Podcast: Play in new window
- Gold Rising With Long Yields Signals Trouble
- China Military “Shows Love” To Taiwan
- Central Bank Gold Buyers To Be Followed By Mass Public Buying
The McAlvany Weekly Commentary
October 23, 2024
“The world of shadow banking and financialization is breaking into new territory. Private credit is what everyone is fawning over today, and it’s capturing market share from commercial lenders. In fact, it is the new subprime. You’ve got juicy fees, you’ve got opacity, you’ve got lockups for investors. And frankly, if you can fog a mirror, you have access if you’re a borrower. The last week, comments from Neel Kashkari at the Minneapolis Fed, he’s claiming that this is actually a safer version of credit expansion than commercial lending. I think we’re going to get to test that supposition in the next correction, and I think his credibility will be tested along with it.” —David McAlvany
Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany.
Well, David, we’re recording remote today because you have been speaking at a conference. I’d like to hear a little bit about that before we start talking about what you’ve been talking about.
David: Last week was Dallas, this week is Florida. So, from one conference to the next, it’s been busy on the road.
Kevin: Well, Dave, there’s so much to talk about. We’ve got people calling in saying, “Hey, gold’s awfully high right now, isn’t it?” And interest rates, we’ve seen interest rates rising, Dave, over the last few years, and we’ve seen gold rising at the same time. What does that say? Does that mean Summers-Barsky, the theory that higher interest rates mean lower gold, do you think we’re throwing that away at this point and we’re seeing something more like the 1970s?
David: Well, the conversations at the conference were pretty intriguing. At the end of a long weekend, and I was listening to real estate experts primarily, the group’s consensus was in line with the Fed’s and with Wall Street equity traders’. Lower rates are here, and more are coming. So, for real estate investors, it’s good news, particularly for the battered segments of the real estate market, at least for now, if that’s what actually materializes.
And I suspect they’ll be right for short time, but wrong in the intermediate to long term. Next year, at this time, I think a surprise in bond yields is likely to be to the upside, not to lower levels. We mentioned Stanley Druckenmiller last week on the program. It would seem by his allocations—short the bond market—that our thinking overlaps with his.
Kevin: Well, Dave, for years you’ve brought up the Summers-Barsky thesis, where it says higher interest rates mean that people can go out and get more income, so they’re less likely to buy gold. We’ve seen the rise in interest rates, and you’ve been talking about, over the last few weeks, the rise in the yields in longer bonds. You would think that if gold was just playing off of the Summers-Barsky thesis, then it would be going down right now. Granted, you’re talking about short-term rates coming down, but longer-term rates are still pointing to— Like you said, in the long run, we’re nowhere near the end of this interest rate rise.
David: Well, noteworthy for the gold market is the breaking of the inverse relationship between gold and interest rates. And this started back in 2020. Rates increased dramatically from negative yields to over five, five-and-a-half percent. Gold moved higher despite that. So, declining yields reduce the opportunity cost for owning gold. Rising yields increase that opportunity cost. So, in theory, that should cause gold selling and a drop in price. Yet rates have been rising, and that has not taken away gold’s glint and gleam.
This is almost very much like the ’60s and ’70s. Gold is rising alongside interest rates, and so it forces you to ask the question, is gold telling us there’s more inflation ahead? Are longer-term bonds saying the same thing? That would be quite uncomfortable for the current stock investor. I think quite uncomfortable for your Fed money mandarin as well, and probably uncomfortable for a few real estate segments as well.
Kevin: My wife and I were talking this morning that we’re starting to see on bills that we’re getting, both at restaurants and when we have service done, a 3% convenience charge, like for credit cards or this, that, or the other. On Sunday we went out to brunch and they had at the bottom of the menu that they would add an additional 3% so that they could pay their staff a livable wage. We’re starting to see people maneuver into this world where it’s costing more and more, and so they’re having to add costs. Do you think the real rate of return on bonds has something to do with it? We can talk about interest rates rising, but if inflation is rising as well, people aren’t getting the advantage.
David: And that’s core to the Summers-Barsky thesis. It could be argued that, consistent with the Summers-Barsky thesis, that rates went up, but real yields factoring in inflation were not sufficiently attractive to migrate investors from gold back to bonds. And again, real yields being the difference between nominal interest rates and inflation. So, perhaps it is the additional income, more than we’ve seen yet in this cycle—additional income over inflation—which would halt the rise in metals, but those levels have not been reached. Not even close.
Kevin: So, let me ask you a question. What about lower rates? What would lower rates do to gold?
David: Well, lower rates are unlikely to make gold unattractive, just the opposite. And you can see from gold’s giddiness since the September 17th FOMC meeting, we are replaying the ’70s now, where rates moving higher are actually supportive evidence for why gold is also moving. Whether that be inflation or the market discounting other concerns, we’ll find that out with time.
Kevin: You brought up the ’60s and the ’70s, but Paul Volcker was Federal Reserve Chairman when I started working here, and Paul Volcker, just a few years before I came here, had broken that cycle with very high interest rates. What do you think? Do you think that’s something we’ll see again?
David: It speaks to the inflection point. Certainly, there is an inflection point where higher rates do matter, and that would be negative for gold investors. In 1981 and 1982, it was in the teens in terms of interest rates. So Volcker’s smashing success with inflation broke inflation, it broke the gold winning streak.
I think there’s different circumstances today. Those interest levels are not likely to be seen again. I don’t think we can get into the teens. Our Treasury market frankly could not bear double-digit rates. Frankly, we can’t even bear one percentage point increase. Our average aggregate interest cost sits at 3.3%. So, just imagine the move to 4.3%, 1% higher. Let’s go out to the end of 2026, federal debt is on track to be at 40 trillion, gross interest on that of 4.3%. That’s 1.72 trillion. 1.72 trillion in interest alone.
Today’s the day. On this day in 1981, October 23rd, the national debt moved above $1 trillion for the first time. Double-digit interest then, again, only on 1 trillion is a bit different than high single digit interest on 40 trillion. And here, we’re only considering the next 1%. Single digits.
142 billion was the interest paid back in 1981. That was equivalent of 2% of GDP. We’re currently at 4% of GDP, and prognosticators are suggesting that we could reach 6% by the end of 2026. Now, 6% sounds manageable till you compare it to the projected tax revenue, and that’s where I think the number is a little bit more, I don’t know, hard to swallow, hard to handle. 30% of tax revenue going to interest payments. And again, I’m assuming a very generous estimate of, say, 6 trillion in revenue.
These relationships bear watching. And just for your information, deficit spending in the first three weeks of the new fiscal year has already tallied to $500 billion, $0.5 trillion. That’s your little pre-election helicopter drop. This is out of control.
Kevin: So, when we’re talking numbers, these are large numbers. I would hate to be the Federal Reserve right now because what I’m hearing you say, Dave, is real rates of return on interest have been dropping even as interest rates have been rising because inflation is overwhelming. So, Summers-Barsky isn’t wrong. Gold is telling us that Summers-Barsky is right if you look at real yields, not nominal yields.
David: Yeah. So, inflation isn’t dead, and I think the Fed is very much trapped. I suspect that what the bond market is beginning to appreciate and what the gold market reflects at current prices is that very issue. The Fed doesn’t have the power to solve the inflation problem in this cycle. Their power now rests on two things, persuasion and showmanship.
Kevin: Okay. But the persuasion and showmanship, the showmanship right now is that inflation is falling. That’s what they would like to tell us. And interest rates are going to fall further. So, which is it, Dave? You’ve been talking all month now about the Fed lowering short-term rates in the bond market, not liking what it’s seeing, and yields rising. So, in a way, we have, it’s like a fork in the road, isn’t it?
David: Yeah. Two rates diverged in a yellow wood. Does that have a ring to it? Do you remember that?
Kevin: Is that Robert Frost?
David: Yeah.
Two roads diverged in a yellow wood,
And sorry I could not travel both
And be one traveler, long I stood
And looked down one as far as I could
To where it bent in the undergrowth;
And you probably recall how the poem concludes.
I shall be telling this with a sigh
Somewhere ages and ages hence:
Two roads diverged in a wood, and I—
I took the one less traveled by,
And that has made all the difference.
Kevin: So, is the road less traveled, Dave, if we actually are being careful here, is the road less traveled, as we look down the road, higher rates, and we have to prepare ourselves for that rather than buy into the perception that the Fed is trying to sell?
David: I think so. I suggest the road less traveled in terms of the intellectual setup— Let’s assume rates are in a long-term uptrend. That obviously is not what Wall Street holds to be true. So, let’s think of our supposition as the intellectual road less traveled. The consensus opposite ours is the view that a two-year yield spike in interest rates has already passed, and a fresh easing cycle has already begun. Fed monetary policy shifting lower in September, I guess you could look at that as support for a case for lower rates. And of course, in light of the forward guidance, and this comes back to the persuasion and showmanship, forward guidance would suggest that further cuts are coming. So, it seems obvious. But that part of the poem, “long I stood and looked down one road as far as I could to where it bent in the undergrowth.”
Kevin: That’s probably what you’re interested in.
David: Exactly. Not what’s visible, but what is lost in the undergrowth.
Kevin: Well, that keeps us also from having surprises. You’ve also, through the years, differentiated between cyclical and secular. And cyclical, of course, is the shorter loop or the shorter cycle, and then the secular is the trend. Would you say this lowering of rates is cyclical, not secular?
David: Very much cyclical. So, for the sake of—call it scenario analysis, for discussion’s sake—let’s say this is a short-term moderation of rates, cyclical. A short-term cyclical move should take short rates—that is, the fed funds—lower throughout much of 2025. Well, that would ultimately reduce mortgage rates as well. That’s a positive. In that timeframe, the yield curve should normalize, it should steepen. Long rates get back above short rates, which, again, would be positive for the economy, very positive for the housing sector. But are there catalysts for a reversal higher in rates? We think so.
Kevin: So to use the Fed’s term, because they tried to tell us that inflation was transitory, are you saying, possibly, Dave, that the thing that’s transitory is lower rates? That that’s not going to last.
David: 100%. We remain of the opinion that longer term rates will increase following the current policy pushed lower by the FOMC. So ultimately temporary—transitory, yes, you could say. There is already a divergence between bond traders and the FOMC. Again, we’ve had fed funds lower, bond yields higher, and that continues even this week.
The divergence between the bond market and Fed policy is awkward to say the least. The collective opinion of global bond traders versus a small cache of PhD economists, it’s becoming more stark. So over time, if the divergence in rates persists, it becomes a credibility issue for the Fed. If it expands further, there is trouble brewing for corporate bonds, for Treasury bonds, for mortgage rates, all of it. Recommendation: if you’re considering a home purchase, if you’re considering a refinance, the rate side of affordability is likely to be as good as it gets over the next nine months, so do something about that.
Kevin: I want to go back to this inflation. I remember being taught in economics that a little bit of inflation is good for all of us, but actually that’s not true. If somebody were stealing 2% out of my wallet every year, I might hardly notice, but over time it really adds up. But they call that the neutral rate, Dave. They say, “You know, this little bit of inflation, that’s good for you. We’re we’re going to call this the neutral rate,” and it’s been 2% up to this point. But it seems that they’re starting to budge on that, and they want the neutral rate to be higher.
David: Well, the neutral rate is where interest rates would be to be neither accommodative nor restrictive. So if you look at Hard Asset Insights this last weekend, the Federal Reserve is already changing tone as it regards the neutral rate. You had Waller, you had Kashkari, you had Daley. They’re all shifting to the opinion that the neutral rate—again, the interest rate where it’s neither restrictive or accommodative—is higher than it used to be, and higher than previously thought. So does that mean that higher rates of inflation are also expected? Even at a lower level of, say, 3% or 4% CPI, that pressures the bond market to keep interest rates at a higher level as well, and perhaps that’s what the bond market is already saying.
Kevin: Well, Morgan, in the Hard Asset Insights, which by the way, I mean for our clients who have not been reading Hard Asset Insights between Doug’s material and Morgan Lewis’s material, this is free, if you go to our website. So Morgan brought up something called fiscal dominance. Would you elaborate on that?
David: Yeah, I think it’s worth your time to read, and he covers it very well there. He mentioned Steve Blitz from Lombard Street who comments on the inflation path being sort of less realistic by the day. Steve says there’s a bubbling sense that the absolute conviction of inflation returning to 2% might be more faith than fact. Doesn’t this argue for redefining success if the Fed wants to bring rates to 2%, that is the inflation rate? Meeting your target objective could be done very conveniently by raising your inflation target. That would be consistent with a northward migration for the neutral interest rate.
Kevin: Right. So for the person listening who has maybe an adjustable rate mortgage or something that—they’re trying to make a decision as to when do we actually, long term, fix rates on a loan—what you’re saying is this lowering of rates may just be a head fake, and over the next six to nine months you’d better get it while it’s good because it’s going back up.
David: At this conference, there were many purveyors of products and things like that in the real estate market. The ones that have struggled the most are the ones that did not have fixed rate debt. The ones that have already hit the wall could not survive that increase to 5%. Maybe they get a little reprieve in here in this sort of cyclical move lower, I think through mid-2025. But beyond that, you’re back to a real grind, a grind for survival. And so yeah, I totally agree. If you have the ability to fix them, you should. And just like your refinance for a mortgage, that is something that should be done in the next nine months.
So in summary, there is a case for an interest rate head fake over this next six to nine months, which first sees a decline in fed funds on top of what we’ve already had, followed by a market-generated forcing of rates to higher levels. Corporate issuance—which has been very heavy all year, that is bond issuance—and demand for corporate bonds by investors is today off the charts. What if corporations are doing a really smart thing? They are issuing as much debt as possible while credit spreads are the tightest they’ve been in 20 years. And they’re frankly unconcerned about fed funds, and they’re focused more on the spreads. Not a bad time for debt refinancing as long as demand is robust—and again, that suggests that financial conditions are actually quite loose and the difference between corporate debt and Treasurys is razor-thin.
Kevin: So do you think that these corporations, as they look at this, they’re thinking what you’re thinking, and they’re actually taking the road less traveled by. They’re saying, “We better get it while we can.”
David: Exactly. Somewhere ages and ages hence two roads diverged in a wood and I took the one less traveled by and that will make all the difference.
Kevin: And that has made all the difference. That will make all the difference. And this is where you have to make your choice. But let’s go back over to the Federal Reserve because Powell is complaining that we have tight conditions. The Federal Reserve is acting like they’ve already tightened the market. This doesn’t sound like a tight market to me.
David: Well, what say you, Jerome Powell, to the top six U.S. banks’ wealth management arms adding $5 trillion in assets over the last 12 months, which is 23% higher year over year? And their collective revenue is $84 billion year-to-date.
Kevin: Wow.
David: Tight financial conditions?
Kevin: Tight financial conditions. Sorry. Yeah.
David: Yeah. What would you say, Jerome Powell, to Goldman Sachs’ profits soaring 45%? This is according to Bloomberg. Profits from investment banking improved 20% year over year. Equity underwriting increased 25%. Here’s the zinger: debt underwriting saw the largest percentage increase at 46%. And this is a miracle indeed if you have tight financial conditions: net interest margin increased 70% year-over-year for the quarter. Again, this is for Goldman.
Kevin: Is that counting, Dave, the shadow banking? I mean, there’s so much that we don’t see in the borrowing world, in the debt world. It sounds to me like it’s just raging right now.
David: And that is the shadow banking. Wall Street is open for business, contrary to commercial banks which, according to borrowers, are not finding the liquidity taps quite as wide open. The world of shadow banking and financialization is breaking into new territory. Private credit is what everyone is fawning over today, and it’s capturing market share from commercial lenders. In fact, it is the new subprime. You’ve got juicy fees, you’ve got opacity, you’ve got lockups for investors. And frankly, if you can fog a mirror, you have access if you’re a borrower.
The last-week comments from Neel Kashkari at the Minneapolis Fed, he’s claiming that this is actually a safer version of credit expansion than commercial lending. And I think we’re going to get to test that supposition in the next correction. I think his credibility will be tested along with it.
Kevin: So what you’re saying at this point is, institutions are issuing a lot of debt and other institutions are borrowing. So in a way, we’re still in the bubble, aren’t we?
David: Yeah, very much so. And it’s the asset allocators amongst your institutions, amongst your family offices, they’re falling over themselves to access these juicy yields in private credit. That typically does not end well for anyone but the purveyors and the Wall Street players. These are your shadow banking players.
Kevin: So you would say unequivocally that we do not have tight financial conditions, unlike what the Federal Reserve would like you to think?
David: Not at all. Not at all. And again, just looking at Goldman’s repo liabilities, added 110 billion in the most recent quarter. They’re now totaling 348 billion in repo assets. Total assets at the bank are up just shy of a trillion dollars since the end of 2019. It is boom time at Goldman, and yet the Fed is saying financial conditions are tight. Right.
Kevin: Right. And you’ve focused on Goldman, but you’ve got other institutions that are doing the same thing.
David: Right. It’s non-bank lending which is exploding higher everywhere with positive results for quarterly earnings and very positive results for stock prices, not just Goldman. Year-to-date returns at KKR 69.6%, Blackstone 34.4%, Apollo 57.7%, Carlisle 31.7%. I mean, financial market equities are, in a word, bubblicious. Corporate credit spreads are the lowest, again, dating back to 2005. That was the period that brought us the CLOs, the CDOs, and all the other exotic tiered and tranched products that became the bane of the financial universe during the global financial crisis.
Kevin: Well, how do you compete then as a bank? Because banks pretty much have to hold two reserve requirements. They have to have a certain balance. For every hundred dollars they loan out, they have to have $8, $10 typically on their books. That’s not what they have to have, but they typically do. These other entities that are loaning out, it sounds to me like they’re loaning out in excess of that, or highly leveraged without really a reserve requirement at all.
David: Well, it’s unsurprising that the largest growth in credit is in the least regulated space. Banks are highly regulated. Banks are held to a higher standard for liquidity and capital ratios. Sure. Banks operate at an average of 10:1 balance sheet leverage, but still are answerable to regulators. The credit markets are, again, using what some would refer to as regulatory arbitrage to grow in out-of-view places. So Kashkari was quoted by Bloomberg as saying, “I’ve examined it. These private credit vehicles look like they’re much lower risk than banks,” and I just think to myself, Kevin, talk about blinders.
Kevin: Wow.
David: Surface-level leverage ignores the issue. The fact that these private market borrowers are very risky borrowers to begin with, paying double-digit interest rates. More and more of them are unable to even make those payments. They’re using what’s called payment-in-kind provisions, which allow them to add interest payments to principal owed or to give equity in their firm, the borrowing company, when debt can’t be serviced. It’s another version of Ponzi finance, and that’s happening a lot right now. No one seems to care. Well, no one cares because financial conditions are simply not as tight. Jay Powell claims them to be.
Kevin: So when does that break, Dave? When does the curtain get pulled back and you see the wizard behind it, and you’re like, “Wait, pay no attention to the man behind the curtain.” Now, this sounds to me like it’s just highly leveraged. You said Ponzi scheme, that’s what it is.
David: Yeah. Doug Noland in last week’s Credit Bubble Bulletin describes it like this: private credit is leverage on top of leverage. The borrowers are highly levered, the lenders are levered, and various associated securitization structures are levered.
So Kevin, contagion effects are built into the structures of private lending. Again, not a concern today, but as and when liquidity dynamics shift, it’s all involved. Everything is implicated. As the private lending boom continues and the holdings are spread throughout institutional portfolios, you’re looking at vulnerability that is not and cannot be contained. So you’re talking about insurance companies, you’re talking about pensions. Yes, you’re talking about banks. And I mention banks because while they’re lending less, they too are now investing in private credit. And of course that’s being rolled out for individual investors as well. You’re talking about no loan committees. Covenants are embarrassingly loose. This is a replay of that 2005 and ’06 period where things were just going bonkers and nobody seemed to care because it was up, up and away.
Kevin: So how are the Fed officials confused? They’re talking about tightness in a period of time that, Dave, you’re saying is just booming.
David: Well, they’re focused on commercial bank lending tightness. So I think Fed officials are confused because commercial bank lending tightness was brought about by the interest rate shock, and those pressures actually still persist if you’re talking about their bank security portfolios. So in that regard, there’s systemic tightness. But frankly it’s the exact opposite if you’re looking anywhere outside of commercial banks. Lower rates are like fuel to the fire for subprime lending, and that is what private credit truly is.
Great credit borrows at four and a half to five percent. Investment grade credit borrows 60 to 80 basis points above that. Remember I mentioned that tightness in credit spreads—that investment grade extra that they’re paying—is less than a percent. Then you move to junk, and borrowing rates range from eight to ten percent.
Private credit is solidly in double digits, which places it, comparatively—apples to apples—on par with triple C paper, the worst junk bond rating, a notch or two above defaulted debt.
This is what is the most popular asset amongst institutions. I mean, I deal this with the colleges and institutions that I consult with on a routine basis. They’ve got to have more of it. Why? Well, what’s not to like about double-digit returns? Risk appetite is unbound. It’s unhinged, but I’m guessing that Kashkari is right. He must be right. Banks are much riskier. I kid, but he’ll choke on that idea sooner rather than later.
Kevin: I want to ask you, since you’re around the real estate market this week, some of the top analysts that are talking about real estate, homes are still unaffordable here in the United States, and you were talking about rates. If you’re going to take a loan out, you better take it out in the next six to nine months. But unfortunately, people are paying right now the highest prices that they’ve ever paid in real estate. But I wonder, let’s contrast that with China. China built all this real estate that is unoccupied, and I’m wondering how tied we are to that market because there’s no way that real estate in China is rising.
David: The game is over for the real estate developers, and you’ve seen a huge spike in yields for Longfor and Country Garden and Evergrande. Even the best of the best, Vanke, is in a difficult place. Equity is getting trashed just as much as their bonds are in recent days.
Over the weekend, I sat in on an excellent macro presentation including analysis on China, and we talked about demographic headwinds. We talked about the real estate market in decline, a hundred million units empty. We’ve been noting that over the last six months. So there was nothing new in the presentation, but it was very well-structured and articulated.
And Kaizen Global believes you get 850 billion in treasury bond issuance coming in China. This is sort of a bailout measure, with 112 billion in proceeds going to support the Chinese equity market, 562 billion to just complete the unfinished residential real estate projects, and then a couple hundred billion more for miscellaneous stimulus measures.
Kevin: So have the Chinese reached the Draghi moment, Dave? Remember, I mean, 2011 changed everything. When Mario Draghi came out, he said, “We’ll do whatever it takes.” I don’t think either of us, as we were doing the Commentary, knew exactly what he was saying. Are the Chinese doing the same thing? Are they saying, look, we’ll just print as much money—quantitative easing Chinese style?
David: We’re just about there, getting the Draghi audible of “we’ll do whatever it takes” in China. The economy is bad enough. It frankly would be a huge surprise if that call never comes. Doug ponders, as he often does on the Chinese situation, a historic Wall Street boom, unprecedented open-ended Chinese reflation, global central banks hell-bent on cutting rates despite loose conditions, and speculative bubbles, extreme geopolitical risks, what could possibly go wrong?
Kevin, from an economic perspective, things are going so wrong that financial markets in China are at a distinct crossroads. You continue to reflect tapering growth rates and structural malinvestments in the past several decades, and you’re beginning to see the issuance of more accommodation, compliments of bailout stimulus.
You may actually have some activity, or revival, if you will, of speculative spirits. And this is kind of a seeming contradiction, that you’ve got economic fundamentals that can deteriorate and yet financial markets that can go crazy. We saw that reflected here in the US. If we look at our own domestic markets, not that unfamiliar. Liquidity infusions, a little bit like a drug that stimulates a quick response, but it in no way reflects the underlying fundamental dynamics. So you could have this period of time where economic fundamentals continue to deteriorate in China. Meanwhile, stimulus measures put a real pep in the step within the Chinese equity markets.
Kevin: So Dave, over the last six months you interviewed Charles Goodhart, who very poignantly, in fact soberingly, pointed out the demographic change that’s coming in China, where you’re not going to have many people left to be able to finance these debts. So China right now is building an awful lot of stuff for people that won’t be there, and they’re printing an awful lot of money to try to keep this thing stimulated. But the demographics, the amount of people actually that can function and create a productive society, is on the decrease in China.
David: Yeah. So you’re dealing again with the contrast between long-term structural or secular changes or developments with short-term cyclical inputs. A Draghi moment could very well light a fire under the Chinese stock market and would look and feel oh, so right to the speculator in Chinese stocks. One of the data points from this presentation of the weekend—demographic headwinds, in that category—was the expected decline of 50% in the Chinese population by 2050. That’s catastrophic.
Kevin: So how does that look with the fourth turning, Dave, which was the time that Neil Howe said the family comes back together? Doesn’t sound like there’s much of a family.
David: Well, I wonder about that because Howe suggests that in the fourth turning you have a return to family dynamics and appreciation of community centeredness, and that’s what reemerges after a crisis. So I mean, we already have the one child policy in China which has been buried, so there’s no longer policy constraints to family size, just the economic and social constraints, concern about being able to afford having children.
But that social dynamic could shift as it did after World War II. We had the baby boom. It was most unexpected. It’s not outside of the realm of possibility that, as catastrophic as that sounds, the expected decline of Chinese population by 50% by 2050, maybe it’s not that bad. We just don’t know what’s on the other side of crisis. We don’t know what that crisis looks like yet. We know that the economy is in a tough spot, but we don’t know if that translates ultimately into a geopolitical crisis, and who the Chinese people are, what they desire, following that kind of a crisis.
Kevin: Well, and they’ve been amazing buyers of gold over the last few years. Gold is screaming something that’s different than what people normally think, Dave. I was talking about Summers-Barsky with you earlier, and that takes into account rates of return. But gold is not always purchased for rates of return. We’ve got gold trading at 2,750, and silver, it’s up in the mid-thirties already. It’s been a great year for gold and silver. But is it really not the rate of return that’s bringing people into it? Or is it basically saying that we want something that’s outside of a failing system? Every angle looks like it’s failing. Even though it’s booming on the surface, it’s failing underneath.
David: At the beginning of the year we were talking about projected prices for gold of 2650 to 2750, and hovering around 2000 an ounce. People kind of raise their eyebrows, like that was even a possibility. So here we are trading towards 2750 today, silver, well over $34 an ounce. Up, call it 35% for gold, 45% for silver. Year to date returns, respectively, 12 months numbers are even higher if you’re not looking at year to date, but 12 month numbers.
I think there’s a must read article from the Financial Times October 20th, if you can get a copy of it, it’s Mohamed El-Erian’s article titled, “Why the West Should Be Paying More Attention to the Gold Price Rise.” And it assesses structural changes in the desirability of the dollar, and policy shifts in the central bank community, managing reserves to include more ounces and—not a surprise—less paper promises to pay. Yes, this is El-Erian, the bond guy.
Kevin: Yeah. Yeah. He’s a paper guy for the most part. But I think it’s important that we go back and say, this is not the Western investor yet. The average guy on the street is not buying gold. It’s the central banks at this point. So we have more waves coming in. Don’t we?
David: Absolutely. The Reserve asset managers at a variety of central banks continue to add to their positions. 29% of respondents in the World Gold Council survey this year anticipate adding more gold, 2024, and more gold, 2025.
Most recently, the Bank of Mexico, Mongolia, and the Czech Republic have been very vocal about adding more gold to their portfolios. Top of mind, as discussed in Bloomberg, “the [unclear] are pointing to lower rates, political tensions, a US election,” and sort of this catch-all, “a lot of uncertainty.” It’s hard to disagree with their skepticism of the status quo.
Kevin: So El-Erian, who is a bond guy, is he saying at this point that this system, which has run so well for so long, this dollar system, which, lets face it, Dave, it’s like having oil in an engine. It is smooth when it runs well, but I’ll tell you, the first car that I ever bought, I ran out of oil. I just was a teenager, didn’t really realize I was supposed to add oil to the engine. And oil works really, really well to smooth out everything while it’s there. But if the oil stops working or if the oil is gone, you can have this thing seize. Is El-Erian basically saying that this oil, this frictionless dollar system, at this point is being questioned?
David: You’ve got to read it. “Why the West Should Be Paying More Attention to the Gold Price Rise.” I mean, El-Erian sounds like an apologist for the king of hard assets. The changes are structural, as described. The dollar-based system remains. But for how long and to what degree, that’s what’s squarely on the table for discussion. There’s a growing divide between countries that enjoy the benefits conferred from the low-cost and relatively frictionless dollar-based system, and those other countries that will allow for a decrease in trade just to be free from western scrutiny and western influence. And I think this is a historic pivot. Gold is one of the key signals of this structural shift, of this historic pivot.
Kevin: So what we’re saying and what you’re saying is we could be in the early stages of the gold move because the early stages are always the professionals, and when you have that type of move, the public hasn’t even gotten involved yet?
David: The last leg of growth in the gold market, the most recent one, has been driven by central banks and a growing group of, think of them as dollar malcontents. The next leg higher for gold will be driven by Western investors responding to, whether it’s political fiscal concerns or geopolitical events, market volatility, any and all of which could appear as breaking news today, tomorrow, next week.
Gold could and should correct at some point, and that could be today, tomorrow, or next week. But it has become progressively harder for investors to touch. They’re all waiting for a significant pullback, and yet that has yet to materialize. All year long I’ve talked to clients, “Well, I’d like to see it back at 1,850.” “Well, I’d like to see it back at 2,100.” “Well, I’d like to see it back at 2,250.” “Well, I’d like to see it back at 2,500.”
Dip Buyers have, as El-Erian says, “This march up in price,” he says, “has been relatively linear, with any pullback attracting more buyers. It has occurred despite some wild swings in expected policy rates, a wide fluctuation band for benchmark US yields, falling inflation, and currency volatility.” So what he’s getting at, Kevin, is that dips have been shallow. They’ve been very short-lived. I would love to see a retest of the 2,150, the 2,200 breakout level. That would certainly reset some enthusiasm, and I think it would definitely prepare for a considerable price move higher. But I suspect that we will see something more like a 10% to 15% correction. Scary for the latecomer, I realize that, but your last opportunity to add to ounces at what a decade from now will be seen as cheap prices may be that short and sharp correction.
Kevin: So, Dave, what you’re saying is the bull market has probably years ahead of it. Now, granted, we’ll have some corrections, but you’re not recommending that people trade out of gold and try to time these things?
David: No, I think that’s a bad idea if your assumption is that we’re going to be going back to sort of the sub-two thousand level. At least as things stand now, that era is behind us. De-dollarization is a feature. It is a feature of the world we now live in, just as de-globalization is a feature of the world we now live in, and so the price of gold must now adjust and equalize global consumption with an almost static supply of the metal.
Kevin: We talked about China, and what strong gold buyers they are and what they’re doing with their monetary system to stimulate, but we also have to look at what’s going on geopolitically, Dave. I mean this Taiwan thing is just heating up.
David: Yeah, we had China max out its airspace activity around Taiwan this last week. 153 aircraft circling the skies. We mentioned the Coast Guard and destroyers also around the island. I thought it was fascinating that the Chinese government issued a map showing its ship location around the island in the shape of a heart, and they were describing their activity—this is to quote their officials—describing their activity as, “An act of love.” That is truly amazing. I mean this is like Orwell’s “war is peace” or “freedom is slavery.” The abuse of language speaks to this misperception or misrepresentation of reality. Kamala has her own version, running a campaign of joy and opportunity, and then you go to the South China Sea and I can almost hear the song from the Hamilton play. Do you remember it?
Kevin: No.
David: King George, “you’ll be back soon, you’ll see. You’ll remember you belong to me.” And then he goes on to say, “And I will kill your friends and family to remind you of my love.”
Kevin: Boy, that is appropriate, isn’t it? Yeah, so they literally did. They made a heart in the ocean. Wow.
David: That’s right. That’s right.
Kevin: That’s amazing. Okay, so before we wrap up on gold, I have, for 38 years, been asked, “Gosh, gold’s at an all-time high. Is it too high?” It’s funny because I came to work for your dad when gold was $300 an ounce. I have seen all-time highs over and over and over. Now, I’m not saying there weren’t corrections, but I’ve also seen bread go from 85 cents a loaf to $7.50 a loaf. I’m talking a healthy loaf of bread, if you buy it at a health food store. So when bread is at an all-time high, gold’s at an all-time high, are we thinking that bread and gold will come down, or are we thinking that it’s just going to get all-time higher?
David: Kevin, our currency has a date with destiny. That is that it’s going to find its true intrinsic value, which is around zero. And as our currency continues to degrade, real things get priced to higher levels. So the big question from the weekend, “Is it too late? Gold is at all-time highs. Is it too late?” The simple answer is no. Many assets reach their all-time highs, keep going higher. This is an interesting market because you’re really just reflecting the weakness in our underlying currency.
In that respect, and I think in terms of the supply and demand dynamics, this market has legs. I would also look at the precious metals complex as a whole and consider that silver is just getting into gear. We had a five-point move in the ratio last week from 85 down to 80. That number is shrinking. It signifies that silver is now on the move. It’s confirming the gold move, with investors now flocking to the value side of that equation.
Kevin: Well, unless we be completely dollar-focused, because the dollar may not be the reserve currency for forever, we ought to look at what gold’s doing in the other currencies, Dave. I mean, it’s been hitting all-time highs sooner in the other currencies than even in the dollar.
David: Well, that’s true. If you want to price gold in other currencies, it’s telling a uniform story, which is that these fiat currencies around the world are also under pressure. If you look at the balance sheets of other countries, they’re similar to ours, being pressured with higher levels of debt, slowing growth, et cetera. And if you want the historical reference, again, thinking of gold as a reflection of a weakening dollar in a secular or long-term trend, just review the gold price in terms of guilders, review the gold price in terms of pound sterling. As the Dutch faced structural changes that over a long period of time eroded their status as the world’s reserve currency to eventually be replaced by the British and the British pound sterling.
Then of course, we had the displacement of the pound sterling by the US and the US dollar. Today, there are no contenders to take on the dollar’s reserve role, but we see this move higher in the price of gold really reflecting this sort of death march for the dollar. It may seem hyperbolic, it may seem extreme to imagine going down that road, losing reserve currency status. Maintenance of hegemony would require that our military remains number one. It would also require that our debt markets retain credibility. Now, how we pull off the former is easy to pencil out. I think it’s a lot easier to pencil out than the latter. Maintaining debt market credibility, I think that is the story of the day.
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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 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.
