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The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Want Slightly Positive Interest Rates? Buy 100 Year Bonds!?
January 20, 2021
The McAlvany Weekly Commentary, covering monetary, economic, and geopolitical news events.
David McAlvany: If you’ve ever made a piñata, it’s the veneer of paper and glue you put on a balloon. I’m fascinated by how quickly we move past even recent history, and ignore the realities of the European Central Bank being in a desperate bind. The Fed acting as if all is well, while in fact, these are desperate measures in desperate times.
Now, here are Kevin Orrick and David McAlvany.
Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany.
I was watching TV the other night. Even though we had COVID, it’s nice that we had playoff games in football. Tampa Bay, Brady was playing Drew Brees with new Orleans, and they were playing at the Superdome, and it just brought back memories. You remember Katrina?
David: Oh yes.
Kevin: [laughs] That was rough, 2005, and in fact, it really was quite a disaster. I went to an article that was saying there are some myths about Katrina in 2005 in New Orleans. The first myth was that this was completely unpredictable. Of course, the weather was unpredictable to a degree. They do get hurricanes, but the brakes of the levies were not unpredictable. They said that this had been looked for for a long time.
There was another myth, and that was that all of New Orleans was built below sea level. [laughs] That myth was only half true. About half of New Orleans is below sea level.
The third myth, and this is the one that got me, is that everything is better now, that maybe it won’t happen again. They said, “No, no this will probably happen again.” It just reminded me. Watching a game in the Superdome, do you know how high or what the elevation is of the Superdome above sea level, there in New Orleans day?
David: I hope it’s at least a little bit above sea level.
Kevin: [laughs] It’s three feet. As we do this commentary, and as we look forward, one of the things that we want to try to do is learn from the past. Do we really learn from the past, Dave?
David: I think one of the issues from Katrina is that we still have the structural issue. It was a maintenance concern. That first myth of whether or not it was foreseeable, you’re right. There’s issues which are very foreseeable, although the extraneous external factors causing an immediate crisis, maybe you don’t see those, but you can stack up. You can assess and analyze where the weaknesses are if you’re looking at structural issues. Levees breaks, is that a repeating issue? Very well could be. You can’t time the storm, but you can certainly look at the consequential issues relating to structural concerns. Never really fully fixed.
Kevin: We have Doug Noland and Lila Murphy, and we’ve got a number of other sources to look forward and say, “What do we know about the past, and what can we do to keep certain disasters from the past from happening?” There’s probably no one better to talk about that than Doug Noland. We have that tactical short call coming up on Thursday, the 21st.
David: Yes, that’s right, 4:00 PM Eastern, 2:00 PM Mountain, Managing in a Mania, and the conversation will be a doozy. Register, send your questions in ahead of time. We have it: a mania. Here we are managing in that context. Don’t miss it. This will be an historic conversation.
Kevin: Last week we talked about the value of a human voice and how it’s terrible to try to shut it down with censorship, or try to control or mute that voice. You brought up Martin Luther King. We just passed Martin Luther King Day. The speech that Martin Luther King gave the night before he was assassinated has really become a classic. You had said that you were going back and listening to famous speeches and realizing we don’t necessarily always learn from the past, but there are voices out there trying to direct us the right way.
David: I think a really careful distinction between prejudice and racism is important for us to keep a conversation and a dialogue alive. I had a fascinating conversation yesterday for over an hour with a gentleman who painted the whole world as racist. I found myself dumbfounded, unable to say much of anything, because there was no point of engagement.
Yet, I could see, from his vantage point, a dozen areas of prejudice. I think we can all look and self-assess and see areas of prejudice. There is an openness in conversation when that distinction is made. If I find anything disconcerting, looking back at last week’s conversation, it is that there are whole broad swaths of America today that does not value voice.
You get in line and you shut up. Those are your two choices. I think Dr. Martin Luther King had… Go back to 1963, “The ultimate measure of a man is not where he stands in moments of convenience and comfort, but where he stands at times of challenge and controversy.” We certainly have our measures of challenge and controversy today.
You might also recall from last week that I do enjoy reading some of those older speeches, whether it’s Solzhenitsyn or, in this case, Dr. King. Last night I read, I’ve Been to the Mountaintop, was his last speech. He was assassinated the next day. Having that fact in mind, you read it a little bit differently. I read the speech to all the kids with some chaos between the dog and the youngest.
You never know who’s listening or who cares, but it was a very moving speech. There are certain points where you understand that these were challenging times. One of the things that would be necessary to engage the shifting sands, social sands at that time, and our own, is an openness to dialogue, which includes a generosity on both sides to sit and listen and not pre-judge.
Kevin: We’re going to the financial markets, Dave. One of the things, just looking at the Katrina situation and just trying to draw an analogy here, there are oftentimes that we can lull ourselves. What Dr. King said, “Moments of convenience and comfort”—that really rings true. “The measure of the man doesn’t come from moments of convenience and comfort, but where he stands at times of challenge.”
A lot of times those challenges are predictable, but our comfort and our convenience blinds us to it. Going to the financial markets, we have seen one of the most remarkable decades, really from 2011 till 2021, the intervention of Central Banks and going in and buying just about anything that might fall in value. Right now, I’m thinking about the corporate bond market. Is there any real price right now in any of the bond market aspects, including the corporates?
David: That’s why I mentioned the Wall Street Journal article last week between Lawrence Goodman and Sheila Bair. It ends with a critique on interventions in the corporate bond market, which have not only put a floor in the corporate bond market as a supportive of price, but, as originally intended, they stabilized trading in bond exchange-traded funds. Apparently, these products could handle inflows of money, putting money to work, but these same products were falling apart as liquidations occurred and relatively illiquid underlying assets could not find a home.
Kevin: One of the things that’s concerned us is the mandates that the Federal Reserve has. Price stability, inflation, the various mandates, interest rates. Those can sometimes create a conflict amongst themselves. We were joking last night, Dave, that they could probably add three or four more mandates because at this point it sounds like the Fed is really responsible for everything, including the sun rising.
David: This is a key point. Financial asset price stability was not on the original list. It’s the unofficial mandate of the Fed today, but originally it was consumer price stability, not financial asset price stability. Instead of the markets wising up to the problematic issue of product structure versus underlying asset liquidity, going back to the interventions we’ve seen in the corporate bond market, 2020, this is an unofficial mandate of the Fed.
Again, you set that next to the standard to consumer price stability and full employment, what we have is the Fed pulling out the stops to ensure smooth market clearing and support for asset prices, come hell or high water.
Kevin: If we were to look for the footprint of the Fed, just about how much is that right now?
David: March of 2020 to present, the Fed, thinking of their balance sheet, so it expanded as they started buying assets in the market. It expanded to $3 trillion dollars in new money spent in 2020. Again, that’s prices being propped up with an extra $3 trillion from the US Fed. If you’re looking at the broader list of Central Banks, the top four, call them the G4—you’re probably familiar with the G2, G7, G20. The top four economies, the world’s largest Central Banks, they put in a total of eight and a half trillion dollars into the financial markets in 2020. With that in mind, I think it’s worth listening to the former head of the FDIC, someone who knows something about excess and problems within the financial markets and particularly banking.
They said in their article, “Capitalism doesn’t work unless capital costs something. Markets don’t work unless they’re allowed to rise and fall. The corporate facilities may have been originally justified as extraordinary one-off interventions to help companies maintain operations, but they morphed beyond this purpose and distorted capital allocation. The result was a windfall for investors, cheap credit for the uncreditworthy, and record-shattering levels of corporate leverage.”
That’s the end of the quote, but they did go on to say, “Let those facilities die,” these interventionist measures, this is not healthy. Behind the price of financial assets today, Kevin, there’s two realities.
One is the inherent merits of the underlying assets. That’s just every asset has to stand on its own two feet. Number two, and more important today, is the external and superficial impact of excess liquidity on the pricing of those assets. Acting like, if you can imagine, platform shoes.
Platform shoes for the height-challenged. Don’t pretend for a second that you’re taking an accurate measurement. If you’re taking a height measurement and someone’s wearing platform shoes, everybody looks a little taller. That’s what we have in that second category today, an external and superficial impact for pricing.
Kevin: It reminds me of the movie Shrek when the prince gets off the horse, and you realize he’s not really this tall guy, but he’s very, very short. Between building half of a city below sea-level, or wearing platform shoes, you can only hide a bubble for so long.
Even Bloomberg at this point is saying, “Watch out. We may have had a 10-month melt-up and a bubble. These are the signs.” Unfortunately though, Dave, you and I have talked about this last week, our emotions don’t normally match the actual reality, the emotion only follows the reality. That’s where the discipline in investing comes in. Are we in a bubble?
David: I love the story of Shrek. My oldest son played Young Shrek in a production here locally. We have green ears that I’ll sometimes wear around the house, which are leftover props from the play. Bloomberg on January 10th was candidly discussing the evidence for a massive asset bubble. It’s suggesting that caution is warranted, and they point out, “Look, we’ve had a 10-month melt-up.”
They concluded that bubble warnings are starting to blare from every corner. That’s how the article ended. What they were suggesting is that the current environment is something like a casino. In fact, this is precisely what they said, “Like a slot machine paying off on every pull, the stock market’s most reliable bets lately have often been it’s riskiest. Emboldened by Federal Reserve stimulus, vaccines, and the psychological conditioning that arises when no bad patch lasts.
Kevin: Dave, one of my clients, you know him, he is a fire investigator. Extraordinaire, actually, he stays busy all the time. He is contracted by insurance companies and fire departments to go back and actually do somewhat of an autopsy of what caused the fire and why it spread the way it did. Let me ask you, when the autopsy report of this market bubble is read in the future, what’s it going to say?
David: The retrospective understanding will be as obvious as it is today. The difference then being a desire to understand and reflect on what, and how – that’s what happens. We all get very sober-minded and, “How did this happen to us? Could we have seen it coming? What were the causes?” Everyone’s very focused on the details, but the current mode is epitomized by your compulsion to participate, maximize growth, and ratchet up risk tolerances.
I mean, we’re surrounded by bubble warnings, and we have the psychological backdrop that promotes rampant late-cycle speculation. It’s showing up in lots of different places. It’s showing up in penny stock trading, the volume’s off the charts. It’s showing up in options trading, volume’s off the charts. It’s showing up in margin and debt levels.
From March to the present, we had a 50% increase in margin debt, taking us to all-time highs, $722 billion on the last measure. Yes, there is a feverish, I say, feverish interest in cryptocurrencies. On that last one, we’re not talking about early participants with insight into some aspect of market disruption. There’s a case to be made for cryptocurrencies.
It’s the investor fear of missing out where what we see and what we hear as we talk to investors day in and day out is that the returns are now so compelling that there’s an absence of self-control. Again, this is not a cryptocurrency criticism, it’s that the investors that are buying today have recalibrated their understanding of investment objectives.
They’re looking at moving towards full tilt speculation, outsized bets on double digit, weekly gains. That’s the expectation, and frankly, they may have a few rude awakenings. The speculative gains should always be managed with disciplines. I think this is where, again, the reason why it’s ultimately not repeatable and not a success story, even for those who are winning today, is that very rarely do you see disciplines and rules applied when people are hungry for more.
Again, it’s options. It’s penny stocks. It’s cryptocurrencies. Experience will teach you, easy come, easy go. What you have, again, the evidence is in, price to sales ratio for the S&P 500 is now 20% higher than at the top of the tech bubble. Manias are always fun for the average speculator, but they always end in tears because speculators can’t control their enthusiasm. It’s never enough. Even ask a sophisticated investor like John D. Rockefeller. You remember the question was asked to him, how much money, John, is enough money? His answer was, just a little more.
Kevin: The thing is, you can get a little or a lot more depending on the quality of the investment that you’re buying. If the central banks are coming in and buying everything, including the highest risk investments. Then why in the world wouldn’t you go for the lowest quality asset category so that you could get the highest return?
David: Frankly, that’s been one of the great winners in the last decade is to look at the, what we call the PIGS, Portugal, Italy, Greece, and Spain, the Southern countries in Europe whose debt was being decimated 2011, 2012, and to just look and say,” All right, the ECB is flowing capital there, and instead of 20% or 17% or 15% interest rates, they’re going to bring them back down and homogenize them with the rest of central and northern Europe.”
That’s an issue, you’re right. There is a distortion of reality when central banks begin to play, as they have, with what is an ordinary assessment of risk. You’ve got investment-grade bonds. If you just look at this week, investment-grade bonds saw $7 billion in inflows, and actually last week, high yield had close to $1.4 billion in outflows. If you look at the past year, high yield has outperformed investment grade.
For some time now, you’ve got these risk dynamics favoring the lowest quality in every asset category. That’s a key point. If you’re just thinking about where you’re at in a cycle, the fact that risk-on dynamics are favoring the lowest quality in every asset category, it’s very telling.
Kevin: We knew either party was going to spend a lot of money, but we’re on track for multiple trillions as stimulus is coming down the pike.
David: That’s right. 2020 was no shy year in terms of deficit spending. 2021, we’re on track or we were on track for $2.5 trillion prior to Biden, and maybe it’s 3 to 5 trillion for 2021.
Look, you’ve got Yellen coming in. Sensitivity for the plight of the people is one of her hallmarks. She brings a certain soft touch and sympathy. Nothing wrong with that, except that we do have deficits already in motion and so anything added to the sympathy list is likely to make them even deeper.
For the first fiscal quarter, 2021, we’re already at 573 billion. That’s again, first fiscal quarter of this year. That translates to 45 cents borrowed for every dollar spent. Of course, on top of that, you’ve got emergency helicopter drops [laughs] 1.9 trillion out of the gates for the Biden administration with another $2 trillion in infrastructure already promised. This is where we have to ask the question, where is the line where you begin to shift sentiment in the bond market?
Kevin: It’s interesting to have Yellen back in the treasury. We saw Yellen replacing Ben Bernanke, who, really, that’s where the word helicopter drops came from, right? Drop the currency with helicopters. With the bond market right now – does Yellen have a PR campaign that she’s going to have to put forward to say that all this stuff is going to continue to work?
David: I think she has credibility and the markets are not suspect of either her credentials or her willingness to engage in an accommodative way.
Kevin: Credibility or not, is there something that could cause the sentiment to shift, and where would we see that first?
David: If sentiment does shift, again, we’re talking about looking forward at the periphery of the fixed income markets. Again, 1.4 billion in outflows for high yield, that’s only one week. You’d have to see much more of the same. Under normal circumstances, that’s what you would expect, is to see riskier assets sold off or reined in first.
It’s a challenge in this environment. It’s tough to tell if that will hold true when the Fed offers to buy assets and provide its entire balance sheet as a backstop for market prices. It’s almost a Victorian criticism to talk about moral hazard anymore. Who really cares anymore? If you’re looking for signs, then you might look to high yield for indications of pressure, and that sort of shift in sentiment, risk-off, so to say.
Kevin: One of the questions I have, going back to the levees in New Orleans before Katrina. There were limits. They all knew there were limits as far as how much water could be held back before it broke. What are the limits in terms of asset purchases? Is it unlimited?
David: It’s a very interesting question because what we have are “new tools.” Describe them as macro-prudential or however you want to, but I don’t know that we have figured out what the limits are in terms of asset purchases from the Fed. We know that they can add 3 trillion to their balance sheet overnight, and we assume that they can do that again this year if need be.
We assume that we can pass 10 trillion and move towards 15. The question is, when does the market skip a beat? When does the market get concerned? What limits, if any, are there in terms of deficits from the Treasury? If there are no policy disciplines applied, you’ll continue to build pressure, and you’ll build pressure on interest rates. It’s like the pressure in a coiled spring.
You can continue to press and press and press. If you’re looking at the dollar, instead of the fixed income or interest rate markets, further deterioration can happen. It’s the foundational stability of the dollar. I appreciate looking at emerging market debt and the crises we’ve had over the last century because what you see in those charts of emerging market debt is a world that’s priced for perfection, and then it breaks.
Rates come down and down and down and down and down and down, and then they move the opposite direction in a violent fashion. We can go from a perfectly calm, low-interest-rate environment to catastrophically high rates overnight. The dollar can make advances, like a beautiful sandcastle reaching ever higher and tempting fate, with what really is, you and I have talked about this in terms of catastrophe math, short-term trading dynamics.
We see the dollar move higher, gold lower, what have you. Short term trading dynamics should not be confused with long-term structural impairment. That’s where I think we’re back to that issue of no real structural change has occurred, doesn’t take much of a storm to bring back the same catastrophic issues that we saw as recently as 2008 and 2009. Perhaps if you wanted to test the mettle of the taper tantrum in 2013 for a more recent timeframe, that would make sense.
Oh, did I forget March of last year? There’s been numerous opportunities to see weakness in the financial markets and to see how quickly the Fed responds. Each time, it’s taken hundreds of billions more than the previous intervention, or in this last case, trillions more than the last time around.
Kevin: You mentioned catastrophe math. Catastrophe math is an interesting science because it looks at tension building and building and building, but it’s absolutely undetectable until it breaks. That’s where the word catastrophe really comes into play. We talked about the quarterly call that you’re about to have this next Thursday.
Doug Noland writes the Credit Bubble Bulletin. One of the quotes that he put in the most recent is, “The system is one unexpected spike in market yields away from mayhem.” That sounds like catastrophe math to me, Dave.
David: Absolutely. If you want to peer into the mind of Jerome Powell, I suggest you read the summary of Doug’s comments in this last week’s Credit Bubble Bulletin. That to me is a great way to start a Saturday morning if you’re in search of an early morning discipline, a tall cup of coffee, and the Credit Bubble Bulletin.
Actually, my pure preference is for a Cuban breakfast: coffee and a cigar, and Credit Bubble Bulletin. I do have to limit that when in training. It is in that sense and in my ideal place with the Cuban breakfast, literally a stimulating conversation with Doug on the back porch. That’s my idea of a great Saturday morning.
Kevin: I’ll tell you, one of your ideas of a great Monday, though, is because we get a chance to talk on Monday nights and discuss what’s happened over the week and just what’s on our mind, what’s happened with the family, and in a way that helps us to talk when we record the weekly commentary.
You love Mondays because you do get to meet with your team. The portfolio management team, these are intriguing people and you’re looking at everything from, what’s it look like if inflation increases or interest rates increase? What’s this political outcome, what’s this financial outcome? In a way you get to play an awful lot of thought experiments for various outcomes. You’re doing it with the top people in the business as far as I am concern.
David: It’s a great dynamic between trading and macro analysis and having a company analyst. All of these things factor into portfolio management. In the meetings recently, we’ve been discussing, among other potential outcomes, the risk of inflation, which is now measurably the highest it’s been in years.
You certainly don’t see that fully reflected in the bond market due to that second reality I mentioned earlier: the superficial value-add of Fed purchases and price distortion. Nevertheless, you can begin to see it showing up in the 10-year treasury break-even inflation rate. Last week, we ended at 2.09%, at its highest level in 27 months.
That could very well be a defining trend. When you look at ag prices, they’re rising. When you look at industrial commodities, they’re rising. When you look at oil, gasoline, natural gas, all up 8% year to date, or roughly 8%. Transport costs are ticking higher. As you’d expect, the cost being passed through to consumers, that’s been pretty consistent through the retail sales figures and what we’ve seen through the end of last year.
Rates have in fact moved higher, but not to threshold levels, which would cause indigestion in the bond market. We’re not at those threshold levels which would end up piercing the bubble in stocks, at least not yet. I say yet because there’s a market logic bedded in the way we look at stocks or analysts look at stocks today. The discounted cash flow model, if you’re familiar with that, it’s the current rationale being used for higher prices and equities.
When you lower the discount rate or the implied rate in that equation, it’s how you justify higher equity valuations so as the Fed lowers rates, you can naturally say according to the DCF model, we can have higher valuations in these higher prices. These are not overvalued markets according to the DCF model. Higher rates on the opposite side of the equation put downward pressure on valuations in prices because the logic works in both directions.
Kevin: One of the things I think we forget, Dave, it reminds me of, I gladly pay you Tuesday for a hamburger today. Actually, the bond market can say, I’ll gladly pay you next year, or in 50 years, or in a hundred years. There’s a point where interest rates don’t matter because you just extend the length of the bonds well beyond a lifetime.
David: At a certain point investors … I don’t know how they have the imagination to consider those kinds of obligations. Certainly, it is a work of fiction because if they knew anything of the facts of history, they might appraise the idea of super or ultra-long bonds as absurd. Before we leave the bond market, it was Reuters this week with an article on ultra-long bonds.
They’re back in vogue with zero, or if we could describe them as chronically like an illness, chronically low-interest rates around the world. You’ve got yield-hungry investors who are willing to ignore credit risk, and then the other second critical risk for any debt instrument, which is duration. The amount of time you’re giving someone your money before they give it back.
What happens between now and the time you get your principal back? This is the in-between time. Classically, that’s been a major component in the pricing of fixed income. Inflation is a factor there, and is one of the reasons why time is working against you because there is a healthy assumption that over time monetary games get played. Inflation has a way of chipping away at principle.
Look at the last 100 years here in the United States. We have a relatively stable currency compared to other currencies in the world. Over the last 100 years, look, 97% of the purchasing power of the dollar’s up in smoke. You spent the income along the way. Let’s say you did that. You’d have to ask, who’s in the Patsy Club? If you look back at the last100 years and are willing to now forget that and look at the next 100 years with some degree of hope instead of consternation.
Kevin: Could you imagine, Dave, if we had to go back 100 years and didn’t know the future and had to predict, now you run a company, you run actually several companies. You have to look forward and say, “Okay, what does this next year look like or two years, maybe five years?” You have to look forward.
One of the things I like doing with clients is just saying, “Hey, let’s go back to 1921. Let’s go back 100 years and see what, oh, I don’t know, a loaf of bread costs.” It was 6 cents a loaf at that time, and now that same loaf of bread, yes, it’s going to be $5 or $6 as far as a nutritional loaf of bread.
We’ve talked about this before, and it’s strange an ounce of gold will buy about a year of bread back in 1921, buys a year of bread now, today, if you take it 365 days a year and you eat a loaf of bread a day. Who would have predicted that the dollar would have lost 97% of its value in that last 100 years? Now, could you imagine buying a 100-year bond valued in dollars, paper dollars? You’d have virtually nothing left.
David: Ian McAvity was a featured guest on the program for many years and he would describe gold as stupidity insurance. He’s basically saying, “Look, we know what government’s going to do to the value of money. If you care about purchasing power or asset preservation, you don’t speculate on gold. You store a part of your wealth in it because you must, being a realist, have stupidity insurance.”
The illustration of the loaf of bread and what’s happened over 100 years is, I think, important to bear in mind. If you’re asking the question, who’s in the Patsy Club of 2021? The patsies are the buyers of government bonds that come due in 30 or 50 or 100 years. I’m sure artificially low rates and coordinated global monetary policy have had nothing to do with investors taking more risk or setting up the system for massive pain when yields increase.
Could investors be surprised when within those timeframes of 30 years, 50 years, 100-year timeframes, that they encounter some inflation? Is there any chance that that factor could eat into the returns that they have over the next 2 years or 10 years, or, again, start pushing the boundaries in terms of a timeframe even beyond your lifetime frame, 30, 50, or 100 years?
Kevin: Back in 1987, when I first started working for your dad, Dave, I framed various currencies at the time, and I remember framing the German mark. I just I framed that along with other currencies and I just watched all of them go away. I remember meeting Klaus Beucher and he told me that the German Mark had failed a number of times.
Actually two or three times in the 20th century. We were talking about going back 100 years. If you would have purchased German bonds in 1921, you would have gone through the complete collapse of that currency by 1923, but it happened, again, after World War II. Now, what’s Germany doing? They’re issuing bonds again for a long, long time.
David: Specifically, the state of North Rhine-Westphalia—they’re offering $2 billion in debt, which they’ll pay you back 100 years from now. That’s a long time from now. Again, this is Westphalia as in the Treaty of Westphalia, 1648, there at the end of the Thirty Years’ War. Do you think the currency those bonds are denominated in, we’re talking about the euro, will be around in 100 years?
You’ve got the credit obligation. Maybe they can make good on it, maybe they don’t, but there’s some question as to whether or not the euro will even exist two years from now, 10 years from now, let alone 100. France, France is in the same thing. They’re out with 50-year bonds. Great bet. How about Mexico and Indonesia?
These are excellent bets for credit risk and duration risk. I think one of the classic experiences. I was visiting my brother, who has spent the last better part of 15 years in Indonesia. When he has a cash payment to make, he goes down to the bank and gets a withdrawal, but he has to bring a duffel bag to make what for us would be, say, a $500 bill or $1,000 bill, he has to fill a backpack or a duffel bag with.
That gives you a picture of what the value of their currency is, and how they’ve abused their currency system through time, and yet somehow Mexico and Indonesia can offer 50-year bonds to the delight of an emaciated fixed income financier or financiers around the world. This is reaching the point of absurd, where Indonesia and Mexico can be considered excellent bets over the next 50 years.
What disconnect do you have from not only the recent past, but the last 20, 30, 40, 50 years in the rearview mirror? We go back to the eurozone. Within the euro area, you’ve got officials who are happy to increase not only the quantity of debt but also extend those durations at low or negative rates. Zero rates. Why are they doing that?
You’ve got central bank officials slapping each other on the back for having saved their governments a ton of money on interest payments. The bond market is temporarily so focused on yield, it’s as if they can’t get past interest rates as the foundation of Maslow’s hierarchy of needs.
Give me something to put in my belly. Give me some form of income. Psychologically, it’s almost like Esau for the modern world. Esau in the biblical story was exchanging his future for an immediate cup of soup. You see that in the bond market today, and it’s just not particularly well thought through.
Kevin: About six or seven years ago, you and I were in Argentina. The inflation rate at the time was 40% a year. I couldn’t even imagine buying a bond for a month. With 40% inflation, you’re not even going to buy a bond for a month. Remember in 2017? In 2017, Argentina came out with 100-year bonds.
David: We joked about the institutional enthusiasm for 100-year Argentine debt. That was 2017. Yet pensions and insurance companies, they were acting, in fact they were acting like they were institutional, when they oversubscribed the offering. You could have locked them up for the insanity. It turns out that what happened over the next 48 months changed that dream story of a hundred-year bond pretty dramatically. Yes, you guessed default if you hadn’t…
David: In case you didn’t know. Can you imagine that, the Argentines defaulting?
Kevin: What if I called you and said, “Hey, Dave, let’s build a city below sea level,” and you go, “No. Let’s just build half below sea level.” I think negative-yielding rates didn’t even exist before 2015. Now, how many trillion? How many trillion?
David: We’re back to structural issues. These are all signs and symptoms of massive structural issues. The context of $17 trillion in negative-yielding debt, that is a driver. That is a driver of this late-cycle investor lapse of judgment. Imagine right now the Conte government in Italy. They’re falling apart.
You’ve got no-confidence votes, you’ve got all kinds of stuff breaking apart politically. They’re in the process of working on a 100-year bond, 100-year paper with an approximate yield of 2.5%. Again, just play this in your mind. This is a deteriorating government falling to pieces. They want to issue debt for the next 100 years.
Kevin: For 2.5%.
David: Honestly, relative to 10-year German bunds, which are negative percent, you’d say, “Well, these are really high yield.” Hold a minute. That’s a generous payout. Italy is priced 45 basis points. That’s just about a half a percent below what the US treasury bond yields. Not rational. Not rational. That’s their ten-year paper.
We knew there would be problems when German savings … this goes back to pre-2008 and 2009. You had German savings accommodating southern European debt-financed consumption. You had a massive spend. You had a massive real estate binge based on low-yielding rates in the north which somehow got translated into low-yielding rates in the south.
Kevin: Yes, you remember Otmar Issing? Remember when you interviewed Otmar, who was … he was the head of the European Central Bank for seven years. He probably would be considered the founding father of the euro to a degree. He told you, he said there was a disjoint in financing between the northern countries and the southern countries.” It looks like they’ve bridged that gap at a very high cost to the Central Bank.
David: Yes he had been … at that point he was the longest standing member of the ECB, and that was what he was commenting on. Now, we’re witnessing more of that disjointed financing than prior to the global financial crisis. The major strains the EU came under, we go back to 2010 and 2011, and really what this says is that the ECB is trapped, just like the Fed is trapped.
Don’t forget this. This is so critical because you have aberrant investor behavior, which is being encouraged and magnified by desperate central bank policies, which is nothing more than an extension of the global financial crisis, 2008 to 2011, if you include the worst of the worst there in Europe, with none of the structural messes cleaned up. They’ve been papered over.
If you’ve ever made a piñata, this is it. It’s the veneer of paper and glue you put on a balloon. Again, I’m fascinated by how quickly we move past even recent history, and ignore the realities of European Central Bank being in a desperate bind and the Fed acting as if all is well, while in fact, these are desperate measures in desperate times.
Kevin: In 2015 when we first started seeing negative interest rates, we said, “It’s really not that large, it’s just strange.” It’s strange that we’re seeing anything offering negative rates. Now we’re up to 17 trillion in negative-yielding debt. How about these long-dated bonds? Right now, it’s like the same thing. It’s not trillions and trillions in long-dated bonds, but they’ve broached something that makes no sense. How large is that?
David: The ultra long-dated stuff is only about $15 to $20 billion in issuance each year. This year we’ll probably top 20 and that’s in a market of $1.25 trillion. It is gaining in popularity because it has something that short duration bonds lost years ago. Drum roll, please. What did short duration bonds lose years ago? Oh, positive yield. [laughs]
David: Actually, that’s not funny. That’s not…
Kevin: It’s not just governments, Dave. Disney, Coca Cola, everybody’s jumping on the bandwagon.
David: Peru, great bet there for a 100 years. Israel, may be a better bet. Walt Disney, Coca Cola, all pushing out a 100-year debt in this most recent period. I’m not criticizing the offerings. If you can find the patsy to part with money for 50 to 100 years, you would expect a government bureaucrat to say, “Why not?” and not care.
This has to be a person who doesn’t care about getting principal back at the end of the timeframe. Again, I’m assuming that there is a consequence to inflation. From the investor standpoint, it’s absurd. From the government standpoint or Walt Disney standpoint or Coca Cola standpoint, it’s brilliant.
I think that the confidence game that we see in play in the bond market is based on ignorance, and ignorance is not bliss. Ignorance is ignorance, and it’s dangerous. At least it’s expensive. As they say, there’s only one genius in any transaction. We see these entities bringing debt to market. What should we say, bottoms up to Coca Cola? L’chaim to Walt? Not even Walt Disney could have imagined so fantastical and creative a world of fixed income.
Kevin: I have a question for you, Dave. Why isn’t the US treasury feeding the market with long-dated paper like Walt Disney?
David: We only go out about 20 years. Honestly, I think the addiction to cheap financing has our Treasury Department looking at interest costs and celebrating a reduction in average interest costs, neglecting the improvement in terms they could get if they extended durations. Again, yes, this is to the detriment of investors, but that’s not … I’m not arguing for some sort of a charity or kindness coming from the US Treasury.
I think what it speaks to, Kevin, is that the margins allowable for an increase in interest expense are very, very thin. I’m not sure that our over-leveraged system, that’s the government debt and perhaps even corporate as well, I’m not sure it can handle a move higher. Again, I’m not talking about Nolan’s interest rate spike. That clearly would be devastating. I’m talking about 100 to 200 basis points of added expense. Run the math on paying an average expense higher, 100 to 200 basis points. That’s 250 to 500 billion in cash needed per year on our small stock of debt. Call it 25-plus trillion dollars in debt.
Kevin: The assumption, though, is that money doesn’t grow on trees. Maybe we’re wrong on that assumption. Maybe generations of parents have told their kids incorrectly that money doesn’t grow on trees, and that you can print it out of thin air, and no matter how much you print, you never have inflation, you never have devaluation of the currency. Dave, I’m going to put you on the spot here. Aren’t you assuming that inflation is coming? My question would be, if it is, can you hear it coming?
David: Assuming inflation is coming borrows from facts we’ve seen in the past, which have been important. M2. We’re talking about monetary supply growth. You look at M1 here in the United States, up 53% last year. M2, up 25% here in the US. This is without precedent.
If you’re talking about global money supply growth at 17, it increased by 17.3%, counting the US eurozone, China, Japan, along with sort of the next eight largest contributors. The tally there brings it to $14 trillion in increase for 2020. That exceeds the previous record. This is really critical.
It exceeds the previous record set back in 2003. Again, we’re talking about monetary supply growth, global. It exceeds that number by 67%. Can you hear it coming? I think what we’re talking about is the sound of silence because digital money machines run at a lower decibel level than Havenstein’s old paper whirlers, that those old school paper whirlers which are cranking out actual notes with ink on them.
It’s like an electric vehicle. You can’t hear them coming. I don’t think we’re going to hear the inflation coming, but we will feel the impact. 2003 is a really interesting reference because 2003 set up a five-year run in commodity prices, peaking in 2008, major moves higher cross the commodity complex. A major expansion in money supply classically boosts consumer price inflation.
We are loading it in now and we’ll feel it for years to come. We’ve talked about bonds today, what we’re really talking about by proxy is all speculative financial markets. We’d have to conclude, you have to be careful, you have to plan ahead, and you have to position accordingly.
Kevin: You’ve been listening to The McAlvany Weekly Commentary. I’m Kevin Orrick along with David McAlvany. You can find us at mcalvany.com, that’s M-C-A-L-V-A-N-Y.com, 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.