Podcast: Play in new window
- When will the Central Bank Digital Currency be introduced?
- Where can we place our economic faith right now?
- Does government debt matter when interest rates are still low?
Your Questions Answered Part 1
December 14, 2022
“While rates are historically low, the debt is significantly greater today, which magnifies each incremental move higher in interest rates. So even with small moves and rates on a very large number, the IMF puts total global data at 230 trillion. The World Economic Forum figures it’s a little closer to 300 trillion. Wherever you pencil it out. To manage that debt at 0% is easy. It’s not so easy at 4%. It’s definitely not easy 5 or 6 or 7%. 1% on 300 trillion, 3 trillion in debt service, but 4% puts you at 12 trillion.” — David McAlvany
Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany.
I always enjoy these programs, Dave, but I enjoy it even more when you’ve been traveling. I know you’re over in Europe right now, and this is more common than uncommon where I’m talking to you, you’re on the phone, and we’re doing a Commentary thousands of miles from each other.
David: Well, the last time I prepared for a commentary in Europe, I was on a train between Paris and Brussels, and sometimes I’ll listen to music while I’m doing that, and it was Palestrina then. Now on the same train with a dear friend and colleague and my youngest son, and it’s the Kronos Quartet instead of Palestrina that’s running in the background.
So we’ve now operated in the US and Europe for a long time as a business, and times change. The way we do business has had to evolve through the years. It’s been 50 years, so some things have to change. We maintain the same relationships here in Europe. Adaptation, of course, has had to take place with new regulatory landscapes, and it’s required us to evolve as well. So a number of years ago, inspired by a very tight supply of physical metals in the US—that was in and through the global financial crisis—we established impeccable relationships in a number of Europe’s gold and silver hubs which allow us to source product even when the US markets are too tight and premiums excessive. So banks, central banks, refineries in the UK, Switzerland, Germany, France, Belgium, they fill the gaps that would otherwise exist and do exist for other precious metals firms. So having superior products and sourcing will continue to serve us well in the bull market that is ahead of us. I’d love to be recording the Q&A from Durango. I’d love to be in studio. I hope those listening will tolerate slightly inferior sound quality. But here we go, the first of a couple of weeks because we’ve had a lot of questions, and we’ll just dive right in and cover as many as we can today.
Kevin: Well, it sounds good, Dave. And actually I’m a beneficiary. I know my clients have been a beneficiary of just having those inventory resources over in Europe, and I bought a tube of sovereigns last Friday, and we haven’t had sovereigns in a while, so I appreciate that you guys are over there. I appreciate that you’re keeping the relationships going.
I’m going to start out with the question from Steve. He says, “Over the last couple of years, digital dollars have been discussed by various governments and NGO entities. Recently, it seems the fire has been turned up. In fact, the FTX Ponzi scheme may be the perfect ‘reason’ for Congress to implement rules and regulations on digital dollars in order to ‘protect the public.’ What is the likelihood that CBDC will be introduced or even made mandatory in 2023?”
David: Yeah. So central bank digital currencies, the idea of them being mandatory in 2023, there is no pilot program at this point. So a realistic timeframe is not likely in 2023. If the Fed launched a program in 2023, again, a pilot program, general adoption would still be several years out from that date. Regulation of cryptocurrencies by the SEC is the likely objective in 2023. Currently, there’s no oversight except where derivatives are involved. So Gensler is the man at the SEC who will get it done, and we’ve incessantly quoted Ken Rogoff on cryptos when he said in a Foreign Affairs article many, many years ago, “what the private sector innovates, the public sector will regulate and then appropriate.”
And it seems to be more than loose commentary, perhaps more of a playbook going forward in terms of the regulation piece and even the appropriation piece. If Wall Street firms are going to offer cryptocurrencies as an option for investors and within retirement accounts, then SEC regulation is inevitable. So now, with the scandals of 2022, this is an immediate imperative. Private tokens are not and will never be official currency. So we’re talking about the monopoly franchise on currency creation that central banks have, and that is not something that is going to be relinquished. So you look at private tokens, on the other hand, and they are a means of speculation like many other things. They’ll continue to develop. They’re not going away, but it’ll have to be within the confines of a securities regulated space. Think about that. How does a group like Fidelity, how does a group like TD Ameritrade or Schwab, how do they offer trading in these tokens without them being considered securities by the SEC?
So this, I think, this conclusion is supported by the SEC’s actions, Securities and Exchange Commissions actions this week against Sam Bankman-Fried. The SEC will introduce a host of consumer protection rules, disclosure rules for firms, and of course the normal limits on marketing and distribution of financial products. So central bank digital currencies are a different animal, really a separate conversation.
Kevin: Well, and you had talked about there not being a pilot program. There hasn’t been a pilot program for you and I as the consumer, but the New York Fed, of course, as you know, did a 12-week pilot program called Project Cedar, which basically was just duplicating a lot of the digital transactions that are already occurring from central bank to central bank or international settlements. So in a way, they have begun doing this, but they’ve been doing this for a while. It’s just, at this point, it’s blockchain technology.
David: The advantages of digital currency to a central bank are first of all that they illuminate the possibility of private and untraceable cash transactions. And this is probably more of a Treasury benefit than a central bank benefit, but one that I think the central bank would still be mindful of. Hundreds of billions in cash transactions occur each year all over the world, which are not traceable, and that allows for the possibility of non-taxability, of opacity.
So cash is considered this evil thing that they want to get rid of—and you can even see that in the title of Ken Rogoff’s book, The Curse of Cash, where he talks about every possible illicit activity, and yes, it’s enabled by cash. That’s his argument. That’s his strong argument is the evils of the world are facilitated by cash transaction. I bought a pack of gum today, and I didn’t feel like it was an illicit activity, but you read Ken Rogoff’s book and you should feel dirty for buying Wrigleys. I’ve watched the regulation of cash transactions in Europe in recent years eliminate all but the smallest of business exchanges and transactions. And on this European trip in particular, I’ve gone through multi-day stretches where businesses no longer accept cash. Everything is digital already.
Kevin: And I’m wondering, they’ve changed our habits. I mean, we use credit cards, but at this point we can get on our phone and Venmo somebody money. It’s gotten to be where cash is almost something that looks like an antique to a lot of people because of the habit change.
David: Well, launching a central bank digital currency is not that difficult when you think of the near universal usage of credit cards and of debit cards. So I think the second advantage relates to monetary policy implementation. A central bank digital currency would be a handy tool coming from the central bank toolbox. Today we see the Fed earnestly seeking to drive down business activity in order to tame inflation. They actually want to trigger a recession, and yes, they presume to be able to control it and then have it be a very short and shallow recession.
But to today, the Fed is seeking to drive down business activity. The hopes of inducing thrift today, well, it’s just that, it’s a hope. A big increase in rates may or may not inhibit retail consumption, in which case the intended economic slowing may or may not occur. It’s like a blunt instrument. Moving rates in a particular direction is a blunt instrument when something more surgical would be required for a guaranteed outcome. Central bank digital currency allows for more surgical precision. I naturally lean towards interpreting such precision as a dystopian development. The Fed would not see it that way. It’s positive, it’s precise. You incentivize spending when you want spending to occur. You provide benefits for doing that. When it’s your patriotic duty and you need to get out and spend. And then of course you can create some barriers to spending and disincentivize it as well, and that’s a lot easier to orchestrate with the central bank digital currency.
Kevin: The Federal Reserve’s gotten so used to controlling everything or thinking that they control everything that sometimes they have to change their parameters. Last week you had mentioned the former IMF chief economist saying, “Well, we need to change our inflation target to 4%.” Remember that?
David: Yeah, that was the argument at the time, actually from his argument in 2010, and then he moderates that to 3% for the sake of his Financial Times article. So increasing or decreasing purchasing power has a significant effect on consumption, and if allowed to dial that in, maybe you dial it in regionally, maybe you dial it in relative to particular products being consumed. A digital dollar becomes an incredibly powerful monetary policy tool and central planning tool when you think about what can be done in this age of big data.
Kevin: So that takes us to the second part of Steve’s question. He’s got a couple of more points on this question. Steve says, do you think that they will come with a carrot, an example, turn $1 to 1.1 CBDCs, or a stick? Or the example would be you have to spend it in a number of months, like we’ve seen recently in China, spend it in a number of months. Dollars will only be accepted at a discounted rate. What do you think, Dave, carrot or stick?
David: In a word, yes. It’s not a stretch to see, in a hyper-political world, the advantages and disadvantages doled out to good citizens or bad citizens. If Keynesian economics remains the dominant basis for praising activity, managing outcomes, and the school of thought that informs both Wall Street and Washington’s views of things. You’ve got the elimination of the rentier class to borrow directly from Keynes. You’ve got the improvement of velocity within the financial system via the suggested carrots and sticks. That all seems to be a reasonable outcome, a desired objective.
Kevin: Yeah. If you’re trying to control everything. Okay, so this is the final point or the final part of Steve’s question. What are the implications—international trade, paying off bank loans, long-term viability of local banks, and other implications? If you had to wrap it up, Dave, what would you see as the implications of this?
David: Well, for commercial banks, they already exist in a digital environment. Any of our local or state banks, think about this, they already keep less than $100,000 in cash on the bank floor on any given day.
Kevin: That’s amazing.
David: You walk in, my guess is it’s closer to 50,000. They’re largely cashless already. The implications there are that even less branches would be required to conduct bank business. Not much else would change.
From a bigger picture. If you’re talking about debt in the system, consumer debt, mortgage debt, I think that debt indexing becomes easier. There’s what we’ve talked about in past shows in terms of the sesame credit criteria. Do you have socially acceptable businesses? Do you have preferred vendors that might see some carrot offering a sanctions discount? Not unlike store credit, which might go further on certain items. Again, where you get to create a social scoring system for the products that are cheaper or products that are more expensive to try to incentivize where a consumer goes.
You could do it very subtly, but in effect, it’s the same thing that—who was it? Mike Bloomberg suggested we had to have a tax on Coca-Cola and supersized drinks because we’re paying more in health costs for particular people. Those people should pay their own way. There may be a rationale to what he had to say. There’s a point at which you have to say what business government has in this or that or the other.
But that’s really what you’re giving away is the ability to gate government and say, “No, no, no, this is my choice. This is my prerogative, and you don’t belong here.” Digital dollars that buy more or less—again, this is the institutionalization of carrots and sticks for consumers. Can’t you see carbon taxes paid at the pump when you fill a diesel tech versus a subsidized energy rate, if you’re charging your electric vehicle at the sanctioned recharging station? This becomes a socially subsidized benefit, on the other hand, to charge your electric vehicle. Just a lot of things that I think you could end up incentivizing through a digital currency system.
Kevin: Yeah. We can see that the Treasury’s already been doing this with our international relations. A big part of the way we fight war is like Juan Zarate’s book, The Treasury’s War. You can control the consumer with these sesame credits that you’re talking about, but you also, hopefully from government point of view, can avoid bloody war by weaponizing the dollar. But in this case, you’re talking about digital currency if we move forward.
David: I don’t even know if it’s a substitute for a hot war or a war with tanks and bombs and guns. I think they’re open to anything to get the job done. It just happens to be something that’s very effective. And you’re right, if you move away from the implications domestically to the international, the Treasury uses our digital currency balances and other currency balances, reserve balances that are held with us. They already have weaponized that.
So digital currency balances as a weapon against other currencies as a weapon against other countries. You’re right, that was Juan Zarate’s point in Treasury’s War. It outlines how this has been a more critical form of warfare than tactical hot war with boots on the ground. The state actors are already at the end of that version of a pointed gun. Individuals are, too, as we’ve seen in the sanctioning of individuals and the freezing of private assets held in the banking system. Dollar balances in the banking system have long been at risk, and we get to see it in real time in 2022. We count on the benevolence—and our foreign trade partners who do keep dollar balances with us—they count on the benevolence of each administration to respect the rule of law as a protection for the people and not as an arbitrary instrument of force.
Kevin: So that takes us to international trade. He asked, “how would the CBDC change international trade?”
David: Yeah. International trade isn’t changed by the implementation of central bank digital currencies as much as it is the practice of the Treasury to use the types and valves in the capital markets to change the flows, if you will, the access to money and credit. Central bank digital currencies likely would accelerate the shift to a rise-of-the-rest trade environment justifying the diminution of the dollar as the primary currency in international trade settlement in favor of other options.
So, again, think about that. If you know that the US Treasury can turn off the valve, and the flows stop, and you are at risk of being cut off, again, this is just a version of sanction. Then you look at the dollar and you look at it differently. You look at it as a risk asset, not as a safe asset. You look at it as something that you have to run through risk analysis, and that’s what I mean by somebody saying, “Well, maybe we look for an alternative as a reserve asset.”
Kevin: And we have seen, even in the days of quasi-gold-backed fiat currency, we’ve seen two tiered systems in the past. After 1933, the US citizen could not trade gold for currency or currency for gold, but if you were an international you could. I mean, the dollar was still 1/35th of an ounce of gold if you were outside of the country. So that two-tiered thinking actually could show up again in digital, couldn’t it?
David: Yeah. It allowed for there to be nuance in the way that the Federal Reserve handled the value of the dollar in the United States, where it was devalued by 65% in one day. And on the other hand, you go to the foreign trade partners and you could still get gold. You didn’t have to take greenbacks. You could still get gold, and gold is gold is gold, regardless of how many dollars it took to buy it—or French Franks or German Marks—gold is gold is gold. There was no devaluation that occurred for you when the debts were payable in ounces.
So yeah, it was illegal for the US citizen to own and trade gold from 1933 to 1975. A central bank digital currency— I think it would allow for a delicate employment so you don’t have to cause a revolt with trade partners. You can have it be, in a very nuanced way, catering to particular countries. And for the domestic citizen, maybe it’s a different story. As you say, we’ve done that before with a two-tiered system. You could have a ten-tiered system within the digital either. So initially I think it would not materially change anything for us, launching a central bank digital currency. I would suspect that, over time, it’d be like the camel’s nose under the tent. So after two, three years from launch, which I don’t think is even possible for another two or three years, so we’re talking about five to six to seven years from here. That’s when I think you could begin to feel the pain of a central bank digital currency being used as leverage on the people.
Kevin: Yeah. This next question is from Adrian. “We hear on occasion about high premiums on physical gold and silver, and large central bank gold buying. Both seem like reasonable early indicators, though I have failed to see any correlation. Do your studies suggest otherwise? Perhaps we need a collapse of the “paperweight” derivatives market or ____?” What do you think, Dave? The central banks have been buying an awful lot of gold, and yet we’re not necessarily seeing it show up in the price.
David: Well, gold is a hedge asset. The central bank buying of gold has, in aggregate, been extraordinarily high in 2022. And it corresponds with the Treasury’s war on Russia and continued pressure on Iran. Other countries have opted to fortify their currency reserves outside the dollar system. Why? Because the cash reserves that Russia held in US dollars have been frozen. And that example is uninspiring to other countries that also hold reserves in US dollars. The US locked up hundreds of billions in Russian capital. This is not an overstatement. $300 billion in Russian, and this is foreign reserves, we’ve got it locked up. We got it, and we will probably use it to help rebuild Ukraine. Maybe there’s 10% for somebody in Washington, we’ll see how that goes.
In the form of currency reserves, that’s one risk. But again, there’s the individuals, too. An additional 30 billion in Russian oligarch assets have also been seized. So gold— From this vantage point, if you’re looking at central bank purchases and say, “Well, why are they doing this? Is this in response to inflation?” No, these are the guys who are helping create inflation. Gold is a hedge against many things. Now the world adds to the list of hedge benefits a hedge against US government interference and theft. That’s a new dynamic, and I don’t think you get to put that genie back in the bottle.
Kevin: In a way, it’s like the international powers that be are saying, “You’re not going to give me an international sesame credit with this digital currency or the dollar. We’ll keep our gold, thank you very much.” And 400 tons of gold, that’s a lot of tonnage for the central banks in one quarter.
David: Well, the benefits of staying a part of the US dollar system still outweigh the cost, but the growing awareness of vulnerability for non-compliance with US policy prerogatives has central banks shifting their reserves. So we get a big purchase in gold this year. That’s likely to continue. And imagine central banks competing with investors for a hedge asset.
So if the costs ever outweigh the benefit—the costs of being in the US dollar system outweigh the benefits—demand for metals— I think this is when you begin to see things— Really volatile. The transition to a new currency regime. It won’t only be volatile, but demand for metals as an interim step would be very high.
So at some point, you have to wonder when the Treasury’s wars become a war on gold. I’m glad it’s a global market. That’s not a concern that keeps me up at night. But I remember Volcker’s comments about taking shots at the gold market and that would’ve helped his inflation fight because you would’ve shut down the barometer for inflation. But for a central bank to see an alternative to the dollar emerge, or to fortify an argument for an alternative, again, where you’ve got larger gold reserves in on the geography. China is an example. What if the Treasury’s war becomes a war on gold?
And again, that’s why that’s not a concern to me ultimately is, this is a global market, like oil. Global demand dynamics are more important than US-centric demand. Look at China’s consumption of gold, India’s consumption of gold. They, in fact, are the elephants in the room. The US not so much. But manipulation in the futures market by US authorities, if we put that future tense, as an extension of the Treasury department’s directed action against central banks moving on and away from the US dollar, would that add to price volatility? Yeah, sure.
But that to me does not sound like a reason to avoid gold. Short-term volatility from manipulation is different than long-term control, and I don’t think the Treasury ever gains control of the gold market. Aggregate strength of global traders, as we’ve seen in the bond markets this year, is far more powerful than central bank and Treasury power. So if your concern is there, just think of the bond market and realize that as much as the central banks and Treasurys of the world have wanted to have a different outcome in the bond markets this year, no, they’re not in control. Global traders, that’s where the real power is, in aggregate. And it’s resources coming from that source that ultimately I think is far more consequential.
Kevin: And Adrian had asked also, “What’s the correlation? Is the motivation the same for the individual investor who’s buying gold and actually having to pay a premium right now on physical gold?” So is it the same motivation?
David: Yeah. Investors are hedging other risks. You’ve got counterparty risk, you’ve got inflation risk, you’ve got deflation risk, you’ve got market volatility risk, and a number of other things. There is no direct correlation to central bank demand. If you’re looking at investors buying gold and central banks buying gold, as was suggested by his initial question, you’ve got the gathering crowd of gold buyers who have, in 2022, they’ve discovered the relative scarcity of gold, with investors in particular encountering the inefficiencies of global mints manufacturing small coins and bars. And this is where the premiums have been the most apparent.
So when you’re looking at particular products mismanaged by various mints, there’s been a supply and demand imbalance and the premiums have popped up. You could say, okay, but even large bars, thousand-ounce silver bars, kilo bars, these large format gold bars, they’ve seen a bump in premiums too. Those are the go-to products for central banks and institutions. So there’s also been some premium pressures there. We’ve navigated this pretty well. Throughout the year we’ve taken advantage of premiums on small format products to increase total ounces held by our clients, and we’ve seen clients increase their total ounce holdings in a range from 30 to 50%. So while gold and silver have traded lower, they’re looking at the spot price here in 2022. Many of our clients have seen significant increases in ounces. Reality is, you need to be positioned in small products beforehand, but just remember that you only are looking at the small products with low premiums when premiums are low. Otherwise you can’t take advantage of higher premiums later on to compound ounces.
Kevin: This next question comes from David, but it is interesting. He’s talking about being realistic rather than being an optimist. And he starts the question, he says, “Hey, David and Kevin. Thanks for your perspective-expanding context on the weekly commentary.” And then he quotes the Stockdale Paradox. I think it’s really interesting. Here’s the paradox. It says, “You must never confuse faith that you will prevail in the end, which you can never afford to lose, with the discipline to confront the most brutal facts of your current reality, whatever they might be.”
And he uses an example, “we’re not getting out of here by Christmas” in the Vietcong POW camps, because the optimists were the ones who did not survive the camps. It was the realist. They were optimistic about their ability to persevere, but not necessarily get out by a particular time. So here’s the question from David. It says, “As you look at America’s economy and national trajectory, where would you encourage people to place their economic faith? What are the basics, the core timeless investing strategies that will pay off in the long-term if applied persistently? And what are the brutal realities wise investors must face right now and moving forward? Putting it another way, what is truth and what is living in denial?” It says “You cover both sides of the paradox in one form or another on most episodes of the Commentary. But for some of us less widely read and more simply minded, could you summarize where we stand right now as you see it?”
David: Yeah. Those are great questions, really great. The paradox is one where difficult circumstances are in front of you, and yet there is faith in resolution in the end, but you don’t know when. If you try too hard to figure out the when, you’re in a dangerous place—typically leading to psychological implosion of one degree or another as your expectations go unmet. And those unmet expectations become an unbearable weight. So when he’s talking about the POW camps with the Vietcong: If people were hopeful, that wasn’t the problem. It was that they were hopeful with a specific date in mind. And when they were disappointed over and over and over again, then they experienced emotional and psychological collapse.
So being more realistic, dealing with the brutal facts, “We’re not getting out by Christmas.” Those are the people who had a way because they basically were managing their expectations. So I think the first immutable law of the market seems to me to be that mankind is incredibly clever, and as such delivers a thousand benefits in any particular generation as we’re solving problems, as we’re creating businesses, as we’re creating amazing reality. But mankind is also too clever, which makes for a cyclical history. So we build until we overbuild, and then we pay for it, and then we start all over again. Think Chinese real estate development, think cryptocurrencies, think credit growth—all too much of a good thing, driven by clever human beings who lose touch with what is too much. What is too much? And then we’re collectively set back.
And something that comes to mind is the structure of Harry Brown’s permanent portfolio. Frankly, I think the returns can be beat. I’m not recommending this an allocation, but the theory is that with 25% in precious metals, 25% in real estate, 25% in growth stocks, 25% in Treasurys, you’re covered on the upside growth. You’re covered on the downside of a cycle. And that’s why they call it an all-weather portfolio. I think there is far more risk mitigation that is required for that to be successful. So there are some serious flaws with that strategy. And I’m not advocating that split, or being on autopilot, but you can see that real estate and Treasurys are income oriented, more long-term stable. You’ve got growth stocks, you’ve got gold, they’re volatile under different circumstances. And with gold, of course, you have an inflation hedge embedded with the deflation hedge. There’s just a little bit of everything.
So it’s interesting in theory, but it’s not so much in practice. And I’m going to come back around to the importance of cyclicality. I first bought a pair of backcountry skis that did everything for me. Again, you think of the all weather portfolio and it’s the Swiss Army knife of portfolios. I bought Fischer E99. Fischer E99. They can do everything, but they don’t do anything very well. And that was the appeal was that they were the Swiss Army knife. They did everything. I didn’t know until I had more experience that they did nothing very well.
A chef will tell you that you need a particular blade for a particular task. Your cleaver, it’s very different than your pairing knife. And you can’t pretend that a Swiss Army knife is going to get you around the kitchen, not very fast, not very effectively.
So this range of options— A jungle explorer may argue strongly for a machete, not a multi-tool. Today when I ski, the backcountry ski is not the slalom ski, it’s not the skate ski, it’s not the powder ski, a ski that does it all, does nothing very well. And I think a portfolio that promises to do it all delivers very little value, very little value in the end.
So we come back to cyclicality. I think it’s appropriate to appraise your conditions and invest accordingly. That means more emphasis in particular places and less in others. We get to do this in our own portfolios with an accordion management style, which ties to risk management and opportunism. We will shrink positions back in particular areas when risk is becoming more obvious in the marketplace. And again, it ties to risk management. And the opportunist side sees us expanding out particular positions when the reward becomes compelling. It’s an active process and it involves reappraisal of these backdrop issues. Where are we at in a longer cycle? And if we can be positioned more attractively for where we’re at in a particular, again, long-term cycle, then I think it’s better than the generic, all weather, 25/25/25/25 split.
So if we’re entering a very different part of a long cycle, different offerings may be emphasized. In this part of the cycle, hard assets are focused. In another part of the long cycle, financial assets will have to play a part. Not now though.
So I come back to the cyclical aspect. Markets are mutable, not just on a daily basis—we experience that volatility every time we listen to CNBC or Bloomberg—but as defined by longer-term trends of expansion and contraction. Clever. And maybe there’s also an opportunity to be too clever. I think of wisdom literature. And for anyone, I think, who fits the well-read category, this includes a whole list of things. But don’t neglect King Solomon’s life observations. Ecclesiastes chapter two comes to mind. You’ve got the seasons of life and a time for everything. There’s a time to be fully engaged. There’s a time to be really on the defensive. And I think, coming back to the question, this is I think one of those truths. There’s always going to be change in the marketplace, and you simply can’t be on autopilot—even with an idea that is elegant. It still needs to be actively managed because things are changing.
I think a brutal truth facing investors is that the cleverest folks on the planet, the creators of credit and financial instruments from Wall Street all the way to Washington—fill in the blanks for your global counterparts—they’re set on non-cyclicality. So something that we find to be natural ebbs and flows, they don’t want to see that anymore. And it’s an expression of belief in themselves. It’s an expression in utopian outcome. It’s an expression of confidence in their ability to manage and control.
We are in the too-clever phase, and it’s defined by hubris, defined by pride. When ego and pride dominate everything, you’re moving towards the danger zone. Pride is blinding. Presumptions of our central planners and the greed of Wall Street creative, that has us moving towards the limits of complexity.
So whether you cast that as a new cycle dynamic or the completion of a long cycle, I think the strategies needed are different now than they have been over the past three to four decades. I mean, this is one of the points of our Commentaries, to say, “What’s the context we’re in, and what are the decisions we need to do in light of a changing context?” If there’s a period of time where you need to play more defense, great. If there’s a period of time where you can go on the offense, by all means do. But you have to understand the context that you’re in.
Kevin: Next question from Northern California is from Preston. He says, “Longtime listener of your show and very grateful to both of you for sharing your thoughts weekly here.” He says, “I have an open-ended question, and it revolves around interest rates. How long has the fed funds rate held such a strong influence over the bond market in the United States? Is it as simple as dating back to the creation of the Federal Reserve in 1913? Or has its influence grown more in recent decades?”
David: That’s an interesting question. In order to take duration risk and credit risk out of the equation, I’ll comment on two-year Treasurys. And I think the big takeaway is that the federal funds rates is correlated to the Treasury market, but it does not control or cause movement in Treasurys or the broader bond market. If anything, it’s the other way around. You’ll see the federal funds rate as a first mover and market influencer in a cut, as a reducing rate, so like we saw in 2008 and 2009. So on the way down the Fed will get aggressive. In crisis mode, the markets price in more risk. The fed funds rate prices in a policy objective. That’s what you’re seeing is the fed funds rate pricing in a policy objective of stabilization, of liquidity infusion, like we saw with QE.
The Fed leads on the downside as an expression of market accommodation, bailout measures, policy agenda. The two-year and the federal funds rate, they came closest. There was a very little gap between them in the 2011 to 2013 timeframe. Since then, the gap between them has widened considerably. So on the upside, the federal funds rate is still biased by policy objectives, and the two-year Treasury prices in other factors, as does the broader market.
So you begin to see this gap growing between them, where the two-year and the bond market are behaving the way you would expect the bond market to—taking an appraisal of credit environment and other risk factors, inflation, what have you. And fed funds rate is still saying, “No, we have a policy objective. We’re not done, even if we overstay our welcome.” So the federal funds rate stays stubbornly low. The increases this year may be in response to higher inflation, but the federal funds rate has trailed the bond market and has trailed the two-year Treasury yield considerably.
The two-year and the broader bond market doesn’t have an agenda. The Fed does. So it’s a different behavior one way or the other. The downside, the Fed accommodates and tends to lead with that accommodating bent. And on the upside, it’s the bond market that’s leading. And the Fed is ever so reluctant to do anything because they have to make sure that they’ve met their policy objectives.
So how far back does it go? The question mentioned 1913. Yeah, I think the grand agenda, the grand conceit in determining economic outcomes, I would dial that into a shift from the Fed intentionally being countercyclical to market trends to being procyclical in the late 1960s. So go back to William McChesney Martin. He was replaced by Arthur Burns in 1969. The political expectations were set. The political policy objectives were clearly defined. Martin was tightening policy. Nixon did not like it. William McChesney Martin refused to concede, defending Fed independence. Nixon replaced him. Nixon replaced him with a yes man named Arthur Burns. This added to the inflationary trends already in motion, which a few years later only the Volcker extremes would aid in resolving.
But I think Volcker was interim. If you’re looking at a major transition away from countercyclical policies to procyclical policies, I date it to 1969. Again, minor pause with Volcker. And then Greenspan, who coincidentally did his PhD under Arthur Burns, Columbia, he expands and perfects pro-cyclical fed policy. And we’ve never looked back.
I would say that Powell has come the closest to counter-cyclicality, a return to an earlier era of leading instead of following the market, operating counter-cyclically versus pro-cyclically. But he was disabused of that idea. The violent market reaction in the fourth quarter of 2019 convinced him otherwise. I think his instincts are good. He hasn’t been able to follow through. Yeah, of course he’s raising interest rates now, but this is in response. He’s not leading, he’s following. The federal funds rate is still catching up to the market moves in bonds. The Fed is only reluctantly “QTing” instead of QEing—quantitative tightening.
Kevin: Next question from Jake from Philadelphia. “Hi team. Thank you so much for your great podcast. Question for the year-end below. Thank you. Yes, there has been a lot of money printed, but most wealth is concentrated to a finite group of individuals. How much of that money will really ever trickle into the physical markets, if any? Very little money velocity—extremely low—seems to indicate people are just not spending.”
David: I’d love to find a study—I don’t know if one’s been done—but I’d love to find a study going back through centuries—a long, long period in multiple countries—and see where wealth concentration and differences between haves and have-nots became very extreme. What happened with velocity in each of those periods? And I don’t know of a study, so if a listener is familiar with that, boy, I’d be very much in your debt if you could point me in that direction.
So the fall of money velocity, as you see the divide between rich and poor increasing. So a couple things in that question: Retail sales have been robust. So this idea that people are not spending: they are—a data point that in fact argues against recession. You’ve only had two out of the last 10 months which have slipped into negative territory. Otherwise, retail sales from the beginning of the year to date have been quite strong, but it hasn’t changed velocity—not considerably. We’re a little off the lows, but velocity has been in a consistent decline since 1997. It peaked with the M2 money supply at 2.19. That dates to the fourth quarter of 1997. It sits at about half that level today, 1.19—half the velocity, that is half the turnover of dollars in our economy, from two decades ago. And we hit the low in the second quarter of 2020, slightly below our current number, 1.19.
I can’t say that I understand the velocity anemia. That’s why I was asking for a paper reference if anyone has one, a white paper reference. I’ll be interested to see if it stays low after 24 to 36 months of above-target inflation. The other part of the question, by physical markets, I’m not sure if that’s a reference to physical metals or not. That’s what I’m going to assume. I’m assuming that’s what was referenced. And I think plenty of money has flowed into metals in the context of declining velocity—because again, velocity’s been declining since ’97. Metals broke a two-and-a-half decades slumber, rising from the low 300s, and now sit six times higher at over 1800. So there has been enough flow to elevate the price by between five and 600%.
Wealthy, I mean extremely wealthy, folks generally feel unfazed by market volatility. So their interest in gold, their interest in moving money and seeing significant flows, hasn’t really happened. But there can be a shift. And if Wall Street institutions and banks begin to come under pressure, then you see the really wealthy start to scramble for real assets, whether it’s art, land, physical metals, demand for those assets does pick up.
There’s a lot of confidence in the super wealthy crowd. Super wealthy crowd generally has a lot of education, number of letters behind the name. There’s a lot of confidence placed in economic orthodoxy. And again, you could even argue amongst the highly to overly educated—I would put intelligence on a different scale from education, they don’t always go hand in hand—but the confidence in the economic orthodoxy and the confidence in the Fed, you’re talking about folks that are at the top of the food chain economically speaking. And frankly, most of the rapid expansion and wealth, or perceived wealth, over recent decades has been compliments of monetary policy largesse.
We go back to that idea of procyclicality. Why wouldn’t you trust the PhD monetary standard? Why wouldn’t you put faith and confidence in what has been working for many, many decades? But money does flow under the right circumstances and in big chunks. I mentioned, the idea that Wall Street firms or banks, if they come under duress, then it doesn’t matter what faith you put in economic orthodoxy, you head for the hills. And I recall a friend of mine being given an instruction at a hedge fund he worked for. As his boss peered across the street in Manhattan during the global financial crisis, he looked at the Morgan Stanley office across the street, and he said out loud, “I’m not certain our money is there anymore.” And then he told my friend, “Buy $600 million in physical gold before the market closes today.” And he did.
The metals markets are infinitesimal compared with the global financial markets today. And a small marginal shift in allocations of even one or 2%, I think would triple or quadruple the price of the metals. I mean, I’m assuming that we still have central banks actively buying as well, where again, you end up with that competition between central bank buyers and investors coming in at the same time.
Kevin: Yeah. Jake said the second part of his question is, “The USA and the world government debt is much higher today, but the cost of that debt is still rather low when all the rates the government pays are put together, something around 4%. It seems like a rather ‘small cost’ for governments. It does not seem like things will unravel anytime soon, although I suppose it’s possible either way.”
David: Well, while rates are historically low, the debt is significantly greater today, which magnifies each incremental move higher in interest rates. So even with small moves and rates on a very large number, so the IMF puts total global debt at 230 trillion. The World Economic Forum figures it’s a little closer to 300 trillion. Wherever you pencil it out. To manage that debt at 0% is easy. I mean, that’s the beauty. That was where we were moving towards modern monetary theory. It was, yeah, if we keep interest rates at zero, who cares? Spend and spend as you will, in any quantity. This debt is very easy to handle.
Okay. Well, it’s not so easy at 4%. It’s definitely not easy at 5 or 6 or 7%. When you go from 1 to 4, you see a three or four times multiple of required cash flow just to pay interest. 1% on $3 trillion in debt service. It’s not an insignificant nominal number, but 4% puts you at 12 trillion.
I haven’t tallied the combined total tax revenue of the G7, the statistics are at the OECD website but the interest component as a percentage of tax revenue, it gets pretty scary pretty fast. And if you just pick the G7—again, you’re talking about the lion’s share of global taxing and the lion’s share of global debt is there with the G7. So unraveling is a question of confidence. It’s a question also of coercion by governments in the process of increasing extraction from citizens, and discovering what thresholds are there, either of tolerance on the tax side or of tolerance, frankly, in the bond market for what happens—the gap between what’s coming in and what’s going out. They have to match, or the bond market—the vigilantes, so to say—go crazy.
We had an example of this. The UK found its threshold this year, just as an example. A little more spending and a little less tax collection flipped the pound sterling into a state of chaos and fed interest rates soaring overnight. And that’s what a loss of confidence looks like.
Kevin, you and I often discuss catastrophe math, the math that determines the collapse of the sand pile. And just to visualize it, you add and you add and you add. And then one grain, not sure which one, but one grain causes an irrecoverable fracture and a slide. It’s the same concept. It works until it doesn’t.
Kevin: Yeah, the Zeeman catastrophe machine. It’s good thing to look up on the internet: Zeeman math.
But let’s get to the next question from Tom. Tom says, “Dear David and Kevin, love the podcast. Look forward to it every week. My question is, you often speak about the size of the derivatives markets and relate it to leverage. It’s my experience that banks, insurance companies, and pension funds hedge long-term liabilities with derivatives. These portfolios are rebalanced daily. Oftentimes there are adverse tax consequences to trading a derivative to adjust the hedge. As a result, these institutions enter new derivatives to offset existing ones. This leads to hundreds of billions of notional for each individual firm when the liabilities are a fraction of the size. Adding across firms, this leads to many trillions. Companies manage exposure through offset agreements. Have you taken this into account when you comment on derivatives?”
So the question, Dave, is just simply, are we looking at the derivatives market as being too large?
David: Fair point, if you take notional value and divide by market value, that gives you the amount of leverage at play. And when I think of risk, I do think of the big number, notional, not the small number, market value. And it’s because of the way assets behave in a market selloff. In a market selloff, the market value can shrink, leaving your leverage number higher and higher. And that leaves custodians wanting more skin in the game, requiring more collateral at an inopportune time.
Under normal circumstances, net exposures are all you need to care about. What makes the gross figure interesting is 1) the implicit leverage, and 2) the consequence of a scramble for liquidity, where counterparties that have offset risk are assuming that more collateral can be raised. And this is where you go back to how quickly things materialized—or maybe dematerialize is the right word—during the global financial crisis. This was your classic liquidity-to-solvency crisis in two steps. Leverage speeds things up.
I had an interesting conversation the other day with a fixed income trader at Morgan Stanley, and I promise I’m not picking on that coincidental conversation. As many trades as possible within the company are offset internally to keep the business on the same books. So you’ve got another division which is making money which would be paid in transaction fees and whatever to another firm if it was done outside—more profitable than offsetting with other firms. But the risk stays concentrated on one balance sheet.
So think about this. The left pocket says to the right pocket, “Pay me to offset your risk.” But ultimately, it’s the same set of trousers burning. It’s lit on fire. So now, in the event that risks are offset with another firm, that may be smarter because now it’s diversified the risk away from you. But you’re assuming continuity of business with your counterparty, which is to say you assume a liquid and continuous market exists when you need a liquid and continuous market. And that’s not how a crisis works. That’s not how a crisis works. That is the one time you cannot rely on liquid and continuous markets. That’s the one time you can’t depend on the existence of your counterparty. So you confidently place your bets, you hedge out aspects of the risk, only to discover that your counterparty can’t pay you.
In different terms, just imagine that the level of somebody takes out a life insurance contract. You’re diversifying your risk, someone who’s going to pay you on death. Imagine a death benefit from a life insurance company. Imagine the unfortunate case of the insolvency of that insurance company coinciding with your death. Your family was expecting to be paid, only to discover that the money is not there for payment. And you assumed something about the viability of your life insurance counterparty, which—this is just, it stinks for your family. So you’re relying on the future financial viability of counterparties, and you’re relying on the normalcy of markets, when in fact that’s not the case. So if I missed the point of the question altogether, then I certainly hope that, Tom, you’ll get in touch if we can have a better conversation. But I think that’s how I’d respond.
Kevin: Yeah. Either way, no matter how you measure the derivatives, it seems like a trillion or 10 trillion or 100 trillion or a quadrillion. Those are all very big numbers when risk starts to come into play. But Dave, I know it’s getting late there. Where you are you traveling to next?
David: Well, we’re on our way home. We’re going to stop in London for about a day, and then we’ve got a direct flight back home. So, looking forward to being home. And I’ve got an eight-year-old who— we have a dozen pictures of him sleeping in trains, planes, automobiles. I tend to wear these guys out.
Kevin: And you might want to get him dinner tonight, don’t you think?
David: That is what’s next, we’re off to dinner.
What a great opportunity to engage with our listeners, and we’re really appreciative of the level of engagement. We don’t presume to know much—maybe a few things, and maybe we’re just here to add to a broader conversation. But love the engagement, love the questions, love the opportunity to dialogue with you in this way, and really look forward to digging deeper into relationship, if that makes sense, from a business standpoint. Be an honor to work with you. The quality of these questions, these are the people that I want to be doing business with, that’s for sure.
Kevin: Well, and I look forward to next week’s program, which we’ll continue with the answers to questions. You’ve been listening to McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany. You can find us at mcalvany.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.
