In PodCasts
  • Turkish Central Bank Head gets pink slip & Lira collapses
  • Putin challenges Biden to a debate – White House says he’s busy
  • Bubbles Everywhere, $1.9 trillion in penny stock transactions last month


The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Necessary Discipline In Central Banking Will Get You Fired
March 23, 2021

“Gradually what we’re seeing is credibility called into question and central banks will do what they have to do unless they’re muzzled. When the system has been abused, the currency has been abused, budget deficits have been abused, the hard road is regaining credibility. One of the tests that we have over the next 12, 18, 24 months is to see if in fact central banks can remain independent from the political pressure that we’ve brought on them as they are forced to respond to market realities.” — David McAlvany

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

David, I know that Thanksgiving normally is in November, but why don’t we talk Turkey here in March? Because what we’re seeing— and we talk about perception management an awful lot, and the central banks sort of being caught in the corner between controlling inflation and trying to do it without scaring people.

David: Erdogan’s been in a tight spot as he’s seen the Turkish lira in decline, and there was a change of power last year. Naci Ağbal was brought in, appointed central bank governor in the fourth quarter. And sure enough, this is a guy who not only talked tough, but actually acted tough too, and—

Kevin: A little bit like Volcker did back in the early ’80s, he was raising the stakes.

David: Exactly. He was raising rates to tame inflation. And the reality is central bankers who raise rates, they’re not popular. Yes, it buffers inflation. Yes, it stabilizes a currency, but it’s not politically popular. It’s not a fun experience for the public, nor is it fun for the politicians who are beholden to the public. So the more democratic the place is, the harder it is to deal with. So—

Kevin: Well, do you remember? We had a guest one time who worked for Reagan in the economic side of things, and they hated Volcker because when Reagan came in Volcker was raising rates and trying to keep the dollar from failing. I would imagine Erdogan has absolutely no patience for something like that.

David: And so this weekend he fired the central bank president, and sure enough, the Turkish lira went into free fall. It was precisely what we said on Friday of last week in our Hard Asset Insights. You either have central bank discipline, as we had in Turkey, or you have bond market discipline, what we would refer to as the bond market vigilantes, who are bringing about a discipline of sorts into the bond market, raising rates. And if those disciplines are abandoned or if there’s control introduced into the equation to suppress rates, the foreign exchange markets show it very obviously. And so the Turkish lira literally went to hell over the last three days. Now it’s not the only thing that has suffered because the credit markets in Turkey have also shown that stress. Five-year credit default swaps jumped 155 basis points, the most ever, to 460 basis points total—

Kevin: Which is sort of— that’s the cost of insurance of something going wrong, right?

David: That’s right. So, first thing this week in our asset management conversation, it’s where do we see stress? Well guess who holds a lot of Turkish paper? European Bank. So European Bank suffered a lot more earlier this week than any other financial institution, and it’s because of their Turkish exposure. Turkey has a lot of dollar-denominated debt. So as the Turkish lira declines, the hurdle to pay back that dollar-denominated debt or euro-denominated debt is that much harder. So that’s why you see movement in the credit default swaps, an increase in the likelihood of default is there. And again, this all comes back to what we talked about last week in Hard Asset Insights, that this discipline is really key and the signal you’re getting in the US Treasury market has been very key. And if you shut up the bond market signaling, and start suppressing rates aggressively, then all of a sudden it’s going to show up someplace. Turkish lira today, US dollar tomorrow.

Kevin: Well, one of the things that we’ve noted over the last few years is the ability of central banks to sort of coordinate with each other has been critical during this period of time since the global financial crisis. Now, what we’re seeing is we’re starting to see cracks. Granted, a lot of Americans might say, “Well, what does Turkey have to do with me? Or what does New Zealand?” We’re going to talk about New Zealand here in a little bit, but the coordination is starting to break down.

David: Well, and Turkey has been particularly on my mind because my wife, we had a little throw down, okay. Not an argument, but a challenge. She thought, “Well, if you’re disciplined in training for an Ironman, you could never do what I do.” She dances probably five times a week or whatever. She says, “I would do a half Ironman if you will take three dance classes a week for five months.”

Kevin: Oh, that was the wrong thing for her to throw down to you because you always take a challenge.

David: And of course I’m like flitting through my mind, how can I fit into a tutu? And it doesn’t have to be that, right? 

Kevin: Bad picture.

David: I mean, now it may be hip hop and break dance or learning swing dance with my daughter and—

Kevin: What’s that got to do with Turkey? I’m not following.

David: Yeah. Well, it does have to do a Turkey because she’s already made the list. This is the way a planner operates. This was a month and a half ago, she presents me over the weekend with a list of potential races around the world because they could all be potential—

Kevin: And there’s one in Turkey.

David: And there’s one in Turkey. And she says, “I like it. It’s an open water swim that I think I can do. It’s a completely flat course.” And lo and behold, I’ve talked to some people who’ve done upwards of a 100 Ironmans before, the half- and full-distance, Turkey is one of their favorite places. So last couple of days—

Kevin: You’ve got to go.

David: Well, you know what I’m thinking? I’m thinking the Turkish lira is going to hell. The whole trip’s going to be pretty inexpensive by the time we—

Kevin: Okay. So, all right, going back to what we’re talking about, because not only do we have— We’re sensing weakness in this whole game that the central banks have been playing and it’s showing up in the form of inflation, it’s showing up in the form of interest rates rising, but even political weakness. Look at Putin. He’s making comments right now that are exposing things that we’re all trying to act like we don’t see.

David: Well, and it’s not just between Biden and Putin this week. If you think about the weekends, we wrapped up the meeting in Alaska between the Chinese and the US. There’s all sorts of shaming and chest pounding, and who’s going to be in charge, and you’re in no position to demonstrate leadership in this or that area. And it was really interesting, contentious all the way through. They didn’t resolve anything from a trade standpoint, zero progress made in terms of— and our new envoy is basically saying the US is back, and the Chinese are saying—

Kevin: Wait a second, where is the strength in our diplomacy?

David: What are you talking about?

Kevin: Isn’t that what we were hearing?

David: And then you’ve got Biden stumbling up the stairs on Air Force One. And I always love The Babylon Bee. They come up with these classic parodies. Yeah, they’re parodies. But this week’s news headline, “Putin challenges Biden to a stair climbing contest.” And of course there was—

Kevin: Yeah. But Putin actually did challenge him to a debate.

David: He did. And that, I think the White House responded that, “the US is hopeful that we can continue to have a productive relationship with Russia,” that was the quote from the White House. And that came right after the White House—not the White House generally, but Biden in particular—was calling Putin a killer. So yeah, I mean—

Kevin: That isn’t a way to start a healthy conversation.

David: Diplomacy of the highest and cleanest form and fashion. Yeah, so Putin, in response, challenges Biden to a debate. And I think he challenges him to a debate because he knows he’s not going to be that hard to beat. Of course, the White House responded that Biden has a quite busy schedule and couldn’t do something like that.

Kevin: No, he’s very, very busy. Well, I’m going to shift to the bond market because things are reversing. The thing that we’ve been scratching our heads on, and actually, Dave, really since we were teenagers, or even earlier, we’ve been in a rising bond market bowl. I mean, interest rates keep falling and bond prices keep going up, but the great bond guys, Bill Gross and Jim Grant, and the guys who watch the interest rate markets, they’re saying, it’s got to reverse at some point. Well, could it be happening now?

David: It’s fascinating watching the investment grade bond market. You have investors who are starved of income and they’ll go anywhere they can get yield. And you look at pension funds and insurance companies, and they’re basically in the same boat. They have liabilities and they’re trying to match up their liability structure, the outgoing money with the incoming cash flows. So they’re not really as concerned with credit quality. We’ve actually seen junk bonds perform the best this year, with investment grade bonds sort of the next best. LQD, the investment grade bond ETF, it’s down about 6.2% year-to-date, which is a remarkable feat when the inflows have continued to surge like an incoming set of waves. Last week, there was $5.4 billion that came in. So, sort of rushing in, rushing out, but LQD has been really quite a spectacle this year. 

But listen, at over a 6% loss, this is about half the loss it experienced in 1980, when the CPI, the consumer price index, hit 14%. Of course, helpful there, insight from Grant’s Interest Rate Observer. The real damage in the bond market this year has been in any area where you’ve got an extended maturity. Your longer-dated US Treasurys are now down 22%. I mean, think about that. In one sentence, US Treasury is down 22%—

Kevin: Well, and those are normally treated as the safety hedge. It’s the one thing that doesn’t go down.

David: Yes. And so some people are beginning to describe that as a bear market, you cross the 20% threshold people start getting nervous. Is this a secular change? As we mentioned last year, that was Ray Dalio’s suggestion: possibly after 40 years, we’re finally seeing a new secular bear in bonds.

Kevin: Dave, I’ve got my 40-year reunion. I graduated in 1981. That actually was when the bond market bottomed out and started rising and interest rates topped out and started falling.

David: Yeah, 1981 to 1921. US Treasurys maturing in 2050, go out on the horizon a little bit, they priced last year just a tad under 100. And they were yielding just under 1.3%, 1.279. They’re now resting very uncomfortably near 75, the price, that is, and so a pretty significant loss in your long bonds. And I think really, if you’re going to see a continuation of that trend downward, it depends largely on inflation.

Kevin: One of the things that’s kept interest rates low, though, is the unlimited buying power of the Fed and the government just being able to come in and buy these bonds. It doesn’t seem to be having the effect that they want.

David: Yeah. I mean, a new age of inflation will erase more value still in Treasury bonds, and frankly for any fixed income with those longer dated maturities coming due way out there on the horizon. It’s remarkable to think of this sort of decline with, think about this, while the Fed is buying $80 billion in Treasurys each month—

Kevin: They’re a guaranteed customer. $80 billion? Of course it’s more than that when you add, what? Mortgage backed securities?

David: So you understand why yield curve control is a potential option for them, maybe necessary, because they’re already putting $80 billion into the Treasury market monthly, and it’s down 22% over the last year. 120, right? 120 billion is the monthly number if you’re including mortgage backed securities.

Kevin: Do you remember when interest rates actually exceeded inflation, or GDP? The idea was to have interest rates exceed GDP by a small amount. We’re not close.

David: Right. Well, where would interest rates be? I mean, we’ve talked about SPACs and blank check companies. What would prices look like in the Treasury market without a blank check from the Fed? And that’s essentially— I mean, they’ll spend whatever it takes. Jim Grant recalls that the old rule of thumb when you’re thinking of interest rates and GDP, rates would sit near the nominal GDP figure. So—

Kevin: So what’s the GDP right now?

David: Moving towards 7%. Now that’s temporary, in my view. We know that there’s a lot of pent up demand from 2020’s consumption hiatus related to COVID. So you’re going to see a pop from the low single digits to— The estimates were three, three and a half, now they’re as high as eight with the solid estimates between six to seven.

Kevin: So even if they’re three, three and a half, we’re not getting that kind of interest right now.

David: No, the 10-year interest rate is still 1.65. And what Bloomberg is observing in an article last week is that the gap between the 10-year Treasury and GDP estimates is now the largest since 1966. The Grant’s rule of thumb, that rates should be roughly where GDP growth is, or where your nominal GDP figure is. Bloomberg would say, “Wow, we’re way off that mark.” Another rule of thumb is that interest rates should be about 2% higher than inflation. That’s another healthy rule of thumb, 2% higher—

Kevin: We’re nowhere close.

David: —than inflation. Yeah. The average return over inflation, if you go back to 1962, to be exact, the average return over inflation, so we’re talking about real return, has been about two and a quarter percent for your 10-year Treasury.

Kevin: Remember when you interviewed John Taylor? He says you should always have interest rates above the inflation rate.

David: Exactly. So it corresponds with Taylor’s prescription for Fed funds at around 2% over the inflation rate. And it’s an idea he first wrote about in 1993. We discussed it with him on the commentary, I don’t know if it was five years ago or whenever. But he was then, and always has been, an outspoken critic of loose monetary policy, specifically ad hoc policy. He likes rules. And so keeping rates too low in the period of 2003 to 2005 really got him frustrated. And he argued since then— that choice of keeping interest rates below sort of the 2% premium, but actually at a discount to where they should have been, that created the housing bubble. And so, I mean, looking at a more contemporary period, is it any surprise that, with rates kept near zero in the seven years following the global financial crisis, we have—we have an everything bubble.

Kevin: Well, we have another housing bubble, plus everything else. Everything else. This goes to a conversation that I had with a client this week, he listened to the Commentary and he called and he said, “What was it that you were talking about as far as blaming capitalism for something else? And it was just loose monetary policy.” That’s what it is. Blaming capitalism is a huge mistake. And that should be repeated every time on this Commentary because you’ve got people who are printing money freely and putting it into the economy and managing something, destroying price discovery, that has nothing to do with capitalism.

David: Yeah. The name was only going to be familiar to our listeners from 2008 and 2009, that time period, but Yanis Varoufakis was with the Greek central bank. And he’s an academic, somewhere between an anarchist and a Marxist by his own admission in his own description. But I listened to an interview with him the other day, and he was accurately describing the problems of capitalism, where it almost felt like a conversation with other friends of ours who would say, “No, capitalism today isn’t what capitalism used to be. There’s a lot of cronyism. There’s a lot of creditism, there’s a lot of one-sided benefits and it’s not really the environment that generations ago that was promoting entrepreneurship and risk-taking, but was a relatively even playing field. It’s not that at all anymore.”

Kevin: If you were to ask Mussolini, should he be alive still, he’d say, “Well, it’s fascism.” It’s capitalism tied in with corporatism, right?

David: That’s right. So fascism, the cleanest understanding of it, is the tie between big business and big government. Yeah. And there’s a whole host of things that are coming out right now about Google and the ties in with the Obama administration and just how helpful Google was for the Obama administration and how much of a monopoly they were allowed under the Obama administration. So we have a lot of things coming up in terms of regulation for big tech, but I think really what it’s going to be is government leveraging the opportunity to get in close and to get in bed with big tech, not just to shrink it back from the standpoint of antitrust—

Kevin: Well, how do you win an election unless you’ve got big tech?

David: And that really I think is the growing reality is that politics in the 21st century will require some private-public partnerships that—

Kevin: You scratch my back, I’ll scratch yours.

David: Yeah. And so what I was going to say with Yanis Varoufakis is, we’ve said before, misattribution of cause places free markets and the merits of capitalism on the chopping block. And likewise, if exceedingly low rates and excessive stimulation, if those are the actual cause of the current everything bubble, then where the Fed is going is very difficult. Difficult road ahead because you’re talking about reputation coming into question, which frankly, I mean, they’re not going to sit idly by and let that occur, but from their perspective, better an untrue telling of US monetary policy history than a loss of prestige, a loss of rock-star status, and with it, the power that they currently wield. So the unfortunate consequence, if there is a requiem here, it is for the final stages of capitalism. And again, Varoufakis would say we live in a post-capitalist world, I don’t disagree with that. We have other things that we can disagree about. But on that point I think he’s right.

Kevin: One of the things that casts a light, it’s an uncomfortable light, on what the central banks are trying to hide is the inflation that’s built into this everything bubble. Like housing prices, how come housing prices don’t show up in our own numbers? I’ve heard that we actually might start seeing that in New Zealand.

David: Yeah, well, we do have them show up, it’s just in a weird contraption. We kind of bend and twist statistics to fit what we need. So Owner Equivalent Rent is what we use, but there is at least one central bank that’s seen fit to shift their inflation calculation and include home prices in the equation. And yeah, it’s New Zealand. And the impact is significant. Last year’s home prices increased 14 and a half percent. So yeah, that’s going to show in their inflation numbers going forward, and they’re going to include the actual housing increase, again, as opposed to our Owner Equivalent Rent. The central bank of New Zealand is on that basis, assigning a max on loan-to-value ratios. I mean, it has real world implications in terms of a tightening in lending. Bank capital requirements, reining in on lending, and they’re seeing it as necessary because unless it’s factored into the inflation number, they’re not behaving with the proper macroprudential tools. That’s their language. What are they dealing with? It’s a real estate bubble that’s already reached dangerous levels. The average house price in New Zealand is 10 times the average household income.

Kevin: So even more than us.

David: Here in the US it’s 4.2 times household income, the average house is, and well above the affordability threshold described in Demographia’s International Housing Affordability report. The US is in what would be categorized as seriously unaffordable, and the Kiwis are in the last and final category of the severely unaffordable. But the New Zealand central bank has the sense to bring asset inflation, particularly in housing, but asset inflation into view when making monetary policy decisions.

Kevin: So they don’t necessarily pay attention to what the whole is saying, because wasn’t New Zealand one of the first central banks to start inflation targeting?

David: They were, going back to the ’90s. And so, looking and seeing what they’re doing now, as it relates to inflation, maybe they’ll set the trend where, because we’re forced to, we’ll become more sensitive to inflation. But again, it’s a credibility issue. If you say, “Look, it’s not raining,” and yet you’re standing there drenched and something is pouring in your head, you kind of look silly, standing out in the rain, just claiming, “Well, it’s not raining.” Well, claiming inflation doesn’t exist, except it does, and the FLMC, I mean like so many ostriches, I think they prefer to put their collective head in the sand and pretend otherwise. But the New Zealand decision is notable because of them setting the trend in the ’90s with inflation targeting, they’ve long been the innovators—for better or for worse, however you want to view them.

Kevin: Okay. So let’s just imagine for a second, because John Taylor, quality guy. Quality in that he wants to see rules for the Federal Reserve here in America. What if the Taylor rule were actually incorporated at this point? Let’s say we had a Volcker who came back in, somebody who didn’t care about the perception of the people, he was trying to actually save the monetary system.

David: Well, and I don’t know that the Taylor rule implies that we would necessarily have a Volcker, it just implies that we’re following rules instead of making it up as we go along. And the excuse has been, by the central bank, by the FMC, is that they’re “data dependent.” Well, they tend to look at the data they want to, ignore the rest, and so we go back to the Taylor rule or the rule of thumb we described a moment ago—

Kevin: Which is inflation being below the interest rates that are being paid on Treasurys.

David: Yeah, or said differently, just peg what you’re paying 2% above the inflation rate.

Kevin: There you go.

David: And yeah, you can begin to see how out-of-step our central bank is with reality. Rates should be significantly higher already, but that reality, of course, would burst virtually every bubble in play. So this is where you have the art of pragmatics still on display, right? Here in the US, and the curators at the Fed, they highlight only the relevant facts to maintain the narrative so there is no concern over inflation. And in the end, they’ll say in a very vague way, “We have adequate tools to address it should it present itself as a problem.” You’d have to call me a skeptic in that regard.

Kevin: Okay. So when I graduated 40 years ago, Volcker did come in and he was able to raise rates, but do you remember what our debt was? Our national debt at the time, it was $1 trillion. A trillion dollars. You can raise rates on what the government pays on debt when it’s a trillion dollars, when you’re what? 20, 29, $30 trillion, you can’t do that.

David: Well, and so my skeptical optics, they come not from sort of a disposition of skepticism, but from very simple observation of national debt and gross interest expense. The gross interest expense, the line item tallied last year, 2020, tallied to $576 billion.

Kevin: Which is not a lot because we have such low interest rates.

David: That’s right. 576 against gross federal debt of 26.94 trillion for 2020. That’s a modest amount of interest, all things considered. Raise rates by edict, or allow the market to dictate the course of interest expense affordability, and you have a budget crisis. And it starts as a budget crisis and then becomes a currency credibility crisis on a secondary basis. But neither of these is a welcome outcome. So you’ve got the interventionist ad hoc policy preferences from the Fed, and what they’re defending against is the cost of discovery, the cost of reality, being too high to bear. Interest expense, as we reach a trillion or a trillion and a half or $2 trillion, it doesn’t take much of a bump in interest rates for a line item that is manageable to become quite unmanageable and to start squeezing out the other important things that we have in our budget. So we have the Fed pretending that they have things well under control, and, as investors, we’re becoming accustomed to theatrics. We’re becoming accustomed to Potemkin-like assurances of interest rate realism. It couldn’t be farther from the truth.

Kevin: Well, okay. So how long can you maintain the illusion of no inflation though? Because interest rates are going to be directly tied to that when Dr. Copper walks into the room and Professor Oil also comes into the room, and look at the rising copper and oil here recently.

David: Well, exactly. You can measure inflation lots of different ways, and the academic will say, “What do you have? These are not important aspects of PCE or CPI. So let’s be clear on what we mean by inflation.” I want to say very clearly, remember this, don’t forget it. It’s expectations. That is the key when it comes to an acceleration of inflation trends. So the fact that copper is higher by a third since the fall. The fact that crude is up 80% since October, driving prices of paint and pipes and shingles and flooring that much higher. The Wall Street Journal on the 17th, so last week, had this to say. And this is my point, Kevin, this is my point. Expectations are key here. “Investors are watching all corners of the economy for signs of stimulus, driving a pick-up in inflation.”

Kevin: Well, and think about driving a pickup with crude up 80%. Okay. I mean, we live in Durango, everybody’s got a gigantic pickup, including you. Driving a pick-up in inflation has two meanings here.

David: Exactly. The Wall Street Journal concludes, “They’re finding it in housing where rising inputs are translating into higher costs for consumer goods. The National Association of Home Builders says that rising lumber prices have added $24,000 to the cost of the average single family going up—to the average single family home that’s being built—and about $9,000 for every apartment.” So again, remember, it’s expectations. That’s the key when it comes to an acceleration of the inflation trend.

Kevin: Okay. So let me ask. Because you said at the end of March there’s going to be a surprise in the banking system, because the banks have been given sort of a gift here this last year with the leverage ratio extensions. And there’s been a lot of talk, and in my own gut I’ve thought, “They’ll just extend that. They extend everything.” But do you think they’re going to extend that?

David: Well, this ties to rates and where we’re at in our perception of inflation, because you’re dealing with a fairly large supply of Treasurys. The SLR stands for the supplementary leverage ratio—

Kevin: The gift—

David: —we talked about it four or five weeks ago. It’s not getting an extension at month-end. In essence, this requires a bank to have more capital compared to the assets. It’s their loans and investments that they carry. 

Robert McCauley, who was at the Federal Reserve Bank of New York, spent a bunch of time at the Bank for International Settlements, now he’s a professor at both Oxford and I think Harvard, a couple of schools. Anyways, interviewed in the Financial Times saying that the SLR relief was from a rule that capped assets to capital at 20 times. Again, when we talk about a bank’s assets, we’re talking about their loans and investments, okay? Compared to the actual capital of the institution. And so there was a cap at 20 times. That cap was removed. So the SLR relief is the removal of the cap.

Kevin: And the rules are now coming back. The rules are the rules, right?

David: Now remember, you thought there was low leverage in banking, right?

Kevin: 20 times.

David: 20 times. Bank profits tied to, of course, net interest margin—that made much more attractive by leverage. And 20X. Tell me that doesn’t help. What would your Robinhood investor do with 20 times leverage? Can you imagine that? The dreams of—

Kevin: They’d buy a company that’s been out of business for the last few years and run it right up to the trillions.

David: There you go. The exclusion was for banks buying Treasurys or any deposits that were then held directly with the Fed. These assets would not be counted in the asset category. So what this meant is: the relief that came a year ago implicitly increased bank leverage, right? A reversal at month-end requires an increase in bank capital. It’s a reduction of leverage, or another way you’d look at it is it requires them to liquidate Treasurys. The third alternative is they can remove the deposits that they hold at the Fed, but where’s that money going to go?

Kevin: Well, if they liquidate Treasurys, interest rates could rise. We already talked about how the government’s coming in and buying $80 billion a month in Treasurys already. What if the banks start selling Treasurys?

David: Right. So the SLR suspension in the March–April period of 2020, it propped up Treasurys. Theoretically, it was also there to provide credit to businesses and households. In practice, however, for the year, it was interesting to watch the trend in bank lending. Bank loan balances have declined 5% since May of 2020.

Kevin: Loan balances.

David: That’s right, the loan balances. And loan growth barely moved relative to the skyrocketing deposit growth, which is over 22%.

Kevin: Okay. So even though there’s a flood of liquidity right now, lending doesn’t seem like it’s doing anything.

David: No. No. So bankers I’ve spoken to describe the asset growth, the influx of deposits, as troubling. Because there’s not enough lending going on relative to the cash coming in the front door. And just kind of a timeout here. You remember one of the classic definitions of inflation is too much money chasing too few goods. And here you’ve got banks dealing with something quite similar. They’ve got too much money coming at them and they can’t place it. So the fact that it’s been going into excess reserves or depository institutions, held with the Fed or invested directly in Treasurys, what do you think of? More money than banks can handle? And yet the Fed is willing to say, “There is no inflation here. We’re not concerned about this,” when in fact they’re creating a really twisted dynamic within the banking system.

Kevin: Well, we’ve talked about it over and over. Dave, you brought up the fact why in the world would a bank bother to lend money to somebody when the government’s already just giving them money not to lend? That’s how they twisted this thing. You’re talking about twisting. Why would you take a risk when you can make money not taking a risk?

David: Right. So on the front end the Fed would say, “We need to keep the system liquid. We want loans to continue to flow, we don’t want the Treasury market to seize up.” But they’re not thinking of the unintended consequences. The change in rules a year ago actually set up a competition between Fed deposits and consumer lending. In the context of COVID, who on a lending committee at a bank wants to quantify credit risk—the ability to pay back a loan to a local business or individual—when you can leverage a Treasury return instead? So you’re dealing with incentives not being aligned. And it appears again, that system stability, bubble maintenance, these are the more important motivators for our central bank. Leaving incentives misaligned for the banks is fine. So now you introduce the unknowns, and this is kind of moving forward if you want to consider the Biden administration. Consider the unknowns of increasing corporate taxes, individual income taxes, which are now going to go down to $200,000 in annual income. It was a couple million, then it was $400,000, now it’s $200,000.

Kevin: So it’s no longer the fraction of 1%, now it’s a bigger percentage.

David: It’s everybody. But we’re off the campaign trail, so who cares? But you have further bank lending issues, that’s the deal. These are complicating factors for a lending committee to say, “Wait a minute. Now we’ve got to reassess the ability of a corporation or an individual to pay back, knowing that their means are going to be diminished in a future context. Let’s wait and see.” Bill King, often on the program, I read him every day, love his comments. He says this, this morning, “No matter how many trillions appear, the US economy is going nowhere unless banks start lending. Banks will be reluctant to lend as team Biden is hiking taxes, re-regulating, and implementing socialism.” That’s just the real world, folks.

Kevin: Okay. So let’s restate this. Last year, this SLR suspension allowed banks to take excess deposits to the Fed and earn interest on them without an impact on banking capital.

David: That’s right. So bank deposits at the Fed, they increased from 1.68 trillion at the end of February last year, 2020, to 2.68 trillion at the end of March. Just one month later, bumped by a trillion dollars. Now they sit at $3.65 trillion. Those reserves at the Fed represent an increase in deposits following the various iterations of fiscal stimulus. And the increase in customer deposits thus flowed through to reserves at the Fed, right? And now we’re talking about the banks needing to balance those figures, the trillions that they’ve placed at the Fed, they now have to count them as assets against their bank capital. Now, again, we’re returning on April fool’s day, some irony in that, to the 20 times capital SLR rule.

Kevin: Well, talking about irony, okay. The Titanic was made out of steel. And one of the things that you look at when you go back and look at history, many of the types of things, like Titanic, it seems like a number of events were just bad timing. Like the left hand wasn’t talking to the right hand. Now what we’re talking about here is that right now the government, even with buying $80 billion worth of Treasurys a month, is not keeping up with the need to borrow, and we’re not getting enough customers, and so basically interest rates are starting to rise. This seems, this new rule, this lack of extending the SLR relief, that seems like bad timing. It sounds like we’re steaming at a faster pace than any cruiser ever during a time of icebergs.

David: Was there an issue with the rivets being overheated in the process of putting that boat together? If I recall from history, it was either the steel or the rivets were overheated and the excessive heat lent them towards fragility.

Kevin: Yeah. Well, that’s something similar with Apollo 13. Remember when Apollo 13 went through what it did? That it had to do with some excessive heating two years before they ever flew.

David: Interesting. Well, inherently this pressures the Treasury market, and forces a contraction in lending to households and businesses. Or an alternative is that it forces banks to raise capital to maintain the appropriate leverage ratios. And it seems an odd time to be making this decision, given the pressure that already exists in the US Treasury market. I mean, in part, the bond market and the move that we’ve seen in the Treasurys to lower levels in price, higher levels in terms of the yield, maybe that’s in anticipation of this very eventuality. A spike in yields throughout the month.

Kevin: Okay. But what if the banks don’t have sufficient capital? What do they do next?

David: The question is— I mean, a lot of these big banks do have broker-dealers that are part of their financial universe and they may be able to stuff those Treasurys into money market funds and make them generally available to the public that way. Yeah. So if they don’t have sufficient capital, they’re not able to place those Treasury securities in various financial products at money markets, then there is a growing probability of a further negative impact in the Treasury market: rates continuing higher, prices moving lower. McCauley, the gentleman who had previously been at the Federal Reserve Bank of New York, he asked the question. The question then is, “Do the big bank holding companies have enough capital to back the $3.65 trillion in Fed deposits at the bank subsidiaries and sufficient broker dealer Treasurys to keep the bond market going?” And when he puts it that way, all of a sudden, Kevin, the $80 billion in monthly Treasury purchases seems small, not large, and who could have imagined that?

Kevin: Which sounds like a massive bailout. Okay. So let’s say that they look at this and it turns out to be the wrong thing. I mean, is there a possibility that they would change the way the banking system works and actually create a system where they don’t have to lend anymore?

David: Well, I mean, we are talking about gradual nationalization of the financial system, and it’s funny to see that happen in the same context of the kind of language that we talked about in India, and it’s coming this way, financial inclusion for all. But a change—

Kevin: Helping the under-banked, I love that phraseology.

David: Yeah. Nellie Liang, writing for the Brookings Institute, argued back in December that deposits with the Fed should permanently be excluded from bank capital ratios. So this would mean that you can have as much money as— We talked about state money versus bank money, and the inflationary nature of bank money. The bank money isn’t flowing, and this is a part of the reason bank money’s not flowing. Loans are not being made, but they’ve created an incentive structure where they’re not going to be made. And Nellie is now saying, “Look, if we have a problem with the Treasury market, we don’t have to have a problem with the Treasury market. We’ll just make a permanent exception and allow those deposits held with the Fed to be always excluded.”

Kevin: So take the motivation completely away from ever loaning another dollar if you’re a bank.

David: And maybe that’s the way we control inflation. But I’m pretty sure that flies in the face of commercial banks serving a social function. Again, what does a commercial bank do? Taking in deposits, lending out to individuals and businesses. And in essence, what Nellie is suggesting— In my view, it basically converts banks into fixed-income hedge funds, trading in excess reserves held at the Fed on a leveraged basis, right? Now, this idea that Nellie put together with the Brookings Institute, there’s a hairball in here. The hairball in the mix comes from Sherrod Brown and Elizabeth Warren. And they don’t want any accommodation for banks. They’re on the war path. Tomahawks, I think Elizabeth Warren has one, tomahawks bear—

Kevin: It’s 1/1000th of a tomahawk—

David: Whatever the case may be. But Elizabeth Warren and her tomahawk does not want to see any accommodation for banks as long as banks are paying out dividends. Yeah, returning capital “to shareholders.” Meanwhile, we’re days away from banks having to address the 365 problem. $3.65 trillion that is.

Kevin: So going back to a metaphor, Dave, that you’ve used for years, since the bailout of the global financial crisis back in 2008. You’ve had us imagine a dam holding back just a wall of money that really has not gotten into the system at this point. We may be starting to see that. There’s a point where that water isn’t— We’ve talked about the dam breaking. I don’t think the dam needs to break. It’s flowing over the top at this point and turning into inflation.

David: Ironically, Biden is thinking about helping America, right? And the next proposal is going to be between 2 and $4 trillion, Building Back Better. We already have the bailout for Main Street with the Biden bucks, 1400 bucks per person, part of the cost involved, and this is really my key point here. A part of the cost involved in this scheme is the dysfunction created by too much money in the banking system. And as we’ve just described, should that really come as a surprise?

Kevin: Okay. But if you create this much money, at some point it devalues the value of the money. I’ve been amazed actually seeing articles and things coming out saying we really need to sell our gold and just go ahead and just bite the bullet and realize that we’re in a new era and we should sell all of our gold and go into Bitcoin because Bitcoin will be the new gold. And if it’s not Bitcoin, it’s GameStop. And if it’s not GameStop, it’s a piece of digital art that’s selling for millions. When there’s a lot of money, people lose value. They don’t understand value equations and they start chasing things. We used tulip bulbs last week. Tulip bulbs, that’s a good example. We had one listener say, “Yes, but the internet didn’t exist the last time tulip bulbs went to the moon. What does that mean? Does that mean that they actually are more valuable now that we have the internet?

David: As the money flows, there’s bubbles everywhere. And for us to talk about a bubble a year ago, two years ago, on the basis of stock valuations or things like that, very reasonable. But Wall Street was generally ignoring it. Now, Main Street, Wall Street, and the mainstream media, including the New York Times, they would tend to agree. Writing last week, New York Times writes, “Penny stocks are booming. There were 1.9 trillion transactions in penny stocks last month, an increase of more than 2000% from a year ago.”

Kevin: 1.9 trillion transactions in penny stocks.

David: That’s fascinating, isn’t it? I mean, essentially what we’ve democratized is casino access. And here we thought fiscal stimulus was for the economy.

Kevin: It doesn’t matter what it is as long as it goes up.

David: How silly. Maybe what we’re talking about is a new version of the economy. Penny stocks are the economy. Really, I think what we’re saying is 21st century bread and circuses are available on your smartphone. And New York Times went on to comment, you’ve got $1.3 million spent for a Tom Brady trading card, the trillion dollar value of aggregate Bitcoins, the Beeple art collage for 69 million. They say this, “These seemingly singular events were all connected, part of a series of manias that have gripped the financial world. For months professionals and everyday investors have pushed up the price of stocks and real estate. Now the frenzy has spilled over into the riskiest and in some cases, wackiest assets, including digital ephemera.”

Kevin: You’re talking about irony, Dave, it’s ironic that we talk about all these values being dependent on digital access, yet last week you were talking about even semiconductors. They’re a real thing. They’re not a digital thing. You need a real thing for digital access—

David: And we don’t have the quantity that we need for the current—

Kevin: For the auto companies, right? You were talking about, you can’t even make a Ford truck right now without it.

David: Exactly. The concerns that we have over China and Taiwan are significant. Whether it’s a potential embargo, whether it’s China continuing to press what is their top priority. The consequence for us is if we continue to have limited supply of semiconductors, there’s a whole lot of things that we cannot do. There’s a whole lot of things that we cannot consume, and life as we know it in the digital era, dependent on so many little chips that come from Taiwan, that supply will continue to be impaired, as it is now.

Kevin: Those are real tokens, not non-fungible tokens. We were talking— Right? I mean, okay, so let’s go back to Turkey because cracks are showing up in the system and we’re starting to see the reaction to those cracks. It may be Turkey right now, it might be New Zealand. And so when does it show up worldwide?

David: Yeah, I mean, gradually what we’re seeing is credibility called into question, and central banks will do what they have to do unless they’re muzzled, unless they’re, in the case of Turkey, fired. Such a significant play this week to see the Turkish lira collapse as Ağbal is removed from office. He’s bringing credibility back to the Turkish lira and back to the Turkish economy, and it’s a hard road. It’s a very hard road. When the system has been abused, the currency has been abused, budget deficits have been abused, the hard road is regaining credibility.

Kevin: Discipline does not bring political success.

David: No, and that was the problem. Erdogan said, “You’re done.” Right? So we still fancy the idea of central bank independence. And I guess one of the tests that we have over the next 12, 18, 24 months is to see if in fact central banks can remain independent from the political pressure that we brought on them as they are forced to respond to market realities.

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 8005259556.

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.

Recent Posts

Start typing and press Enter to search