly a US inflation. Right now, look at what’s going on with the currencies, Dave. I want to talk about this because you brought this up in our meeting just about 30 minutes ago before we came into the studio. You said the inflation that we were experiencing in the ’70s and early ’80s was a US phenomenon. Okay. So right now the dollar is strong, our dollar is strong and we’re experiencing inflation. The rest of the world is already plummeting if you look at their currencies.

David: Well, exactly. There’s some nuance here because we get the benefit. The dollar gets the benefit in terms of safe haven migration. You get global disruption, the issues with Ukraine and Russia still in play, and really no surprise to see migration of assets in the direction of the dollar.

Kevin: Now the dollar is about as high as we’ve seen it almost.

David: 10377. 103.77. We’re at the peak levels which we got to back in 2020 and in 2017. And you can make a strong case that this is a time for a reversal in the US dollar. We’ve moved up higher. To break the 104 level would be really significant. Talk about a melt up dynamic. It’s already been disorderly. The US dollar has been on a disorderly rise. We are at a point where the euro’s at support after a disorderly decline. The yen has been in free fall. Now the RMB is under pressure as well, the Chinese currency. And I mentioned the dollar because sometimes it’s not the direction of a move, but it’s ferocity.

Kevin: Yeah. You said disorderly. What do you mean by that?

David: Yeah. I think that is important. And I think, I registered the word disorderly in the back of my mind in our portfolio manager meeting at least four to five times earlier this week. The dollar was one of those items being referenced, the yen, disorderly, the euro. Again, these are trading inverse to the dollar strength, trading lower.

Kevin: Yeah. But what’s amazing is gold. Okay. With the dollar at nearly 104, gold— The last times that we were there, gold was nowhere near as high as it is now. So gold is showing. Talk about resilience.

David: It has been resilient. For metals enthusiasts, it’s notable that when the dollar was at these same levels in 2017, again, just roll the clock back. 2017, the dollar was right here. Gold was at $1150. Dollar returned to 104 in 2020. So again, this is Covid panic, migration to stability, gold at $1600 an ounce. So far the strength in the precious metals in the face of a massive move higher in the dollar is a meaningful signal. 

And yes, it speaks to chaos and uncertainty in the rest of the world in a variety of other asset classes. It speaks to the realization that other asset classes are at risk in the context of quantitative tightening. Right? But traders typically view rising rates and a strong dollar as the kiss of death for gold. And that’s not always the case, but short-term traders, that’s the way they behave. They’re like, “Oh, dollar up, gold down.” Not now.

Kevin: Not now. We’ve got a strong dollar. We’ve got strong gold. I’ll never forget. We’ve talked about this before. When Barings Bank had a trader who was using the carry trade, using currency, it literally put that old institution out of business. I’m wondering about all the leverage right now with these currencies falling.

David: Yeah.

Kevin: What do these guys do?

David: Well, that’s where the leverage comes unwind. So you’ve got the yen and the euro also disorderly declines. The flip side of dollar strength is the increasing chaos in the currency markets elsewhere. So Doug Noland reminded our team on Monday that foreign currency volatility is deadly for leveraged players. And again, this is the carry trade dynamics that feed the hedge fund community and allow for exaggerated positions. You leverage your positions, borrow money inexpensively, and make as much as you can as fast as you can. When currency swings start to move in a disorderly way, the risk of financial market accidents increase. And that’s what we’re really talking about is— I love the way that Christopher Blattman described conflict last week. Take that picture of the plane flying in the open skies.

Kevin: Right.

David: Yes—

Kevin: Not a care in the world.

David: —a potential pilot error.

Kevin: Right.

David: But as soon as you’re in the valley, as soon as you’re in the canyon, anything bad happens, there’s nothing that you can do about it.

Kevin: From a dead response.

David: That’s exactly what happened. That’s exactly what happened with the RAV4 and the semi. You’re in a pinched canyon, literally stone walls going up on either side, could not go anywhere. I don’t know what happened. It was a super windy day. I have no idea what happened, but the potential for accidents when currency swings start to move, that’s when the financial markets and leveraged players are in a really difficult spot.

Kevin: Well, you brought up Christopher Blattman, and we were talking about war and the options that you have with war. Isn’t it interesting that you have Poland and Bulgaria refusing to pay for natural resources, or gas, basically, in rubles. That’s going to end up costing them a lot of money, but that is a war decision. Isn’t it?

David: That’s a part of the reason why the euro is at a five year low. So you look at the trade, the decisionmaking and Gazprom suspending supplies of gas to Poland and Bulgaria last week because they refused to pay in rubles. And so they know that paying in rubles props up the currency, and if it props up the currency, it props up the regime. So I appreciate— Look, the Polish and the Bulgarian governments have basically said, “We’re willing to pay higher gas prices, consequently, rather than continue to fund the regime.” Right? So think about that. So far, the Germans have said, “We’ll consider it, but not yet, but not yet.” And the Poles and the Bulgarians have said—

Kevin: Now.

David: — “It’s necessary” —

Kevin: Now.

David: — “We’re not going to do it.” And prices rose 17 to 20% as soon as the Russians said, “Fine, we’re shutting off gas to you if you’re not paying in rubles.”

Kevin: Okay. So that pushed the euro down. But look at the yen. The yen is just— It’s decimated.

David: It’s at levels I haven’t seen since I sat in the office of a Japanese industrialist 22 years ago, and listened to him exploring ways to sidestep yen devaluation. His compensation was in yen. And here he was at his office in Southern California. And again, at the time the yen was between 120 and 125. We’re worse than that now by, I don’t know, 8%, 10%. But in the 22-year period of yen strengthening, and then now weakening all over again. What I think is really interesting is that gold did not sit idly by. It’s up over 500%.

Kevin: Well, and yen?

David: To look at the yen’s devaluation vis-à-vis gold over the last 22 years is absolutely stunning. The yen in gold terms is down 88% since I sat in that man’s office. It’s a catastrophe. And these are the guys, Bank of Japan. These are the innovators of quantitative easing. They’re the ones who said, “it can be done and there’s no consequence,” right? And now the rest of the world has said, “it can be done and there will be no consequence.” And now we’re talking about, this week, raising interest rates 50 to 75 basis points, beginning the process of reducing our balance sheet by $95 billion a month—which is probably not going to happen. But this is the reality. We can do it without consequence. Right?

Kevin: You see. You just see the impact of currency moves. I’m just thinking back to an investment that I made at the wrong time. I bought a company called Durban Deep, and that was when the rand, the South African rand doubled relative to the dollar. So the workers were having to be paid in rand and the gold was being sold in dollars. Well, it just totally upended them, but it was all based, almost all of it was based on currency.

David: Currency rude awakening. You remember the name of the company? It was actually Durban Roodepoort. Durban Roodepoort Deep.

Kevin: Did you lose anything on that, or was it just me?

David: Well, it is in my journal of shame. I have one painting in our living room that— Yeah. I didn’t have any cash at the time. And Mary Catherine and I were in Santa Fe and we saw this painting. We’re like, “That’s beautiful. We could grow old looking at that.” And so I sold some shares of Durban Deep, Durban Roodepoort. Rude awakening Deep. And we bought that painting. And that’s the only thing good that ever came out of a deep, deep South Africa.

Kevin: I don’t think we talked about this, but I had enough in there to buy a new car. And then when it went down, I had enough to buy a bike for my son, because he was a biker, but I sold my Durban Deep to buy a bike. But okay. So let’s shift here for a second, though.

David: Well, I just want to say one comment because this is like battle scars, if we want to like share all here.

Kevin: Yeah.

David: We were exchanging some war stories in our Monday meeting, the MWM.

Kevin: You and Doug and— Yeah.

David: Yeah. And the reality is that the hedge fund community looks and says that we’re moving into an inflation, we want some gold exposure, but these guys are so amped up on leverage and high growth, bullion is far less interesting to them than mining shares. So in a particular period of time where you have an unwind of leverage in the financial markets, gold can do very well. And gold shares do not have to do very well because you’ve got weak hands. The weak hands, you think, “Well, how can the hedge funds be weak hands?” Because they’re leveraged. They’re borrowing other people’s money to make high growth bets. And if they have to unwind for any reason—say, for instance, currency evaluation changes. Yeah. Now they’ve got to unwind. 

So knowing what hedge funds own is important, and that’s not a good thing. Hedge funds own a bunch of gold shares. So there is downside. Do I think that’s a terminal scenario? No. It just means that there are scenarios where you can expect to see downside volatility, even though the fundamental case has never been stronger. So you have to decide how you engage. It’s definitely not a space for the faint of heart.

Kevin: Well, and you have to think about the unintended consequences, like what we were talking about, the rand going up and the dollar going down relative to the rand, who pays who and what. Think about China right now. If Japan is plummeting at this point, what does China do? Do they have to devalue their currency?

David: Well, that’s why I mentioned, I want to talk about the yen a little bit, because at the Energy Conference I spoke at on Amelia Island a few weeks back. And I noted that the RMB was the currency to key off of. And the yen’s decline is a reflection of the Bank of Japan’s decision to keep the 10-year Japanese Government Bond, JGBs, at a 25 basis point yield, quarter of a percent. They’re like, “No, we’re not letting it move.”

Kevin: So they’ll throw the currency away to keep the interest rate low?

David: Exactly. And so the currency is the sacrificial lamb. Of course, it has been for a long time because QE is not something that’s new to them. A permanent fixture in central banking as far as the Japanese are concerned. But now this commitment to keep Japanese government bond yields, the 10-year bond yields at 25 basis points, it is causing a cascade lower in the yen. So as for their goal of suppressing rates, they are succeeding.

Kevin: Well, and that makes the goods that they manufacture cheaper. So the manufacturers don’t mind this one little bit.

David: Right. If the yen is devaluing, the costs of goods and services for the consumer may go up, but for the producer, you’ve got this interesting value proposition for the rest of the world, which is, we can produce and sell to you things at a price that other people can’t. So buy in yen instead of any other currency. 

So the Japanese manufacturers benefit cheaper exports coming at a time when— This is what’s really interesting to me. It’s coming at a time when the Germans are reconsidering the extent of their economic ties and dependencies on China. They’re having to reappraise everything after they’ve looked at their energy dependency with Russia. 

But this gets super interesting. Reuters covered the visit of Olaf Scholz to Tokyo, right? Scholz said, “It’s no coincidence that my first trip as chancellor to this region has led here, to Tokyo.” Just pause for a minute and think about it. Germany is in a bind. If they thought dependent relationships with Russia were a challenge to navigate, try dependent relationships with China. Germany is China’s largest European trade partner. Germany sells a lot of product to China, that China then turns around and uses for manufacturing. Who makes better manufacturing equipment and hardware than the Germans?

Kevin: Boy, and they didn’t see this coming. They’re trying to get rid of the Russian porcupine at this point, and they can’t tell me they didn’t see this coming.

David: Yeah. My dad always references things like that. He’s like, “Oh, that’s a tough one. Yeah. You got to be careful how you embrace a porcupine, and really how you unembrace.”

Kevin: This is the Russian porcupine.

David: That’s right. So Berlin is scrambling to unembrace the Russian energy porcupine. And then you’ve got, according to Bloomberg last week, now they’re reevaluating their economic and political ties to China. 

So currency values over time, have a way of reorienting economic decisions by companies and by countries as products become more compelling from a cost standpoint. So competitive devaluations are a means of keeping your products moving, keep market share, maintain it, or even expand it. 

And so you and I as investors may look at a chart of the yen and think, “Oh, that’s a problem. Somebody’s losing money.” The Germans see it as an opportunity. They may force the hand of the People’s Bank of China here, because, again, think of the dominoes that fall. As the yen declines, now the Chinese products are less affordable. To maintain affordability, to maintain market share or even expand market share, the RMB has to give.

Kevin: Its competitive currency devaluation. It’s a form of war.

David: You can see inklings of it with the Korean won; the Singaporean dollar under a little pressure too. But it’s the RMB which is the key. It’s down nearly 4% year to date, and it’s accelerating. It’s accelerating. And that, again, this acceleration factor is also worth keeping in mind. Will they devalue further? 

Look, we had the 2015 RMB devaluation which caused close to a trillion dollars in capital flight out of China. People were like, “We gotta get out of here.” And it caused Beijing to redouble their efforts in terms of capital controls, limits, and monitoring who’s moving out what, and for what reasons. 

Kevin: So if the Japanese don’t change course—

David: —then the Chinese will devalue. Right? The Chinese will devalue if the Japanese don’t change course. And then there are the considerations of capital controls within China. And as we heard from the Chinese this week—this is a Financial Times article. A fresh exploration by the Chinese government as to how to insulate Chinese assets, specifically Chinese Bank assets from sanctions is, they’re looking and saying, “Yeah. This is pretty powerful tool that the US and the west have used against Russia.” So very interesting Financial Times article on that topic.

We are in tumultuous waters. So, look, you get the RMB decline. It’s already in motion. Clearly not to the degree that the yen is, but that’s where, if the yen decline continues, the RMB and the People’s Bank of China, their hand is forced. Capital controls—read the Financial Times article on fortifying bank assets ahead of sanctions. I think that’s a key to keep in the back of your mind. Everyone else is processing it in a position of policymaking and decision making. You should be processing it, too.

Kevin: One of the guests that we’ve had on the Commentary a few times, you go out to New York to his conference on a regular basis, Jim grant. We were talking, you and I, last night over a Talisker.

David: It’s good to be back.

Kevin: I’m so happy that we—

David: Table 30.

Kevin: Yeah.

David: You got to love table 30.

Kevin: But we were talking about Jim Grant’s latest newsletter and he brought something up that was just astounding to me. The Federal Reserve has lost half a trillion dollars—

David: Since the beginning of the year?

Kevin: —because of the interest rate move.

David: Since the beginning of the year, $500 billion?

Kevin: Does it matter to them though? Do they have to account for that?

David: No. For the Fed, the math does not need to add up. And a part of that is this mark to market, that’s a rule for common folk. It’s not a rule that applies for those managing the affairs of the central bank. So Jim grant reminds us that few would choose to navigate a bear market with eight and a half trillions worth of fixed income assets leveraged 217 to one.

Kevin: Wow, that’s a lot of leverage.

David: But the Federal Reserve’s not like the rest of us. Its rules are not our rules. Its ways are not our ways. Grant says that the Bank of Powell suffered a $500 billion loss in the first quarter, swamping its $41 billion stub of capital. And he’s drawing that insight from the chief economist, Bill Nelson, who is currently at the Bank Policy Institute. But he was the former deputy director—this is great—of the Division of Monetary Affairs at the Federal Reserve Board.

Kevin: So he would know?

David: Yeah. And this is sort of a back-of-the-envelope estimate on realized losses on the Fed’s securities portfolio—half a trillion dollars. So it’s the beginning of the year. The gain and interest rates in Q1, the first quarter, that’s what’s to blame, of course, but what’s particularly shocking is the speed coupled with the severity and the decline of value. Because we had, at the end of 2021, that same securities portfolio had a $128 billion gain. So how do you go from December 31st, $128 billion gain, to within a matter of 90 days swinging to a $500 billion loss?

Kevin: You used the word disorderly. You use the word disorderly. We see that in interest rates as well.

David: Leverage works that way as a force multiplier. Right? So while the Fed’s loss, it’s a nice cocktail party curiosity. Oh what’s half a trillion dollars here to you or to me? But we live, the domain of mark-to-market is of greater immediate consequence. Because now you’ve got fund managers, you’ve got hedge funds, you’ve got mutual funds, you’ve got ETF administrators, you have a debt-laden system at the front edge of adjustments into higher interest rates, which are going to test the thresholds of loss tolerance.

Kevin: Well, and your point—

David: Which are going to test the thresholds of portfolio paying.

Kevin: Yeah. But your point is just running around my head that inflation back in the ’70s was a US phenomenon. It’s global now. And so what we’re talking about is we’re talking about China reacting to Japan, Germany reacting to Russia and then to China.

David: So we’re all in inflation right now. And everyone’s in agreement that the supply chain issues that we experienced as a result of Covid are now here with us for at least another year, right? Because now we have Covid shutdowns in Beijing and Shenzhen—

Kevin: And Shanghai.

David: —and Shanghai. I should say Shanghai and Shenzhen and potentially Beijing. So these are very important to keep in mind in terms of it’s ongoing.

Kevin: The inflation is global, right?

David: It’s global. And that is such a critical concept. If you can just close your eyes and imagine an inflation which was affecting 200, 250 million people.

Kevin: Yeah.

David: Right? So that defined gold moving from 35 to 875. Now you have an inflation affecting, I don’t know, 8 billion people. And we’re well below the inflation-adjusted numbers for gold even at these levels. So where do we go from here? You’ve got global inflation that continues to pressure global interest rates to higher levels. And this is why we will continue to see that tolerance, the pain tolerance, the pain thresholds tested, and the resilience will find out in terms of portfolio construction. 

But the quality of the balance sheet now becomes a lot more obvious in the context of global inflation increasing and higher rates beginning to just reveal things. Eurozone inflation for the month of April hit 7½%. Okay. That’s the eurozone. Germany—the inflation hawks of all inflation hawks, the folks that care more than anybody about inflation getting out of control—German inflation for the month of April was 7.8%.

Kevin: Déjà vu. They’ve gone through a number of inflations in the last a hundred years. Déjà vu.

David: And they don’t even have Havenstein at the helm. Yields are rising in all quarters of the government bond market. And as the Federal Reserve has demonstrated, that quickly erases gains. Right? Was 128 billion in gains to 500 billion in losses. So it erases gains and then multiplies fixed income portfolio losses. You can take comfort that it’s only our central bank with the Lehman levels of leverage, actually. Well, well beyond what Lehman had. Not all institutions can access that kind of buying power, that kind of leverage. 

But it’s worth keeping in mind that as banks have looked and said, “We’re not seeing a lot of demand for loans,” a lot of their money has gone into securities portfolios. Now imagine this, your local commercial bank, low leverage is 12:1, leverage 20:1 leverage, not uncommon in the commercial banking sector. Again, nowhere near 217:1. But still consequential if you’re talking about rising interest rates in a securities portfolio that is tied to those interest rates.

Kevin: Hedge funds have higher, too. Don’t they? You’ve got 12 to 20 times leverage in commercial banks. Hedge funds, how far do they go out?

David: 20 times, can be. 50 times, can be. There’s a way to structure products, custom bespoke financial products that allow you to create little micro bets.

Kevin: Like Long Term Capital Management?

David: Yeah. Well Long Term Capital Management comes to mind. Sure. They blew up—blowing up as a way of describing what happens when leverage and market pricing rapidly move against you. And certainly Archegos in the most recent iteration of high leverage—for a family office, not even a hedge fund. An ex-hedge fund manager with somewhere between 20 and 50 times leverage. That’s amazing.

Kevin: Yeah, but we’ve got the Fed.

David: That’s why people are willing to do it because they assume that the Fed is waiting in the wings to provide the resources to smooth things over. But keep in mind the entity which is supposed to be there with the resources to help you smooth things over is hemorrhaging themselves.

Kevin: Right. $500 billion loss in one quarter.

David: Yeah. Divide 500 by their total capital base of 40. And they lost a multiple of their capital base. And they still have a lot to give up. Particularly if interest rates normalize towards what a Ken Rogoff or Larry Summers would suggest would be a normal fed funds rate of say 5%. There’s a long way to go from here to there. And that is a very painful road in terms of interest rate normalization. 

So then of course we see what real determination costs in the world of fixed income assets, right? Central bank smoothing operations. We go back to Japan. Central banks can do whatever they want. The Japanese are the case in point. And truly their assets—they don’t have to be marked to market. So you say, “Well, who cares if the Fed loses $500 billion? Who cares what the Bank of Japan loses? It doesn’t matter.” Right? Because they don’t have to mark to market in the same way that Archegos did or that we do—yet. And I think this is the key point. When excess liquidity is deployed by the central banks, there’s good evidence that the currency will be a mark-to-market revealer.

Kevin: Right. And we’re the ones who pay that price because it comes in the form of devalued currency. It comes in the form of inflation, and now it’s global.

David: Yeah. So save Long Term Capital Management, save a host of hedge funds, save the commercial banks, save everybody. And you’re not doing it from a very good footing if you’re at 217 times leverage and you’ve got eight and a half trillion dollars in assets on your balance sheet and they’re losing value at the most rapid pace they have. And I don’t know. I don’t know when you’ve had this much interest rate— you’d have to go back to 1994 for this kind of interest rate volatility. But they’re the ones who can save everything—and will, if required to. 

And again, remember excess liquidity, when it’s deployed, there’s good evidence that it was too much when the currency starts to, on a mark-to-market basis, reveal the truth. You’ve got that in the yen right now. In this case, the yen is hitting a multi-decade low, more than 131:1 compared to the US dollar. Need I say it? Gold in yen terms is pressing to new highs. For the Japanese investor, gold’s not been a bad place to be. But maybe this is instructive. Maybe this is instructive for those who look at the Fed’s balance sheet and wonder how sustainable it is. This week is a good week to wonder about such things.

Kevin: Because we’ve got an interest rate increase coming. What’s built into the system? What’s already baked into the cake?

David: This week, the commitment to raise rates— I don’t think they can back away from at least 50 basis points. The consideration is up to 75. Fifty is the easy. Fifty is a given, but the speed and ferocity of reducing a mammoth-size presence in the fixed income markets—that is, shrinking the balance sheet—that’s what they’ll probably tinker with. And again, the language about how fast or how soon or how they’ll modulate that, expectations of pacing for the balance sheet shrinkage ahead, that’s going to be critical to keeping the markets from melting down. 

While the Fed need not worry for its own solvency, you and I have to. Others have to worry about their solvency. We get mark-to-market every day. And we lack the flexibility to print ad infinitum and they’ve got that going for them too. We plebes operate with a different set of rules. And so, with rising rates and the stag inflation, I think these are things we have to pay attention to.

Kevin: Yeah. The thing that we have to really look at is, okay, the financial markets have grown accustomed to the Fed. And I know Robert asked me not to sing, but they’ve grown accustomed to the Fed, and now they’re starting to realize the Fed can’t do it.

David: I actually know that song.

Kevin: Do you know it? Did you sing that to your wife at some point?

David: No.

Kevin: No.

David: No. But I do know it.

Kevin: Oh, okay.

David: And do you know that when I finished the conference at Amelia Island, went back to Jacksonville, Florida and was going to spend the night at a hotel airport on my way out. And The Who was playing a concert in Jacksonville.

Kevin: The Who. Who? Who?

David: It was unbelievable.

Kevin: Yeah.

David: Yes.

Kevin: And you went?

David: Of course I did.

Kevin: You sent me pictures, of course sent pictures. You said name that tune.

David: Oh, it was fantastic.

Kevin: Yeah.

David: I’m not going to sing a Who song for anybody. Yeah. No, there is a pickle in the financial system because everyone’s grown accustomed to an expansion of credit and hasn’t developed much know-how for navigating credit shrinkage. We know what to do as long as credit keeps on expanding. What’s the know-how? How do you invest when actually credit is shrinking?

Kevin: How do you adapt when the RAV hits the semi or vice versa?

David: How do you survive?

Kevin: Right.

David: The markets have come to view as normal this 40-year super cycle bull market. And it’s positively impacted every asset. It’s been influenced by easy money. It’s been influenced by loose credit. So to tighten now, which is what this week is the kickoff to— To tighten is to grind the gears of this machine. It’s like forcing a reversal of forward movement. Try it sometime. You’re cruising along and you go from fifth gear, right? Just cruising it along the highway at 70 miles an hour and you slam it into reverse. See what happens to the transmission. Bringing in a real tightening measure may be like that, throwing the gears from forward motion to reverse. It may well be—may be witness to the same kind of an accident—when the semi, he hits the RAV4.

Kevin: You’ve been listening to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany. You can find us at, And you can call us at (800) 525-9556.

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

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