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QE or NOT QT? That is the Question
October 12, 2022

“We know that quantitative tightening is a temporary policy statement. It basically says, “We’re not buyers today. In fact, we’re selling.” The UK was scheduled to sell products this week, but because of market dysfunction, they were forced to reverse policy course and go back to buying. If they had not done so, we would already be in the throes of a global financial market panic. And this is where, again, if you look at asset inflation on a global basis, what it has revealed is just how interconnected the world of finance is.” — David McAlvany

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

Well, I thoroughly enjoyed the last few days, Dave, with our clients coming in for the McAlvany Wealth Management Conference. What really hit me as I was talking to these wonderful people—and they were enjoying each other, too, a lot of them had not met each other—what hit me was there really is a grand narrative, or there’s a theme, there’s a framework for thinking that when you share that with other people, it can become very rich if it’s based on truth.

David: We do this once a year, where the clients will gather here in Durango. In addition to that, we have our quarterly calls just exclusively for clients. And again, it’s a venue for exploring what our thinking is on the markets up to that point, and prospective ideas looking ahead. It’s also an opportunity for Q & A to occur. This is not a common thing for most asset management companies to do, but it is something that we feel is very important to be proactively communicating, and dissecting what is happening in the markets in real-time with our clients. Of course, we do have a framework for thinking about what is happening, and so that was a really great couple of days with clients. So glad that some of them could make it in. For those who couldn’t make it, of course, they’ve got access to the video archive. Unfortunately, it is a client-only video because we do talk about the unique things that we have in the portfolio. But a great job by Robert and Doug and Philip and Morgan, and very helpful insights, so—

Kevin: I was impressed just listening to the team talk. Each one knew their area really, really well. And for the listener who wants to go back and hear what Doug Noland had to say, he did publish word for word what he said in the meeting in the Credit Bubble Bulletin, at least the first part of it. So, that would be worth going into the Credit Bubble Bulletin and reading. 

Dave, we have limited time, I know we think based on the stacks of our books and what we just buy with one click at Amazon, we have this idea that we have the time to read all these different things. But one of the things through the years that I took the time, almost every day, to read, there were two things. If I could only read two things in the morning before talking to clients, I would read Bill King, the Bill King Report, and fortunately, thank you, Dave, for paying for the subscription for that for all of us, so we would get a chance to look at it. But Richard Russell, this was a man that going back even before World War II, he was looking at something called Dow theory, which went back another 40 or 50 years, back to Charles Dow.

David: It’s a healthy framework.

Kevin: It’s a framework. Yeah.

David: Yeah. He was a fan of Dow theory. I think when he encountered it, what it unlocked for him was an understanding of the markets that he didn’t have previously.

Kevin: Didn’t he start writing in the ’50s? And he picked up the baton from the person who was using that system before that?

David: Yep. Mid to late ’50s, he continued that discipline. Well past the year 2000 as a writer, almost on a daily basis. And he contributed to Barron’s early on, and found a mentor and a friend in Alan Abelson. And what he was continuing was the work of Charles Dow and the person who followed after him. I forget if it was Robert Rhea or Hamilton, I forget what order they came in, but it’s a tradition of analyzing trends in the market and they use a core model. What I loved about Russell is that he shared some of his journey through World War II. Through the trauma of flying in a bomber, being one of the few to survive, working his way through Freudian psychotherapy, motorcycle riding, collecting cacti, these different interesting personal pursuits. So, it wasn’t just sort of a dry look at the markets, but always fascinated by Dow theory. Charles Dow was the creator of the indices that we’re familiar with, the industrials, the transports, the utilities. And he was the earliest editor of the Wall Street Journal.

Kevin: Right, yeah. So, when we go back and we say, “Well, what’s the Dow Jones Industrial Average doing today?” That takes us back to 1896. It was Edward Jones and Charles Dow, and they just basically said, “Look, instead of having these mass of stocks, let’s go ahead and pick 12 that are likely to be around for the next couple of 100 years, and let’s start watching those.” 

The thing that I love too about Richard Russell, though— I don’t care much for people who have a framework and then they’re a slave to their framework. Richard Russell would, on a daily basis, he would have a discussion. If his framework told him that we were in a bear market, and he didn’t think so, he would argue with the framework, but he would still use the discipline of the framework. Remember the framework talked about 90% down days, and how when they start repeating, you’re probably going to have a panic sell-off.

David: Yeah. And a lot of these, again, comes from observations that Charles Dow originally had as he’s watching the tape and watching stocks trade literally on a ticker tape.

Kevin: And then it was time-tested after that. They just kept testing the theory.

David: Yep. So, the market event that Russell looked at, we actually had one last week, a 90% down day, where 90% of the total New York Stock Exchange volume for the day was negative. That’s a key indicator of pressure in the marketplace. So, to Russell, it spoke to a growing urge to get out. And usually, if it was in a series—so, again, multiple 90% down days in a short period of time—it precedes a significant market decline, what we would view as panic selling. So before the panic came the assertive march to the exits—Friday was a 90% down day for the New York Stock Exchange, 87% for Nasdaq. Multiples of those days, we should look out for them.

Kevin: Yeah. And Dave, you and I both know, if you don’t have a framework, especially in this day and age where it’s almost a hypnosis to turn the news on and watch the ticker, and everything is breaking news. Remember when everything became breaking news about two decades ago? It’s just sort of ridiculous. Used to be breaking news was something that was really important. But if we don’t have a framework, and daily we’re watching prices and making decisions basically on daily news, that’s erratic. I mean, talk about erratic markets, look at last week.

David: 2019, I remember being stuck on a treadmill sometime between 11 and two in the morning. I was training for my first marathon, and it’s just where I could find the time to train. And there’s three televisions on at the club. It’s open 24 hours a day. And so, you’ve got CNN, you’ve got Fox, I forget, maybe it was MSNBC, but it’s breaking news for three and a half hours, and it’s the same thing on a loop. I mean, is it breaking news three hours after? I mean, it’s just really interesting because what I loved most about that experience was all three were muted, and all three looked like silly theatrics. As long as you could take out the sound effects and all the things that they do to produce the show. But that’s exactly what it is, it’s a show. It’s for entertainment purposes. So, that breaking news and the sensationalism of it is—

Kevin: Could you imagine though? Seriously many people, that’s their investment strategy is to turn the news on and then go do something.

David: Right. Well talk about erratic markets, between Monday and Tuesday of last week, the S&P’s up 5.7%, and then it slides the rest of the week into an ugly Friday. Unstable to say the least. When we watch the UK, specifically the Bank of England, and their gilt intervention, bringing rates lower only to see them buoy higher once again a matter of days later. The pressures exist under the market’s glossy veneer, and in spite of the interventions, they’re moving back to problem levels. So pundits wanted to pin Friday’s movements on the jobs data. I’d say that’s coincidental, it’s not causal. There is a massive, latent instability, and frankly triggers within the marketplace are of secondary importance.

Kevin: Well, and triggers. So, that’s what we would call breaking news. Historians like to go back and say, “Well, this is why something happened.” But oftentimes you can look and see that, no, that’s not really why it happened. It was going to happen anyway. Look at what’s going on with tech stocks. I mean, last year we were talking about— Everybody was just buying the same names.

David: That’s right. And it didn’t matter who you were, an individual investor, mutual fund, hedge fund, almost everybody piled into the same names, and that goes back 12, 18 months at least. Big winners got the new allocations, and they kept winning big. And so a lot of that was big tech. Now, the big losers are seeing more concentrated selling. It’s not a surprise, in large part because they’re the stocks that are over-owned.

Kevin: So, Bill King at this point would say, “How’s that working out for you?”

David: Meta, what was Facebook previously, it peaked at 380, it now trades at 130. It’s a 65% decline. Note, we haven’t hit panic selling yet either. If you look at the other ones in the FAANG index, so Facebook, the original, 380 to 130; Amazon, 190 to 105, with more to give up as a universally held stock. Netflix, from 700 to 175.

Kevin: Wow, 700 to 175.

David: Now it’s sitting at 230, so it’s off the lows. Near 67% decline. Looks like, I don’t know, looks like Bitcoin. Alphabet, Google, it’s fared the best if you’re looking at current returns, from a split-adjusted $150 a share, it trades at 98 today, a mere 35% decline.

Kevin: Well, I wonder about PayPal. I’m going to probably not— Oh, maybe I shouldn’t mention the name, but I canceled my PayPal account last night when I found out that, whoops, a little bit of a slip. If—

David: They’re changing the policy. If they disagree with something that you were posting—

Kevin: They could take $2,500 out of my account. It’s connected to my banking account.

David: Right. Fascinating overreach. A fascinating overreach.

Kevin: For convenience.

David: I kind of wish they had set it in motion because they would’ve been slapped with so many lawsuits.

Kevin: Oh yeah. They came out and said, “Oh, we didn’t really mean it.” Well, it’s like, “Well, why was it said, then?” But okay, so let me ask you a question on all these tech stocks, or the stock market in general, how far do you think it’s going to go down? I mean, do you have any limits that you’re thinking of?

David: When we come back to CNBC and the news networks, Bloomberg, et cetera, they quote the indexes. And actually, some of the constituent parts of the indexes are far worse than the indexes themselves. Again, Facebook is a pretty popular stock to own, down 65%. And so, if somebody’s quoting the S&P at being off 20, 23, 24%, you might not feel so bad. If you do the math on your portfolio, you might actually have some grave concern. 

I think, in answer to your question, a revisit of the March 2020 lows is an easy guess for most of our large indices. Companies will be put through two versions of scrutiny. And so, beyond the index trades to the March 2020 lows. The two levels of scrutiny, one, how is this company going to fare in light of the global economy? What are its future prospects in the short run, given a slowing in demand on a global basis? And the second point of scrutiny will be, “Can I sell it? Is there a bid?”

Kevin: That’s important.

David: What can I recoup at this point? And this is, I think sort of the transition point. We’re very close to this. Return of capital displaces the desire for return on capital. And that’s of course, as selling picks up.

Kevin: Well, and when you have everybody buying the same things, then sentiment is really a critical driver because you could ask a lot of people, “Why did you buy Bitcoin? What does it do other than go up?” Well, they have found this year that it goes down, and many people had no other reason to buy it except for they saw their neighbors were buying it. It’s the same thing.

David: But there were articles of faith attached to it, and there’s always a reason given. Whether or not it’s justifiable is a secondary question.

Kevin: But sentiment drives things to excesses both on the up and the downside.

David: Both extremes. And that’s the nature of the markets. It’s critical to remember that stocks never find, never stay at fair value. For that matter, real estate, cryptocurrencies, or what have you. The ride is always from one valuation extreme to the other. And that’s why Smithers’ analysis is so important. You need to have some idea of where you’re at on your journey from one extreme to the other.

Kevin: That’s your framework.

David: So, we’re back to levels of overvaluation currently, right? So, we’ve had a decline in the markets, great. We’re back to levels of overvaluation seen in the year 2000 during the tech boom. We’re not as overvalued as we were 11 months ago. So, market commentators will claim that the current market is a reasonable choice, a reasonable value. Buy now. And relative to all-time highs in the rarefied air of 2021, fair point, fair point. It just leaves out the sentiment swings, which drive prices far below what one might expect.

Kevin: Dave, we both read a book, and I bring it up often because it was so well written, called Deep Survival on what does it mean to be in a situation where maybe you’re lost, and how do you survive? And the human mind is interesting in that it needs to recognize its surroundings, or oftentimes it can feel that it’s lost. And even if you’ve never been in a place, if the surroundings match what they call future memories, then you’re okay. You don’t feel like you’re lost. But when there’s a lack of clarity, when you’re in a situation—it can be anywhere, you could be in the middle of a city, you could be in the middle of the woods in Pennsylvania, it doesn’t matter. If your mind starts to realize that what’s occurring does not match its future memories, it can create a panic. And being lost isn’t something that happens. Being lost is a state of the mind, when future memories no longer match what’s occurring. Could that occur? I mean, isn’t that what sentiment is in the market when it shifts radically, and it panics?

David: Sure. Well, I think sentiment is complex. I mean, what defines sentiment is an argument worth having or exploring. And you’re right, morale and panic and— A variety of books have been written about how there can be a disorientation within the marketplace or within a social structure, but it’s no accident that sentiment is most positive when the future is clear, and uncertainties are limited. A competition for return on capital, that’s what ensues when you’ve got all of that clarity and future certainty. What’s my return? What’s your return? Oh, I’m getting a better return. Again, this competition on capital.

Kevin: How much are you making?

David: The opposite seems true as well. Sentiment turns negative when the future is less clear. If you can’t fathom what the future holds, then the return of capital, that’s the priority.

Kevin: Well, this goes back to framework. The framework is, you can keep yourself from panicking even when you think you’re lost if you have something to look at, like market fundamentals or let’s say that you have a discipline. The MAPS platform that you guys have— I love the fact that you were all talking about discipline. Doug Noland was talking about discipline because the markets can make you feel lost sometimes, and you can do some pretty stupid things. But even— Sentiment doesn’t necessarily pay attention to the fundamentals, does it? Even if the fundamentals are improving, if people are scared, it doesn’t matter.

David: Well, that’s right. I mean, so some of the companies that we have in our hard asset strategies have a compelling case if you’re looking at the fundamentals. And yet we come in and have to mitigate risk on a routine basis when sentiment blows over those fundamentals. And you can hold fast to your principles and say, “Oh, I know this is going to work out.” And you can go broke in the process doing it. So, one of the points made by Robert Draper in our client-only conference last week on Thursday and Friday was that 2022 has seen the fundamentals dramatically improving in certain sectors, even as pricing pressure has emerged more broadly. And in this environment, fundamentals are a secondary consideration. You must be cautious with all allocations, even those with a very strong story. Selling pressure tends to climax and ignore all fundamentals for a time. Now, once selling pressure is alleviated, there is a resurgence of sanity at some point, but not in a panic.

Kevin: And that’s bargain buying for you if you’re paying attention, right?

David: Yeah. So, our cash positions are now approaching 60%, with direct equity exposure down to 20%. We’re light, we’re liquid, and as disciplined as ever.

Kevin: Well, it’s hard to have a short strategy in a market that’s being fueled by the central banks, but this year, Doug’s short strategy has been the way to go, Doug Noland’s.

David: Absolutely. Protective hedge without a tremendous amount of volatility, our risk managed on a daily basis, his short positions are pushing past the 20% gain threshold for the year. Who knows where we’ll finish, but we’re watching others join us as we position more broadly to cash and move some exposures to the sidelines.

Kevin: Remember what Ray Dalio said in the past? He said, “Oh, cash is trash. You want to stay out of cash.”

David: Notably, notably, that reversed this week. Ray Dalio has reversed his “cash is trash” mantra, actually only in recent days. And so, here’s the famous risk parity strategy that he runs getting beat on both sides of the portfolio. Bonds bludgeoned, stocks bleeding, both are in the cross hairs.

Kevin: Well, I don’t think anybody expected some of the things that are going on right now. Even the CIA, with their analysis, thought that Putin was going to take Ukraine very quickly. Here we are, how many months are we into this thing?

David: Well, and I grant you, there’s some geopolitical unknowns. But I think more to the point, and even prior to the Russian invasion of Ukraine, you had a move in the bond market and the stock market already in the fourth quarter of 2021. So, what was missed is this epic transition to an age of inflation and the commensurate rise and interest rates. So, you look at the seven-month Russian invasion into Ukraine, and as time drags on, you’re right, the CIA thought this was going to be a week or two before Putin had victory. Now sentiment is souring. Why? Because it’s just taking so darn long, and it’s grinding on the Russian people. Ratcheting up the stakes by bringing nukes into the conversation and increasing civilian targets here in recent days, what that suggests is a need, a need to wrap things up.

Kevin: Well, you’ve talked about bringing nukes into the conversation. Unfortunately, and it’s a little bit scary, Biden is the one who’s bringing nukes into the conversation. It’s Biden talking about it more than anybody. He’s like, “Hey, this guy’s serious. This guy’s serious. Hey, it’s an election year. This guy’s serious.” That seems like a mistake to me.

David: I’ve never heard quite the public castigation of a president by another president. Macron almost reached across the pond and slapped him silly.

Kevin: Shut up.

David: Saying, “You don’t say these things out loud.”

Kevin: Exactly.

David: You monitor what you communicate when it comes to anything nuclear. There is absolutely no justification. Anyways—

Kevin: Well, is it any wonder? Europe is on edge right now. I mean they; they’ve been through a lot of war in the last 100 years, Dave.

David: The realities of war, uncertain markets, an impaired and hamstrung central bank. There’s the cloud hanging over, more broadly, the global economy. You’ve got the Chinese contribution to the global economy and growth diminishing. You’ve got a greater autocratic rule expressing itself around the world if you look at various places. In the next week, it’s likely to be a shoo-in for Xi Jinping’s third term. I mean, I don’t know if you’ve seen in the news, but there’s been a couple of people given life sentences, death sentences, any pressure points as it comes into this election cycle. And he’s making sure that there really is no second voice or alternative option. So, yeah, I think we can safely say he’ll be in for another five years. We’ve got currency instability. We’ve got bond market pressures not letting up. 

You had the IMF managing director—she’s originally from Bulgaria—she understands what Eastern European and peripheral European volatility looks like. And here she is as an economic practitioner, worrying publicly about the stability of emerging markets’ debt. Now it’s trading at distressed levels. It was actually priced to March of 2020 levels. Some markets have already gotten there. We mentioned where might the stock market go. Some markets are already at the March 2020 lows. We talked about Credit Suisse last week, blown past the March 2020 lows. Credit default swaps are already significantly higher. And of course, their bond prices and equity prices are in the toilet. All markets are likely to follow suit.

Kevin: Well, you mentioned emerging market debt and the concern from the IMF leader. That brings me back to the last in-person client meeting that we had back in 2019. I was there as well, just like this time. There were a couple of years we had to do it virtually, but now everybody’s back in person. And I remember in 2019 when Doug Noland got up and gave his speech, he talked about moving from the periphery, which would be the emerging markets, into the core. In 2019 the periphery was actually functioning just fine as well, but it was starting to crumble. What you’re saying now is the head of the IMF from Bulgaria is saying the same thing: emerging market debt is a problem.

David: It’s already in distressed status. And that notion of periphery to core, now you see tensions and pressures building in the UK and the US, particularly in the pension systems. I can’t think of a time in history when we had a cross-asset-class no-bid market. In other words, no buyers stepping forward to meet the seller, and the seller’s initial interest to sell regardless of the asset type: stock, bond, commodity.

Kevin: It’s an incredibly important point. Something only has a price if it can be sold to somebody else. Otherwise it’s a no-bid, and there is no price that exists until you have somebody step in the room and say, “I’ll take it.”

David: But the possibility of a cross-asset-class no-bid market is increasing. It’s not there now. Could we see it happen in the next two weeks? Two months? We’ve got margin calls and counterparty risk, going back to things that drive sentiment into dark negativity. They’re back again, they’re back again already. And the British government bonds are the first place where the indicators of a no-bid market have appeared. The announcement of 65 billion in quantitative easing, providing support for UK bonds.

Kevin: They reversed that.

David: It was actually an understatement. They provided for 100 billion. That was the allowance made for this tranche of market support. What has ensued since the announcement, because the timeframe of when it would begin and when it would end was included, there’s been a broad-based fixed income liquidation. Institutions want to get liquid with their less-liquid assets while there is the cover of government liquidity in play. They know “less liquid” for the assets that they still have on their books means “not liquid at all” under certain circumstances. And if the time clock has started for when the UK is going to stop its interventions, then you know when the pressure emerges in other areas. And of course, that’s what we’ve seen is a broad-based liquidation, investment grade debt, corporate bonds, it’s not just UK bonds. The British government bonds got the headlines. And if you look at a chart of the sterling compared to the US dollar— It traded at over 140 last year.

Kevin: Yeah, yeah. Now, what is it? Almost at parity.

David: Its lows were 1.035. So, a dollar and three cents versus a dollar forty, that’s a big move.

Kevin: And you talked about this last Friday. You said, “Okay, that sounds like it’s across the pond, over in Britain.” This probably is a primary lesson for the US dollar holder going forward. Is it not?

David: Yeah, very interesting. I mentioned this in the client meeting, that the sterling story is an important one in context, and provides a lesson for the US dollar holder in future years. And the emphasis, I think, is still for future years. We have— Our Treasury market is reasonably secure, particularly if you’re talking about the very short-dated paper. And the US dollar still has a good head of steam on it. 1931, 1949, 1967. These were the years where the sterling was depreciated, again, ’31, ’49, ’67, they were depreciated. If you roll the clock back to that pre-’31 depreciation, in the teens, about the time of World War I, 11% of government revenue went towards interest. By the time you got to the early ’20s, it was 24% of government revenue went to paying interest. And just before the collapse of sterling, 1931, you were at a 40% number; 40% of their revenue went to paying interest and principal on their debt. It’s a fascinating thing because there does come a point where if you have too much debt and interest rates are rising—

Kevin: You have to either default or devalue.

David: And this was a market devaluation. Actually, the ’49 and ’67 devaluations were policy choices; the 1931 devaluation was a market reaction. So, last week when we gathered with clients and were talking about the return of the bond vigilante, it was the bond vigilante in 1931 who said, “To heck with this, the numbers don’t match. This is unsustainable.” And boom, boom, a big devaluation. People forget that the US dollar compared to the pound sterling used to trade at 4.86. Now we’re talking about 1.03.

Kevin: Almost one-to-one.

David: Yeah. So, what does the story of a reserve currency look like through time as you are dethroned? King Dollar dethroned is not the dollar that we have today. It’s a very different picture tomorrow. Now I think we’ve got a good decade or more of remaining the world’s reserve currency. So, I am not concerned or panicked about the US dollar, but the analog from the 1931 period is just that. You let interest rates move to higher levels on a very large stock of debt. Does this sound familiar at all? What is happening in real-time, right now, and disturbing the UK debt markets, and it’s coming to a theater near us in the US, $31 trillion in debt with rising interest rates. Today the percentages are manageable, but if rates continue higher, 11, 24, and then ultimately 40% of revenues for the UK went to servicing debt. It’s not sustainable, and that’s when you see a revolution occur within the currency markets. We’re not there yet, but let the UK story be a lesson.

Kevin: When I was a kid, I used to build radio-controlled model airplanes, and if a prop got nicked when the engine was going, it could shake the whole plane apart, literally. The balance in the prop is so incredibly important. And the reason I’m thinking about this is the derivatives market; you talked about the analog, going back to these other historic occasions. Yes, there’s an analog. The problem is, we’ve got an engine that’s firing in the trillions right now, and everything needs to be in perfect balance. 

I’ll just tell you a quick story. This afternoon I am, after a dentist appointment, going to pick my boat up and take it down to a marine shop because, unfortunately, my prop on that boat is out of balance. Now, it’s not the prop’s fault, it’s a wall that I backed into’s fault, but I realize that that can change everything. You have to have balance. Whether you’re flying an airplane with a prop or you’re using a boat with a prop, or whether you’ve got assets that are being hedged with derivatives, and you can’t have that thing go out of whack because of the RPM speed.

David: What appears to be developing is that a complex system of assets and the derivatives that support them are not functioning as designed. And thus, the scale of the assets market is now very problematic. Just the size of it, you’re right, it is different than 1931 or ’49, or ’67. The scale of this is absolutely stunning. For instance, pick your asset, whether it’s stocks or corporate bonds, or government paper, there has been a race to all-time highs for all these assets within the last 12 months. October to November of 2021 was the peak for most of those assets.

Kevin: How much are you making? Remember?

David: Exactly. Return on capital was the primary question. Some peaked in April to June of 2021, with the majority of assets testing the upside limits towards the year’s end. And the sense was that downside protection, if it was available— If it was necessary, it was available for any sort of risk imaginable.

Kevin: So, you bring up a no-bid market, you can only hedge your risk if you’ve got somebody who’s willing to do it.

David: Well, that’s the point. Derivatives allow us to hedge risk if someone will take on the risk instead of us, right? Often this is the role that derivatives have. Derivatives are used to increase the scale of directional bets. That’s certainly— you can use them to speculate, that’s another issue. For now, let’s think about what happens when the scale of the asset markets grows to some degree because of the confidence that participants have that either central banks will back them up against their losses or they can buy cheap protection in the derivatives market and not worry about losses. Put a cap on losses. Derivatives are a beautiful thing if they can deliver that.

Kevin: Yeah, because the central bankers were the bid. They were the bid. That’s the balance of the prop. You’ve got a buyer and a seller. And if you can’t find a buyer or a seller on one side or the other—

David: Buyer of last resort.

Kevin: Exactly.

David: So, enter inflation. Central banks ignored it, thinking it was a short-term anomaly tied to supply chains. It’s still here and now casting a shadow over central banks’ credibility. That’s a problem we could spend more time talking about. But the market’s support function is a question on the minds of speculators. Again, central bank credibility is in play, to what degree will they provide market support? If that function is not there, then speculators have to rethink how they’re engaged with their quote-unquote insurance policies. It’s another uncertainty that once was a source of certainty. Will the central bank bailout crews socialize the risk building in the system? QE or not to QE? That is the question.

Kevin: Your play on Shakespeare again this week, QE or not QE? That is the question. But we haven’t had to really ask that question because inflation hasn’t really been here for 40 years.

David: And since inflation is in the picture for the first time in 40 years, we have a second paramount concern. Can we insure against loss inexpensively? Not as cheap as it used to be. As the cost of capital rises, it should come as no surprise that the cost to protect a portfolio does as well. Repo markets have seen rates increase. It changes everything a bit.

Kevin: Well, just think of your personal experience, Dave. This is a 50-year-old precious metals company, and I don’t know what our average trade size is, but you can usually hedge average trade sizes. Let’s say it’s a 100-, 200,000, 50,000, whatever, you can hedge those markets because it’s not hard to go out and have somebody buy the other side of that trade.

David: Scale becomes an issue.

Kevin: But what if somebody comes to you with a 5, 10, 40, 50 million, and that has happened, is that easy to hedge?

David: It’s generally not a problem. But the scale of the asset markets begins to matter because to hedge a small market is a small task, right? But plenty of counterparties—

Kevin: That’s done all day long.

David: And they’ll take the other side of the trade. And so, getting insurance against downside is not that hard. So, you have an asset, you get insurance against downside, you’re hedged. In a massive market with rising costs and the uncertainty of whether central banks will be the buyer of last resort, with no buyer of last resort, you can discover a no-bid market. And I guess that’s what I’m getting at. What you find is that there’s less participants who want to provide hedges. So take away the buyer of last resort, and now there’s less participants that want to provide hedges, less participants traditionally providing a market-maker’s function, and keeping the markets liquid and continuous. This is an issue that Doug brings up regularly. So, liquidity is leaving the markets in part because risks are becoming unhedgeable.

Kevin: Okay. So, go back to the example. Let’s say you’ve got someone who wants to sell you $50 million worth of gold. That’s— $50 million worth of gold is a great thing to buy, but you can’t, with the company, ride the market risk. You have to hedge it.

David: So, this is not a real-time scenario, but this is just to illustrate. If somebody wants to sell me $50 million worth of gold right now, I can either buy it or facilitate the trade into the broader markets. So it’s easy. If I buy it, I have no desire to take on inventory risk with prices moving up and down daily. So I seek to hedge the asset, insulate myself from any price changes. That assumes that I can hedge the position and someone that is a counterparty is willing to take on that risk. Perhaps they pass on the risk to someone else, and it just goes on and on. There is sort of a daisy chain of interested parties that I rely on to do one simple thing, hedge the 50 million in gold. 

But what if no one wants to hedge the position for me? What if the cost to hedge that position at some point exceeds any benefit that I might derive from being the market-maker and taking on the inventory? So, perhaps I do the math and I just pass on the trade. If it’s not economical or I can’t adequately hedge the risk of a position, I pass. That impacts market liquidity.

Kevin: And we’re using gold as an example here because gold is a real thing that really exists, but the interest rate markets have to be hedged as well.

David: Yeah, the swaps market allows for hedging either interest rate or currency risk. So, the swaps market is very important in this market environment. There is dysfunction in the swaps market, and that is a problem. The bond markets of the world are huge. The currency markets of the world are huge. The greater the price volatility in those markets, the harder to adequately hedge and the more expensive the hedges become. And yes, size does matter, right? These are gargantuan markets, they’re typically the most liquid. But with radical volatility comes a little bit of dysfunction, right? When the swaps market is not working perfectly, trillions of dollars of interest rates and currency hedges don’t provide the same assurance, and the traders and the market makers say something like I would, “I pass.”

Kevin: And if you have an entire market saying, “I pass,” that’s a no-bid market.

David: Particularly if there’s no buyer of last resort. So, it brings back in the central bank, why would I as a market maker, have concerns about where the market’s going down the line? I need to know that the central bank has my back. Liquidity becomes an issue of concern, spreads widen. It’s the process of bid discovery. When the future is unclear and risks cannot be hedged, no bid or just an embarrassingly low bid are the consequence. So, there has to be some compensation for risk as risk widens. Again, this is just an indication of markets not functioning well. We’ve already got it.

Kevin: The last thing you want to hear, when you say I need to sell what I have, is crickets. That’s the last thing you want to hear.

David: So, we don’t have crickets yet, but we do have the question being asked, “How much?” Because the price is going to move based on how much, and it’s now a trickier issue to hedge a big position. 

So like in physics, the law of conservation of matter or mass states that matter is not created or destroyed. It just changes form. So if we take that idea by analogy, and move to financial physics, risk is not eliminated. It’s just shifted to other parties. So while one party feels that when they’re buying derivatives and hedging a position, that risk has been eliminated, it has not been eliminated. It’s simply been moved. Someone else had to assume it. That’s a big issue. 

Then you’ve got the aggregate market size and the aggregate risk shifting throughout the derivatives market. That becomes critical. This is where any individual party, any individual bank will look at their exposure on a net basis and feel like it’s well covered. Where we end up with systemic problems is that gross exposure—again, that’s usually not a market’s concern, a participant’s concern within the marketplace, because they feel like they’ve netted it out. But it assumes that the game can continue as before, and I think something has shifted dramatically. One, the cost of capital is increasing. That changes the backdrop. Even more importantly, your buyer of last resort is currently working on QT, not QE, and that is a problem.

Kevin: Yeah, that is the question. So since we’re slaughtering Shakespeare, let’s slaughter it again. So, now we’re to quantitative tightening. This is a dangerous time to be removing liquidity from the system. So, is it QT or not QT? That is the question.

David: Well, we know that quantitative tightening is a temporary policy statement. It basically says, “We’re not buyers today. In fact, we’re selling.” The UK was scheduled to sell products this week, but because of market dysfunction they were forced to reverse policy course and go back to buying. If they had not done so, we would already be in the throes of a global financial market panic. And this is where, again, you look at asset inflation on a global basis. What it has revealed is just how interconnected the world of finance is. We go up together, we go down together. Variance is just a matter of degrees.

Kevin: And sometimes those degrees can be talked about in a different way than what they actually are. The Fed is talking about reducing its balance sheet. What is it, about $9 trillion? How much has that reduction actually been so far?

David: Well, they set the goal starting in June, July. Of the $9 trillion balance sheet, the Fed has about 200 billion that’s been liquidated thus far. Frankly, that’s not much.

Kevin: Is that three percent? Two or three percent?

David: Yeah, not much considering the operation’s been in effect since June. I think that was the start date. There’s a lot more selling scheduled. Scheduled. Let’s just leave it at that. I doubt very seriously that the emergent illiquidity trends across asset classes are going to promote the further liquidation of Fed assets. Now, what’s really unhealthy here is that your equity trading jockeys, they love this idea. Worse is better for them. How soon will we get the pivot from QT to QE? Not soon enough for the bargain hunter who’s already leveraging up, buying shares. But this is the problem. Maybe the Fed waits, and maybe the pain accumulates.

Kevin: Okay, you called them equity jockeys. What we’re talking about is, “How much are you making. How much are you making?” And I hate to say it, but the equity jockeys, almost all were not here for the 2008 global financial crisis. They don’t remember the tech stock bubble blowing up. They probably definitely don’t— or weren’t even born in 1987 when the stock market crashed. Sometimes age really helps, and a few scars on your back really help.

David: I think the first time that I heard this phrase was from Richard Russell 25 years ago: Pigs get fed, hogs get slaughtered. And so your equity jockeys who are out there trying to buy the dip at the present may have more in store for them. I think of the real estate buyer in the mid-’80s and the Texas oil patch came in, bought cheap, prices rebounded 40% before they crashed another 60 to 80%. They were the geniuses for about a two-day period. Maybe it was a two-month period.

Kevin: But the Fed is still trying to pretend like they’ve got the back. Remember this week we heard that, “Don’t worry about liquidity. Stop letting them complain about liquidity. There’s plenty. There’s two trillion bucks.”

David: That’s right. One Fed official this week said, stridently, not to worry about liquidity. And I can tell you anytime Fed officials are saying not to worry about liquidity—

Kevin: They are.

David: Yes, that speaks for itself. But you’re right. He pointed out there’s two trillion in liquidity. No lack of liquidity. And that may be true, but will individuals and institutions put it to work and make it available when someone else wants it? Like so many mismatches within the banking industry, this is a form of liquidity mismatch. When one party’s timeframe doesn’t match another party’s timeframe. Short-term deposits versus long-term loans, that’s a common banking structure. That’s how they operate. But a bond or an equity seller assumes that someone is willing and waiting in the wings to act as a buyer, right? So, liquidity may exist. Yep, 2 trillion. There it is. But that in no way indicates a willingness to be the on-demand buyer. So, I think the Fed officials are overplaying the overnight repo as a liquidity tune. And maybe if they wanted to see those dollars back in the system, maybe they should consider stop paying interest on them, right? You’ve got $2 trillion sitting, they’re paying over 3%, and the folks who’ve got those deposits, no risk, no duration of credit concerns. It’s just stupid.

Kevin: We used gold as an example just because that is a real thing. And I don’t think in history there’s ever been a no-bid market on gold. There’s always a price for gold, and it usually is much better if counterparty risk is crumbling everywhere else. Gold is the one investment that you can have without these counterparty risks.

David: Well, let’s play this differently. Let’s say for instance that everything is a no-bid market. What do you have with your paper assets versus your tangible gold? So, my final thought would be on the value of gold in the midst of counterparty concerns. Is it bulletproof? Well, prices can and will fluctuate. Maybe the price goes down. 2008, we certainly saw the price of gold drop in the context of the global financial crisis.

Kevin: It lost about a third of its value, but it—

David: What was fascinating, beyond the recovery, what was fascinating is to see the smart guys on Wall Street begin to reconfigure their portfolios and say, “I don’t know what I’ve got in terms of counterparty exposure in our paper assets. Buy me ounces and make sure they’re off the market.”

Kevin: Do you remember the physical market separated so much also from the paper market?

David: Amazing. So, you had a one-third decline in the price of gold, but you couldn’t buy it at that cheap price. You could not buy it at that cheap price, right?

Kevin: Nobody was selling.

David: Because the physical market was locked in at a higher number, and it was only in the futures market where you saw that extreme volatility. What you have with gold is an asset that is not subject to counterparty risk, and thus eliminates the return of capital concern. If you’re still fixated with the return on capital, you really don’t know what’s developing in the markets today.

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 Express 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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