Tactical Short 3rd Quarter 2024 Recap

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Late-Cycle Bubble Fragilities
MWM Q3 2024 Tactical Short Conference Call
October 31, 2024

David: Good afternoon, this is David McAlvany. I want to welcome you to our Tactical Short Third Quarter Conference Call. Thank you for participating in this call. As always, we want to give a special thanks to our valued account holders, we greatly value our client relationships.

I came across a quote from Carmen Reinhart, who has been a guest on our weekly podcast in the past. She’s spent time at a variety of universities and with the IMF and World Bank, working as an economist. Co-wrote a book with Ken Rogoff a number of years ago. If you don’t know Ken, he’s a chess Grand Master, Harvard professor, author of many books, including one that they co-wrote, This Time it’s Different. They look at debt and what is ultimately sustainable or not sustainable. And as we go into the conversation today with Doug, there’s a lot of complexity and a lot of detail, and I appreciate how simple and focused this one quote from Carmen is, because it gets to the nub of what we’re dealing with.

She says, “If there is one common theme to the vast range of the world’s financial crises, it is that excessive debt accumulation, whether by the government, banks, corporations, or consumers, often poses greater systemic risks than it seems during a boom.” And just holding onto that simple idea, where we begin today is with that simple idea, we’ll move through complexity, and I want to come back around to that simple idea of too much debt ends up being a bad idea when you get out of the boom times.

So a little context: With first-time listeners on today’s call, we’ll begin with some general information for those unfamiliar with Tactical Short, and there is more detailed information available at mwealthm.com/TacticalShort. The objective of Tactical Short is to provide a professionally managed product that reduces the overall risk in a client’s total investment portfolio. At the same time, we’d like to provide downside protection in a global market backdrop with extraordinary uncertainty at extreme risk. The strategy is designed for separately managed accounts that gives us the ability to— The advantages of that are that it’s investor-friendly.

There’s full transparency, there’s lots of flexibility, reasonable fees, there’s no lockups, and that’s why we’ve chosen that structure. We have the flexibility to short stocks and ETFs, and our plan has been to, on occasion, buy liquid listed put options as well.

Shorting entails a unique set of risks and we’re set apart both by our analytical framework, as well as the uncompromising focus on identifying and managing risk.

Our Tactical Short Strategy began the third quarter with a short exposure targeted at 80%. The target has held steady throughout the quarter at that level. Focused on the challenging backdrop for managing short exposure, a short in the S&P 500 ETF, SPY, remained the default position, which is the case for high-risk environments.

I’ll give you an update on performance, and then I will pass the baton to Doug. Tactical Short accounts after fees returned a negative 4.28% during Q3. The S&P 500 returned a positive 5.89. For the quarter, Tactical Short accounts returned a negative 73% of the S&P 500’s positive return. And as for one year performance, Tactical Short after fees returned a negative 20.99 versus the 36.33 return for the S&P. So, Tactical Short’s loss was that of 57.8% of the S&P 500’s positive return.

We regularly track Tactical Short performance versus three actively managed short competitor funds. The first is Grizzly Short Fund, which returned negative 5.48 during Q3. And over the past year, Grizzly has returned negative 14.14. Ranger Equity Bear returned a negative 9.27 for the quarter, with a negative 12.47 for their one-year returns.

Federated Prudent Bear Fund returned a negative 3.58 during Q3, and negative 18.63 for one year. Tactical Short outperformed the actively managed bear funds for the quarter on average by 183 basis points. Tactical Short underperformed over the past year by an average of 591 basis points. Tactical Short has significantly outperformed each of the bear funds since inception, that is April 7th, 2017. Inception through the end of June, Tactical Short outperformed the three competitors by 1,961 basis points, 19.61 percentage points.

There are also popular passive short index products, so the ProShares Short S&P 500 ETF returned a negative 3.68 for the quarter, negative 20.41 for the past year. And the Rydex Inverse S&P 500 returned a negative 3.67 during Q3, negative 20.01 for the one year. And also, the PIMCO Stock Plus Short Fund, the Q3 returns, negative 3.13, and the one-year returns of negative 18.44.

Doug, over to you.

Doug: Thanks, David. Hello, everyone. Thank you for being part of our call. The quarter ended a month ago, and there have been important developments in recent weeks, and we’re just now days away from an election with major ramifications. I’ll discuss the eventful quarter. Also, let’s look ahead to what appears to be a highly unsettled end for 2024.

As usual, I’ll begin with comments on performance, as David highlighted. The quarter’s additional 183 basis points boosted Tactical Short’s outperformance since inception to 19.61 percentage points. Expecting ongoing volatility, I stuck with the wider than typical band around short exposure that I discussed in our last call. There are advantages and disadvantages associated with a wide band. It certainly reduces the amount of rebalancing required.

Back in my mutual fund days, we would typically rebalance daily. This means doing trades to return to target, buying back shares to reduce exposure when short exposure is above target, or selling shares if short exposure is below target. When the market rose and the fund lost money on the day, we would typically buy shares, but when the market was lower and the fund made money, we would add to shorts to return exposure to target. Especially in volatile market environments, if you do this on a repetitive daily basis, buy high, sell low, it tends over time to have a negative impact on performance. Over the years, I’ve referred to this as the meat grinder effect. So during what was a notably volatile quarter, the wider band significantly reduced the number of rebalancing trades and minimized the meat grinder.

The disadvantage of the wider band comes when a significant rally forces short exposure rebalancing at the top of the band. When the market commences a major rally, it would benefit performance if rebalance short covering occurs sooner rather than later. The challenge is, you just don’t know when choppy market volatility is going to give way to a rally.

I know this tends to be confusing, and it’s tempting to just skip this discussion, but it’s important for a clear understanding of our investment philosophy and process. During the third quarter rally, there were rebalancing trades at the top of the band. Overall, I’m confident that the benefit of minimizing rebalancing trades in a particularly volatile market offset the negative impact from some rebalancing at the top of the band.

We live today in a world of seemingly stark inconsistencies, confounding incongruence, record stock prices, unprecedented household wealth, and incredible technological innovation. At the same time, society is resentful, deeply divided, and insecure. Meanwhile, the geopolitical environment is extremely alarming. In its third year, the war in Ukraine has turned increasingly dangerous. Ukraine occupies a small Russian enclave while expanding drone attacks across Russia. The West is considering allowing Ukraine to use its weapons to strike deep into Russia, as Putin uses revisions to Russia’s nuclear doctrine as a direct threat to the US. Russia has been firing North Korean missiles, and now Kim Jong Un has sent thousands of troops to fight for Putin.

Conflict in Gaza has now engulfed Lebanon, and risks consuming the entire Middle East. In alarming escalation, Israel and Iran have been in tit-for-tat missile strike retaliation. And a couple of weeks back, China’s military encircled Taiwan, stating openly that it was war-gaming for a blockade scenario. Just this week, Beijing threatened to retaliate if US arms shipments to Taiwan continue. It’s only a matter of time until China moves to fulfill its often-stated top priority, the reunification of Taiwan with the Chinese motherland.

It’s commonly viewed as the most dangerous geopolitical backdrop since World War II, yet stocks are at all-time highs and market optimism remains at extremes, and the AI technology mania is indeed underpinned by incredible innovation and scientific advancement. What gives?

From my analytical framework, these incongruencies have a common thread. They’re all consistent with late cycle dynamics. An incredible end game for a historic multi-decade super cycle.

During last quarter’s call, I discussed the parallels between the current environment and the roaring ’20s. Both periods were remarkable for a confluence of monumental technological advancement, financial innovation, credit and speculative excess, and catastrophic boom and bust dynamics. The wedding of late cycle financial excess and momentous technological advancement pushed the cycle to fateful extremes, even as mounting financial, economic, and geopolitical risks had turned conspicuous.

When reading the history of the late ’20s, one ponders how it was possible for bullish stock speculators to disregard so much. Egregious excess, profound social change, inequality, and cultural angst here in the US. Post-hyperinflation, economic, social, and political turmoil in Germany. The rise of authoritarianism and fascism in Europe. Post-revolution instability and the rise of communism in Russia. Social and political tumult in Latin America and the Middle East. Civil war in China, just for starters. Like today, wild, speculative excess and mounting social, political, and geopolitical turmoil were not coincidental. They were instead tragically interconnected late cycle phenomena.

I want to again highlight a theoretical framework that helps bring some clarity to today’s confounding backdrop. Bubbles are mechanisms of wealth redistribution and destruction, with detrimental consequences for social and geopolitical stability. Boom periods engender perceptions of an expanding global pie. Cooperation, integration, and alliances are viewed as mutually beneficial. Late in the cycle, perceptions shift. Many see the pie stagnant or shrinking. A zero-sum game mentality dominates. Insecurity, animosity, disintegration, [unclear] alliances and conflict take hold. It bears repeating, things turn crazy at the end of cycles. Years and even decades of credit expansion, speculative bubbles and government-led bailouts conspire for parabolic blow-off surges in risky late cycle credit inflations and market manias. Meanwhile, years of destabilizing price inflation and increasingly conspicuous wealth redistribution push societies and nations to the breaking point. These dynamics foment complex, late cycle dynamics highlighted by manic speculative blowoffs, concurrent with rapid degradation in both the social fabric and existing world order.

Late cycle bubbles exhibit peculiar behavior. As we’ve witnessed, once bubbles have inflated to precarious extremes, confidence in the marketplace only solidifies that central banks and governments will act early and forcefully to thwart crisis dynamics. Such a posture foments instability and volatility as market sentiment pivots from alarm over bursting bubble risk—manic affirmation that inflating markets enjoy a foolproof backstop. This is precisely the dynamic witnessed in August, and I’ll devote a few minutes to discussing August 5th instability.

On the 5th, at intraday trading lows, the S&P 500 was down 4.3%, the NASDAQ 100, 5.5%, and the KBW Bank Index, 5%. The VIX equities volatility index spiked above 60 for the first time since the 2020 pandemic crisis. Japan’s Nikkei 225 stock index that day sank 12.4%, capping a three session collapse of almost 20%. South Korea’s KOSPI index dropped 9% as intense de-risking erupted across markets globally. Bitcoin was down 14% intraday. I believe we’ll look back on that erratic market session as portending trouble ahead, a warning of mounting bubble fragility. In particular, August 5th exposed acute vulnerability for two historic bubbles, the yen carry trade and the AI tech bubbles.

This past March, the Bank of Japan raised its policy rate to 10 basis points, ending a seven-year experiment with negative rates. Japanese rates had not been above 10 basis points since 2008, and hadn’t surpassed 50 basis points all the way back to 1995. Literally for decades, artificially low rates incentivized borrowing cheap in Japan for leveraged carry trade speculations in higher yielding instruments across the globe. Between speculative leverage and Japanese institutional and retail flows, trillions have flowed freely from Japan. An abrupt reversal of this torrent would be highly destabilizing across the world of finance. With domestic inflation and imbalances having pushed the Bank of Japan to commence policy normalization, currency markets were understandably on edge. The dollar/yen spiked to a multi-decade high of 162 on July 10th, before reversing sharply lower. Over the next four weeks, the yen would rally 12% with a dollar/yen trading at an intraday low below 142 on August 5th. A disorderly unwind of yen carry trade leverage spurred intense market instability and fears of broadening de-risking/de-leveraging.

From last November’s lows to July highs, the semiconductor index surged 86% and the NASDAQ 100 rose 45%. Nothing short of a historic mania and speculative melt-up took hold, led by AI, the semiconductor companies, and the magnificent seven tech behemoths—and to later widen throughout tech, the financials, and utilities, along with the broader market.

We can assume enormous speculative leverage has accumulated margin debt, hedge fund leverage, and importantly, embedded leverage in derivatives. At August 5th lows, the semiconductor index and NASDAQ 100 had sunk 28% and 15% from July highs. With the unwinding of yen carry trade and technology stock speculative leverage, markets were at the cusp of a systemic de-risking/de-leveraging event. This explains the VIX’s spike to multi-year highs.

Wall Street was close to panicking on that fifth day of August. According to the narrative, at the time, the economy was in trouble and, after waiting too long, the Federal Reserve must now respond forcefully. Cries immediately rang out for the Fed to aggressively slash rates, with some even pleading for an emergency intra-meeting cut.

Market relief was provided by timely comments from the Bank of Japan’s influential Deputy Governor, Shinichi Uchida who said, “We won’t raise interest rates when financial markets aren’t stable.” Japan’s Nikkei index rallied 10% on August 6th as global markets quickly stabilized. A couple of weeks later, from a dovish Chair Powell at Jackson Hole, markets received the news that they had clamored for, “The time has come for policy to adjust. The direction of travel is clear.” And in September, the Fed slashed rates 50 basis points.

Policymakers responded just as speculative markets had assumed, especially in a backdrop of acute fragility, markets count on central banks to respond swiftly and forcefully to nascent instability. And this key dynamic underpins extreme risk embracement and other late cycle speculative excess, in the process extending the lives of historic bubbles.

And brief comments on market structure. Repeated interventions and bailouts over the course of the cycle alter market perception, structure, and function. Over time, markets turn increasingly dysfunctional, with mounting excess and imbalances promising only more policy stimulus. Risks can be ignored. Market dynamics become increasingly preoccupied with chasing trading opportunities from recurring short squeezes and the unwind of bearish hedges. And as this speculative market dynamic is rewarded by Federal Reserve behavior, it only grows in dominance.

After trading at 4.6% in late May, 10-year Treasury yields fell to a 15-month low of 3.62% the session before the Fed’s September meeting. The S&P 500 enjoyed a year-to-date return of 20%, with the broker dealer index returning 24%. Most market risk premiums traded to the lowest level since the Fed commenced its rate hiking cycle. In short, the Fed aggressively eased monetary policy with financial conditions exceptionally loose. Sustaining bubbles is risky business, with systemic risk rising exponentially late in cycle.

The S&P 500 recovered to trade to new record highs in September as bullish exuberance reached extremes. A record 500 billion flowed into ETFs during the quarter. There was a record 600 billion of global debt issuance in September, with US investment grade bond sales surging to a record 171 billion. Another 128 billion of leveraged loan deals were launched, the first time to surpass 100 billion. With two months to go, asset-backed securities have already posted the strongest annual sales since the mortgage finance bubble. Sales of collateralized loan obligations have also boomed. Feeding frenzy is an apt description of happenings in the bubbling private credit universe, in what is essentially corporate America’s subprime boom. A key risk premium—corporate investment grade spreads to Treasurys—recently traded to the lowest level since 2005. That period, at the heart of the mortgage finance bubble era, was similarly notable for liquidity abundance-fueled excess.

I want to stress an important point. You just don’t see this degree of inflationary market excess without some underlying monetary dislocation. I’ll highlight that. Money market fund assets surged 360 billion during the quarter, or 23% annualized. Money fund assets have inflated 1.9 trillion, or 42%, just since the Fed began its tightening cycle in March 2022, and an incredible 2.9 trillion, or 79%, since the start of the pandemic. This historic monetary inflation runs unabated. Money fund assets have inflated 374 billion, or 26% annualized, over the past 12 weeks.

I believe a surge in money market liquidity emanates from the repo market’s funding of leveraged speculation. I’ve written about this dynamic, and discussed it recently at the McAlvany Wealth Management Client Conference. This is epic monetary inflation flowing chiefly from the expansion of speculative credit in the money markets. Short-term repo market funding of levered Treasury basis trades and more general fixed income carry trade leverage.

I’d liken the expansion of money market deposits to fractional reserve banking and the bank deposit multiplier, but without reserve requirement constraints. In the late ’90s, I referred to this dynamic as the infinite multiplier. I just never imagined the repo market and money market fund deposits would inflate to surpass 6.5 trillion.

I closely monitored this dynamic during the late ’90s bubble period, and then again throughout the mortgage finance bubble. But excesses during today’s most protracted global government finance bubble have reached an entirely new level in scope and duration, along with deeply corrosive effects on market, financial, and economic structures. The only period of comparable excess and maladjustment would be the fateful roaring ’20s bubble experience.

Over the years, I’ve been asked why this so-called perpetual money machine couldn’t run indefinitely. And this irrepressible bubble has repeatedly made my warnings look foolhardy. But it’s more important today than ever to recognize that policymaker interventions, especially here so late in the cycle, spur only more destabilizing excess, speculation and leverage, high-risk lending, and resulting deeper financial, economic, and social maladjustment.

There’s just no escaping this harsh bubble reality, and it’s reached the point where consequences include historic market and AI manias, [unclear] fiscal deficits in a $2 trillion range, a trillion dollar-plus highly levered basis trade, incendiary social angst, and geopolitical turmoil. Nothing good comes from extending terminal phase excess. But it’s all consistent with the end game for a historic multi-decade super cycle. Only too fitting that the greatest bubble in human history concludes with a prolonged period of the craziest excess and the wildest instability. After all, policymakers around the world are doing whatever they think it takes to hold bubble collapses at bay. Japan continues to defer normalization. An increasingly desperate Beijing has succumbed to whatever-it-takes reflationary measures. The Fed ignores precariously loose conditions and speculative bubbles. The ECB aggressively slashes rates.

Meanwhile, all these measures promote late cycle terminal phase parabolic debt growth—government and private sector—along with a fateful deluge of speculative financial credit. It’s the obvious question, how will this all end? I wish I knew. There are ample potential catalysts. Normally functioning markets would’ve brought such egregious excess to a conclusion years ago, but even irrepressible bubbles eventually succumb. Markets have been afflicted with the frog in the pot syndrome when it comes to geopolitical risks. Does the Middle East erupt into a more globalized conflict, could the Ukraine war escalate into a nuclear crisis? What’s North Korea up to? Is China preparing to tighten the noose on Taiwan, and how would the US respond?

The new and formidable axis of evil—China, Russia, North Korea, and Iran—is determined to capsize the US-led global order. I fear we’ve entered a highly unstable period of unending conflict and crises, yet markets have remained comfortable, disregarding mounting geopolitical risk.

This extraordinary complacency has a clear source—Federal Reserve and global central bank market backstops. But we’re now seeing a dangerous escalation in geopolitical risk concurrent with unappreciated issues with policymaker backstops. 10-year Treasury yields surged 52 basis points this month. Yields on benchmark MBS securities are up 82 basis points. At yesterday’s record price, gold was up $140 for the month, or 5.3%, while silver was up 10%. The Atlanta Fed GDPNow forecast of current growth has increased to over 3%, and yesterday we learned that Q3 personal consumption jumped to 3.7%.

Overheating risks are increasing, and especially with China’s newfound determination to inflate, the likelihood of upside inflation surprises increases. Market complacency also applies to inflation risk. For starters, our federal government ran a $1.8 trillion deficit last year, or almost 7% of GDP. Whether it’s a Trump or Harris administration, most analysts believe the deficit only grows from here. There are reasonable scenarios where it spirals out of control. Legendary hedge fund operator Paul Tudor Jones last week stated the issue concisely, “We are going to be broke really quickly unless we get serious about dealing with our spending issues.”

I was reminded of Ernest Hemingway’s two paths to bankruptcy: gradually and suddenly. I believe inflationary psychology throughout the economy has become more deeply rooted than Wall Street and the Fed are willing to admit. At a 4.1% unemployment rate, labor markets remain tight. Labor unions are emboldened ,as again confirmed by Boeing’s spurned offer of a 35% pay hike to end its strike. Companies have learned they can pass along higher costs. Meanwhile, I believe climate change will present growing inflationary risks. We’ve already experienced rising food costs along with incredible inflation in various types of insurance, and we saw just weeks back the scope of destruction wraught by back-to-back hurricanes Helene and Milton. There will be considerable spending on cleanup and rebuilding, economic stimulus that underpins the forces of inflation.

There will also be greater spending on emergency preparation as large swaths of the country confront growing exposures to extreme weather events. Over the past two years, US and global inflationary pressures have been somewhat mitigated by disinflationary forces out of China. With the ongoing deflation of China’s historic apartment bubble, stimulus measures were buckets dumped into an ocean. But this summer, global deflation entered a dangerous acceleration phase. A crisis of confidence was taking hold. Xi Jinping has hit the reflation panic button. Hundreds of billions for the stock market, hundreds more for the deeply troubled local government sector, many hundreds to try to stabilize China’s apartment markets. What’s more, Beijing has essentially promised to spend whatever it takes to reach growth targets.

A Reuters article this week placed Beijing’s stimulus at 1.4 trillion. This is for a system that has been locked in massive credit expansion upwards of five trillion annually. Considering the powerful forces of bubble deflation, I appreciate the view that even the grand scope of the latest stimulus barrage won’t be enough to turn the tide. This is almost beside the point. I expect Xi Jinping to throw everything at a now open-ended reflation effort. He’s highly motivated. Collapse would be blamed on him and his Communist party, while Xi’s global superpower ambitions would crumble right along with China’s global financial and economic standings. Xi made telling comments last week when meeting with Putin. He said, “At present, the world is going through changes unseen in a hundred years. Tthe international situation intertwined with chaos.”

A deluded Xi Jinping will view mammoth inflationary efforts as fundamental to ensuring chaos doesn’t engulf China. Mounting domestic risks, I fear, raise the odds of Beijing diverting attention with the hastening of Taiwan reunification efforts. We see the geopolitical backdrop underpinning price pressures for many things. There are already added costs for shipping that avoids the Red Sea, while Russia has been sinking grain ships in the Black Sea—just as examples. An upsurge in trade protectionism and tariffs would impact pricing, availability, and supply chains for key goods and resources. We expect the acceleration of de-globalization to come with heightened inflation risks. While the risk of another inflationary spike is not remote, in the near term, I’m focused on the potential for a more moderate uptick in inflation that would put the Federal Reserve on its heels. Importantly, mounting bond market deficit and supply concerns intensify if the Fed is forced to put its easing cycle on ice.

I believe global bond markets have finally begun to wake up to the problem. Recall that bond deleveraging and a spike in yields brought down UK Prime Minister Liz Truss and forced belt tightening in the UK in October 2022. Well, UK yields surged another 18 basis points last week, and 26 basis points this week, to trade today at 4.50%, surpassing the 2022 crisis highs.

More recently, markets nervously eye French politics and looming budget battles. French yield spreads to German bunds recently touched the widest levels since the 2012 European bond crisis. Italian spreads widened to 2021 levels, and Japanese JGB yields are back to 1%—near 13-year highs.

From my analytical perspective, the highly leveraged Treasury market today poses a major risk to global market stability. The basis trade is said to have easily surpassed one trillion, and I suspect this is only a segment of speculative leverage that permeates the entire US credit market: Treasuries, corporate bonds, muni bonds, MBS, ABS, private credit, leverage loans, structured finance, and derivatives.

I’ll return to the VIX index’s August 5th spike to 60. De-risking/de-leveraging today creates a momentous risk. There are scores of bubbles globally interconnected across markets between nations and regions. In early August, the unwind of yen carry leverage pressured the AI tech bubble. These two faltering bubbles were at the cusp of triggering a systemic de-risking/de-leveraging dynamic. Importantly, a more systemic de-leveraging would spawn market liquidity issues, widening risk premiums and general pressure on credit market leverage—the extremely levered basis trade in particular.

I’ll reiterate the end-game thesis. Sure central bankers could once again bail out speculative markets, but all that would accomplish is another wave of speculative excess and more problematic leverage. And keep in mind that once markets succumb to late-cycle manic excess, prolonging the bubble comes at a steep cost.

Crazy turns only crazier. The tech mania has inflated to the point where trillions are to be spent on data centers, semiconductor fab plants, energy infrastructure, old decommissioned nuclear reactors, and all things AI. Meanwhile, the proliferation of uneconomic businesses runs unabated, corporate and consumer debt growth runs unabated, Washington deficit spending, unabated. A large and expanding swath of the US bubble economy, certainly including the AI mania, is addicted to loose conditions.

The Fed concluded its so-called tightening cycle without financial conditions actually tightening. This only raised the odds that it will be market de-risking/de-leveraging that unleashes a highly destabilizing tightening dynamic.

These days I worry mightily about economic structure and the vulnerability to market dislocation, de-leveraging, tighter conditions, and illiquidity. Years of loose finance, credit excess, and bubble markets have nurtured an economic structure, acutely vulnerable to market instability and a resulting interruption in credit expansion.

We have a pivotal election next Tuesday. In last Friday’s CBB I highlighted insight from legendary hedge fund manager Paul Tudor Jones. He referred to November 5th as the macro analysis Super Bowl, an analysis harmonious with my analytical framework. Tudor Jones sees the election as a potential catalyst for sudden bond market reassessment. He warns the potential for a so-called Minsky moment that, “financial crises percolate for years but they blow up in weeks.”

I’m in complete agreement with his view that federal debt growth is unsustainable and that we are at “an incredible moment in US history.” I won’t venture a guess on who our next president will be or over the composition of party control over Congress. The bond market has shown vulnerability to what has been incredibly imprudent tax cut and spending proposals from both Trump and Harris. For me, the spectacle of this election cycle pushed deficits-don’t-matter to precarious extremes, perhaps crossing market red lines. Such profligacy has been a dangerous consequence of repeated Fed market bailouts and resulting detoothing of market discipline. My basic assumption throughout this most protracted credit bubble has been that market discipline would eventually win the day. It has been an incredibly long wait, and we all know the pitfalls of asserting “this time is different,” but I do believe it’s telling that 10-year Treasury yields have jumped 65 basis points, and MBS yields, 102 basis points since the Fed slashed rates 50 basis points in September. Gold and silver have surged 6.6 and 6.4% since the Fed, increasing year-to-date gains to 33 and 37%. Something’s definitely up.

I’ve intensely analyzed this bubble now for over three decades, and have been repeatedly astounded at the scope of central bank and government inflationary measures, market interventions, and bailouts. That debt markets would so embrace open-ended inflationism has been mind-boggling. I’ve long believed a point would be reached where the bond market begins to respond negatively to Federal Reserve loosening measures. Such an occurrence with likely mark a critical juncture for the cycle—a point where the Fed would finally be forced to think twice before once again calling upon its inflationary toolbox.

There are a few things we understand today with confidence. This is very late cycle. We’re really late into this late cycle phase. The scope of excess, it’s off the charts. Speculative leverage is today unprecedented. This ensures that the next serious bout of de-risking/de-leveraging and market illiquidity will place excruciating pressure on the Fed and central bank community to restart QE to meet their buyer-of-last-resort obligation. We also know that inflation remains elevated, with myriad risks both domestic and global. It is this backdrop that shapes my view of the Fed being trapped.

This is a really uncomfortable backdrop for the Treasury and bond markets. Loose conditions continue to fuel manic late cycle asset inflation and debt issuance, underpinning already elevated inflation. And a new administration will soon move to implement a laundry list of budget-busting tax and spending campaign promises.

Meanwhile, now, interminable late cycle bubble fragilities ensure the inevitability of desperate inflationary policy measures. I don’t want to make too much of poor bond market performance following one Fed rate cut. But enormous speculative leverage has accumulated in markets on the premise of an open-ended Federal Reserve liquidity backstop. Moreover, there has been a recent parabolic spike in leverage in anticipation of an aggressive Fed easing cycle.

Risk of bond market instability and de-leveraging is growing while the manic stock market speculative bubble is an accident in the making. And we’ve already witnessed bubble fragility reveal itself globally within the massive yen carry trade and AI tech mania.

Next week’s election creates a possible catalyst for market reassessment and de-risking. At the same time, with all the derivatives and hedging, there’s potential for a post-election head fake rout. Hopefully election outcomes don’t drag on for days and even weeks and that results are not contested. Coupled with escalations at various geopolitical flashpoints, market risk today is at the highest level of my career, arguably the highest in generations. I’ve fallen into the habit of concluding with a simple wish: I hope I’m wrong. David, back to you.

David: Thanks Doug. We’ll go to the question and answers, and we’ve had a number of questions submitted. If there’s something that comes up that you’d like to discuss with us after the fact, perhaps how to include Tactical Short in your total portfolio mix, feel free to set an appointment, and we look forward to discussing that in the days and weeks ahead.

The two markets which continue to be a part of our internal conversations multiple times a week relate to the bond market, which we’ve covered extensively in the comments, and in the currency markets. These are two areas where we see a lot of activity, and growing concerns not reflected in the equity markets, so very different thematics and frankly very different players.

You’re dealing with perhaps a more robust set of skills that go into trading currencies and bonds, and perhaps it’s not a surprise that those who are less in tune with these market risks that Doug described are enjoying enjoying the equity markets today.

The first question is from Ed, “How would you weight cash, stocks, and precious metals for the next three months? Rebalance now or wait until January? Would you weight any of these three heavier for a while, or lighter?”

One of the references that we use oftentimes just as a starting point in conversation is what we call our perspective triangle. It’s a very simple asset allocation model, which assumes we don’t know what the future holds, but being able to mitigate risk and balance opportunity with the various risks that are in play is important.

Think of it as a third, a third, a third—a third in cash, a third in stocks or income producing fixed income, a third in precious metals. These are for liquid assets. That’s a simple framework, and oftentimes we’ll engage with folks about whether or not they prefer the equilateral to an isosceles where you adjust one of those legs more aggressively. To Ed’s point, where would we put more of a focus?

Let me give you as an example what we’re doing now within our hard asset strategies. Current cash in the hard asset portfolios is between 30 and 35%. That’s interesting because if you look at the most recent Bank of America survey of asset managers, it’s hovering around all time lows between 3 and 3.5%. So we’re obviously looking at things from a different perspective, with basically 10 times the quantity of cash in our portfolios relative to asset managers today.

There are times that our cash levels will be lower in the asset management strategy, but we remain cautious, and particularly in the four areas that we focus on in hard assets, we remain cautious in real estate and global natural resources. There are some recent additions to infrastructure, and I think post-election we’ll take another look at infrastructure names, but suffice it to say we’re comfortable with that level of cash today.

Within our equity exposures, the precious metals have the most compelling story. The free cash flow story is a compelling one, and with rising energy costs in the years ahead, we’ll have to manage those exposures carefully. Its current margins could be severely impacted, so at present we’re currently moving about 50% of those exposures to an inflation protection mode, if you will, where rising costs would be less of an issue.

For the next three months, back to Ed’s question, I would say that healthy cash, healthy physical metals’ exposure, if you’re not focused, as we are, on hard assets within the equity space, if it’s a more general allocation to equities, then I would pare it back. I would pare back those equity positions by 20 to 30% at a minimum. So if it’s, say, an S&P position, that kind of a position, 20, 30%. If it’s more aggressive in something like the QQQs or technology, 40 to 50%. These may sound like severe trimmings, but the exposures, if they’ve done you well, I would say either hedge using something like Tactical Short or you must do some trimming. Semiconductors, I would be even more aggressive in cutting those back. I think hard assets are a different animal.

We would weight cash heavier, and I would say that even precious metals over a one-month period could be lighter if you are over-allocated in that space today. We have looked at the potential for price correction in the metals, something we’ve been anticipating. Actually we’d love to see something in the range of 10 to 20% off of the recent all-time highs, but the longer-term story on metals is very sound. I think that weakness in price represents a dip worthy of buying. And so as we come into this one-month, three-month period of time, I guess what I’m saying is de-risk what you can, and hedge. If you’re concerned about leaving cost basis behind or the tax implications of a move out of equities, then by all means hedge. And I think that’s where direct consultation with Doug and myself and figuring out how Tactical Short fits into that mix is really, really important.

The same questioner, Ed, asks as a supplement, “I purchased most of my precious metals 25 years ago, spot prices of gold and silver up 40% year-over-year, premiums are nil. What percent of my gold holdings, for example, should I sell with New York spot at 2775?”

I’ll frame this a little bit differently. I’m not a seller at 2775, nor am I a buyer. Part of that is because I already have what I need in terms of a hedge asset and a position in metals. So I’m a seller on the basis—not on the basis of price, but someday on the basis of a ratio. And we’ve talked about this ratio before, but this is a really critical concept. I want to know what my ounces are going into, the Dow/gold ratio north of 15 to one, that’s not a trigger to move out of metals.

If we were at five to one, regardless of what the price is, that’s a ratio that all of a sudden is speaking to me. It’s telling me that I should be beginning that exit or reallocation process. So exiting gold at 2775, that’s a price call. I still view gold as a currency, ultimately reflecting the relative value of the US dollar. So the question I ask is, do I see the dollar having a bright or a bleak future? And I think the longer term picture for the dollar is bleak. So I think it’s difficult to call this a top when we’re really not sure what the bottom is for the US dollar.

Now, certainly on a cyclical basis, gold can and will, and it should, correct but, Ed, as a 25-year holder, this has been a long game for you, and I would encourage you to continue with that perspective. The ratio is a better guide than the price. As inflation continues to distort value in nominal terms, ratios are the key to understanding where you are and what things are worth.

As for premiums, you asked about premiums, Ed. There’s a case to be made that low premiums—and we’re talking specifically here in the US market—low premiums reflect tepid US demand for metals. That might be hard to absorb or take in, that being at 2775 here recently, that somehow there’s not a hugely robust demand for the metals. And I think these premiums, again, are one source of evidence that there’s just not a lot of traffic into metals here in the US markets. That will change either with a sell-off in US equities or with a Harris win. And just knowing that the constituency that’s most concerned about the metals market, ownership of metals, I think those premiums would shift dramatically in either of those cases. Low-premium US gold is a place that you could actually consider buying. Premiums over spot, have them in that buy category. Lowest we’ve seen in 50 years.

So for me, if I wear my other hat in our sister company, in terms of inventory management, we are buying everything we can in that category. Even with a weakening of spot gold, there is a premium gain that I’ll hold out for. It’s the same with something like junk silver. Our cost today in the wholesale market is under 2% over spot silver. Two years ago we were getting clients out of those same bags at an over-40% premium. So the possible premium expansion is in some sense like downside protection. You could view it that way. If you don’t have a metals portfolio already, that’s where money should go. It’s as close to a hedge as you’ll find without actually hedging. So we’ve aggressively moved out of bulk bars in favor of bags to be able to compound ounces using those premium dollars as and when they return. Five of those trades since 2009. The last one was the biggest. I mentioned 40%. Most of what we’ll see in terms of those kinds of trades, 12% to 20%. Two years ago was a bit of an outlier, and the spot price was irrelevant.

So there is a way to engage in the metals market where timing and price become less important. I would just say institute a strategy, and that’s where timing the market becomes less important.

Doug, Allen asked this question, “Do you have an opinion of the probability of the scenario as described in the article by Charles Calomiris, titled ‘Fiscal Dominance and the Return of Zero Interest Bank Reserve Requirements?'”

Doug: Thank you for your excellent question, though I’ll admit that I generally prefer easy questions. For obvious reasons, fiscal dominance is top of mind these days for some analysts. For listeners on the call, I pulled a definition from the referred article from the St. Louis Fed, in quotes here, “Fiscal dominance refers to the possibility that the accumulation of government debt and continuing government deficits can produce increases in inflation that dominate central bank intentions to keep inflation low.” Under fiscal dominance, a central bank, they’re constrained in their ability to focus on the price stability mandate. A test would be whether the central bank’s priority remains adhering to its inflation target or has the focus drifted to accommodating massive deficit spending. This issue has layers of complexity, federal deficits and outstanding debt. They balloon to the point where the Treasury market is definitely a primary Fed focus. At times it seems the priority.

After all, during the pandemic crisis, the Fed purchased trillions of Treasurys. Importantly, buying treasurys is the primary mechanism for the Fed to add liquidity into the system. Over the years, the Fed has repeatedly reinforced confidence that it will backstop marketplace liquidity with open-ended Treasury purchases as needed.

Even before the pandemic, in September of 2019, the Fed restarted QE, not because of economic weakness, not because of market crisis or deflation risk. It began buying Treasurys again to thwart repo market instability.

Though it doesn’t meet the standard definition of fiscal dominance, the Fed years ago shifted its priority from price stability to what I’ll call Treasury and market liquidity dominance.

The article that you mentioned there focused on the issue of whether a huge debt and deficits would force the Fed to stop paying interest on bank reserves. In the grand scheme of things, I don’t see interest on reserves as that critical of an issue, and from Fed responses to previous crises, I expect the Fed to remain focused on supporting the banking system. So I would tend to believe that they will prefer to pay interest on reserves.

I’m assuming the Fed will have no alternative going forward than ongoing purchases of trillions of Treasury debt securities. I would imagine that if the Fed is gaming out a severe market crisis scenario, it would expect to aggressively slash interest rates. This would obviously reduce debt service costs. Maybe it’s not obvious. It would reduce debt service costs for the federal government, and importantly, funding costs for the leveraged speculators.

And this gets back to the issue that I’m referring to as Treasury and market liquidity dominance. I don’t believe most policymakers and academics fully grasp the gravity of the risks involved. My analysis doesn’t emphasize the more traditional issues associated with fiscal dominance. Instead, my framework prioritizes speculative leverage and associated marketplace liquidity. Fiscal dominance unfolds over years and even decades. Speculator de-risking/de-leveraging tends to erupt quickly, forcing abrupt and potentially monumental policy responses.

As I highlighted earlier, the key issue for me is whether inflation risks going forward will restrain the Fed in providing the massive liquidity injections that would be required to stabilize markets in the event of a major de-risking/de-leveraging. Moreover, does ongoing inflation risk and potential constraints on central bank liquidity backstops alter the risk versus reward calculus for leveraged speculation, more specifically the egregiously levered Treasury basis trade. Do the hedge funds just say, “Wait, wait, I don’t like this game as much anymore.” And if there is waning enthusiasm for being levered in the Treasury market, suddenly markets will be concerned about deficits in the ongoing massive supply of new Treasury securities that have to be absorbed in the marketplace. This scenario would see the return of the so-called bond vigilantes and a long overdue return of market discipline.

I think we’re heading in that direction. Bonds have begun moving in that direction. Politicians and the Fed, they haven’t figured it out yet. Always believed only a bond market crisis would force some semblance of fiscal responsibility out of Washington. The Fed has for years now delayed this day of reckoning, ensuring this unavoidable reckoning will be painful. And thank you for your question.

David: Art asks the next question, “Do you think gold will pull back after its recent run? Should one purchase gold stocks now? Any percentage of assets recommended?” And then two other questions along with this. “Will the BRIC meeting affect the dollar? What’s your current investment thesis?”

Let me start with that last one, our investment thesis. Our current investment thesis is to hedge general exposure in equities using Tactical Short, and then we have our hard asset strategies as well. So we would suggest owning hard assets. Inflation and rising rates are structural impediment if you’re talking about growth in financial assets, and inflation in rising rates, we think, are woven into the fabric of a debt-dependent global economy. Hard assets in the period ahead, they’re at the front edge of growth.

So our thesis is working, and I think caution is still warranted. I mentioned we’re still allocating to over 30% cash, in a large part because what Doug has described as market structure, which is in a precarious place, and we want to manage market volatility with higher levels of liquidity in the portfolio. But if we’re making a market call over the next three to five years, it’s that hard assets outperform financials, and our portfolios are structured for that advantage.

As to the first question, do you think gold will pull back after its recent run? The simple answer is yes. If you look at technical factors, if you look at COT reports, it certainly argues for a correction in the price of gold. What I would say in almost countering that, if I will, there is the possibility that technical factors are ignored. And that’s because some of the buyers in the market today just don’t care about those things. I refer you to Mohammed El-Erian’s article in the Financial Times on October 20th titled “Why the West Should Be Paying More Attention to the Gold Price.” And he goes into the reasons why Central Bank reserve asset managers are interested in owning more gold as sort of an exit from a dollar-based system or as a means of hedging their risk and exposure to both dollar assets and Treasury department interventions.

There’s another article from Barron’s, out last week, and it does relate to the BRICS question. China, Russia, Brazil want to demote the dollar. This is from October 25th in Barron’s, and the rest of the title for that article is “Gold Is The Answer.” And they’re again looking at this issue of countries and central banks positioning in metals in a way that doesn’t take into effect how they’re trading technically. So I can make a case for a correction in gold, but I can equally make a case on a longer term fundamental basis that there are things that are shifting and that’s really what El-Erian is getting at. Typically, a strong dollar is negative for gold. Typically, rising rates are negative for gold. And the “typically” can be set aside because that’s not what is happening today. We have gold rising in the face of a strong dollar. We have gold rising in the face of increased interest rates, and so the classic relationships are having to be reassessed, and that’s where El-Erian is saying, “I think,” and again, as you said earlier, Doug, it’s dangerous to say this, “I think it’s different this time.”

Part of that is because we’re not dealing with strictly an investor base and typical demand sources in jewelry and industrial demand for the metals. So it’s worth looking at all of those factors. The short answer is yes, but there are caveats to that. Hopefully I’ve provided a couple of those.

As far as gold stocks, I think gold stocks are poised to run as bullion corrects. If it does correct 10% or 20% off recent peaks, the miners will be even more attractive. I would say talk with us about implementing our strategy for you. It’s a space that is very differentiated in terms of risk. It needs a lot of attention to minutia. Our names, risk adjusted, are the best you can own. Our current allocations in the portfolio are between 20% and 25%, and we have to continue to manage that risk as we see adjustments in the broader market. Perhaps we shrink those back in the short term, but it’s an area that we’re intrigued by. The free cash flow story I mentioned earlier is a powerful one.

BRICS, over time, are going to have an impact. And so this migration that El-Erian refers to and we see in Barron’s this last week, that is a long-fuse issue. There’s a curious anecdote I’d like to share. So yes, we could think that the BRICS and their migration away from dollars, that will be a concern going forward. But again, the BRICS meeting a week or so ago in Kazan, Russia—and this is just to say that the impact on the US dollar from their meeting and the direction they want to go, it’s not immediate. Attendees at the conference were encouraged to bring and settle their bills in euros and dollars. Just let that sink in. Attendees were encouraged, as they traveled to Russia, to pay their hotel bills and bring ample euros and dollars. If you think about that, the ruble is really competing with toilet paper for usefulness. When your Russian hosts are griping about the dollar system, but suggesting you bring dollars and euros to the event, there is an important subtext. And again, that’s just to say that the BRICS de-dollarization is a very long fuse indeed.

The next question is for you, Doug. Raymond asks, “How are the global markets reacting to the pre-election date?”

Doug: Well, that seems like a straightforward question. General global markets have remained relatively strong while bonds have been under pressure. And as I discussed earlier, and David has mentioned also, the precious metals, those prices have been exceptionally strong. Most market commentators are saying that markets have moved in the direction of a Trump win. That’s not necessarily apparent to me in international markets. Chinese stocks have enjoyed a big rally on Beijing stimulus measures. If markets were positioning for a new Trump administration, I would expect Chinese stocks to be under some pressure. But again, there are major domestic considerations at play there. In general, international stocks are not showing the level of anxiety one might expect.

The bond market is where the action’s at. Global bond markets have been under significant pressure, as I discussed earlier, almost across the board—developed, developing. Most Wall Street strategists agree that Trump outdid Harris in budget busting campaign promises.

It’s conventional market wisdom at this point that the rise in Treasury yields has been the market discounting a Trump victory. There may be some of that, but I think there’s much more to the story of rising yields. I monitor global bond markets closely, and it is becoming clear that global investors are increasingly focused on deficits and debt sustainability. Just yesterday, and really yesterday and today, the UK bond market has reacted negatively to Chancellor Reeve’s budget presentation to Parliament. UK yields are up 45 basis points this month and 70 basis points off September lows. Yields, as I mentioned earlier, they’ve even surpassed the level from the October, 2022 spike.

Other debt or nations, France and Italy I mentioned, they’ve seen their risk premiums rise. So it’s reasonable that prospects for a Trump presidency have contributed to the rise in Treasury yields and rising Treasury yields have likely had some impact on global yields. I believe it is likely the case that global markets had already become more attentive to deficits and supply issues with the US presidential campaign only underscoring, I’ll just phrase it, how daringly politicians have embraced deficits don’t matter. It was as if the bond vigilantes made their dramatic return back in the fall of 2022 to doom spendthrift Prime Minister Liz Truss. But Trump and Harris obviously didn’t get the message that vigilantes have called in reinforcements here. Thank you for your question.

David: Next question is from James. He says, “I’m interested in this McAlvany product as an investment consideration. Markets are at nosebleed levels, profits on the downside can be used to convert dollars to cheap tangible assets created by the downside.”

We’ve been talking about very loose financial conditions, and I think just as perhaps an illustration of that and to look at what it would be, again, just an illustration, one of many of markets being at nosebleed levels. Carvana is an interesting company, an auto vending machine, today at $247 a share, up from its recent lows of $3.55. It trades at 62 times book value. It trades at a current PE of 99, a forward PE of 125. In essence, from earnings, I would make back my investment when I turn 150, or on a forward basis when I turn 175 years old. I think that’s fair to call sort of a nosebleed level.

Can the shares go higher? Of course. You’ve got 11% short interest in the stock, and anything can happen in a market that is overly liquid. So I agree with the premise of the question, and sort of where Tactical Short fits into this. Tactical Short, it’s a product that’s designed to create more liquidity via capital gains as financial assets get cheaper. Converting those gains to cheap tangibles is a real possibility. I think the exception to that, I would say, the exception to that is gold, which given its safe haven characteristics and strong positioning by central bank reserve managers means that it can and it often does move opposite the market. So in that sense similar to Tactical Short. Global natural resources, real estate, those are two of the areas that we focus on, they would be more likely to suffer in a general equity decline. That’s in part why we remain less allocated there.

So when you describe tangible assets going down in value, I think there’s even some tangible assets at risk. So what you’re looking at with Tactical Short is a mechanism of creating purchasing power, firepower. It does exactly what was described by the question. It’s a tool for both reducing downside volatility and providing a pocket of liquidity for redeployment when others are liquidity constrained. Doug, would you want to add anything to that?

Doug: No, David, I think you did a great job with that.

David: The next question, Rich asks, “In a late cycle, what form could another coordinated attack on the gold price take this time around, remembering 2013?”

Futures markets are where games are often played. So you look at margin requirements and it’s very common and expected that margin requirements increase as the price goes higher. That’s normal. It’s a professional move that keeps traders with adequate skin in the game. If margin requirements are not increased, the implied leverage in futures trades gets flat silly. So proportional increases are normal, but when margin requirements move to, say, 50% or 75% or 100%, COMEX is working on breaking price momentum. There’s sort of a nonverbal communique there. If you go back to 1980, you can recall the episode where COMEX quit taking buy trades in the silver market at all, and you could only sell, and the reason for that, if you know many of the players and know the balance sheets in play, it saved a number of the member firms on COMEX, which were bleeding, and of course it bankrupted the Hunts.

So the only other policy measure I could think of, in answer to Rich’s question, changing margin requirements to the extreme or taking only sell trades if you really wanted to get serious about punishing price. I think from a policy perspective you could look at taxes, a windfall profit tax of some sort, and I think that is best addressed in an account diversification where you’ve got some ounces in a tax-deferred account where something like that would likely not apply.

I think this question would be best for you, Doug. “Is there going to be a financial debt or otherwise crisis in the near future this year or the first of next year?”

Doug: Well, most unfortunately, I believe odds of a financial crisis are unnervingly high. I’ve been on crisis watch for a while now, so my track record of late, it’s nothing to write home about. But all the necessary elements for a major crisis are in place, as I highlighted earlier. I would point to speculative excess, leverage, extreme bullishness, major market misperceptions, disregard for risk, and financial structure fragilities. In my analysis, if I’m on the right track here regarding a major change in bond market behavior, I would be surprised if we get much through 2025 without the eruption of crisis dynamics. I would also be surprised if we don’t see major geopolitical flare-ups, and when I look at my Bloomberg screens today, I can build a case that crisis dynamics could gain momentum quickly. The jump in UK, US, and global yields appears poised to accelerate. The semiconductor and tech stocks are at heightened risk of a breakdown here, which would catch everybody by surprise. The emerging market periphery appears vulnerable.

And I mentioned earlier that key risk premiums are at multi-year lows. Investment grade spreads to 2005 levels. I mean, that’s crazy. This degree of exuberance, really stunning complacency, it’s almost a prerequisite for a market panic, and never have markets been so dominated by speculative leverage. As I mentioned earlier, all the elements are present for major crisis, and I would be surprised if we have to wait that long. But as I said earlier, I hope I’m wrong on this. Thank you for your question.

David: Chris’s question is similar to one I addressed earlier. Maybe I’ll just expand a little bit. He says, “What’s the trigger for getting out of gold and silver as the big escalation begins?” I come back to that Dow/gold ratio, and just watch it under 10, and act on it in tranches from six on down. The one-to-one ratio has occurred two times in the last 100 years. Six to one was the extent of the ratio’s shifting during the global financial crisis, and with massive QE interventions and the Fed’s integrity, which was not compromised at that point— The confidence in the Fed allowed for that dramatic intervention and I think a saving of the system. So six to one was the extent then. I think we will see three to one if your exposure to the metals is out of balance. And I think maybe as it grows in value, it’s going to be, it’s almost a mathematical certainty.

If your exposure gets out of balance with other assets, then I would say be early and sell often. Selling into strength is very important. So at a six to one Dow gold ratio, you could take 10% off the table at a five to one, 10% of what remains, four to one, 10% again, three to one, I would begin to increase the scale. 25% of the remainder, two to one, 25% again, one to one 50% of the remainder. And that still keeps you with a strong metals position, but in essence, you are dollar cost averaging into equities as they’re being discounted and ultimately are putting in a bottom, and you’re exiting the market as the metals reach, what only in hindsight would be an unsustainably high level. So that discipline of using the relative relationships and looking at the ratios, and again, I’d say if you’re over-allocated, then you want to begin that process a little earlier.

The next question is from Norman. He said, “What will be the effect of the required US interest rate payments on the national debt for next year?” Doug?

Doug: Sure. Yeah, I’ll give that a shot. So interest payments exceeded $1 trillion—I guess it was $1.133 trillion to be exact—for the fiscal year ended September 30th, and that was a 30% year-over-year increase. For perspective, defense spending was up about 7% to $830 billion. I believe interest payments now only— It’s only Social Security payments, I believe, that are larger than interest payments.

What are the effects? Well, I think it has added to income for households that hold Treasurys, and quietly contributes to a resilient consumer sector. To this point, massive deficits have not yet translated to a spike in market yields sufficient to cause general financial and economic problems. It just hasn’t happened yet. Earlier in my career, there was a lot of angst about growing deficits and the so-called crowding out of private sector borrowers. Add that to the long list of concerns that sounds archaic these days. And why haven’t massive deficits of ballooning debt service caused more issues? I’ll point to two key factors. One, with the rise of whatever-it-takes open-ended QE, the bond market has operated with the assumption that any issues of illiquidity or yield spikes will swiftly be rectified by Federal Reserve buying. Second, with this Fed liquidity backstop taking highly leveraged speculative positions in Treasurys has been perceived as a low risk, high reward proposition.

Basis trade and other popular leveraged strategies have provided a huge source of demand for Treasurys, irrespective of deficits and supply concerns. But is financing our massive deficit through leveraged speculation just part of this era’s financial folly? Well, I suspect it is.

So what is the effect of mounting deficits and debt service next year and beyond? I think it matters tremendously how deficits are being financed. I certainly wouldn’t feel comfortable being highly levered in Treasury securities right now, and I made this point earlier. If inflation surprises to the upside and the Fed is forced to approach QE more prudently, I think this would alter the risk versus reward calculus for leveraging Treasury securities. When hedge fund manager Paul Tudor Jones last week warned of a Minsky moment, I imagine he’s worried about a scenario of Treasury market deleveraging and how such a development would profoundly impact the most important market in the world. Financial markets and the economy would have significantly less liquidity to play with in the event of a major de-risking/de-leveraging. And thank you very much for your question.

David: Next question is from Richard. “With tensions rising and the risk of widening war around the globe, how is it affecting capital flows into the US markets? Conversely, how does the current political driven and potential turmoil inside the US affect the same?” Doug, you want to take a crack at that first?

Doug: Sure. I’ll take a crack at it. I’m sure you can speak more eloquently on this than I can, but let me give it a try. So thank you for your question, Richard. I follow the monthly TIC, the Treasury International Capital flow data. And the flows, they vary month to month, and I can’t really discern if heightened geopolitical risks are having much of an impact so far. The most recent data showed strong inflows in August that followed a relatively strong July, but I don’t put a lot of faith in the data set, candidly. I suspect flows are often associated with leveraged speculation rather than international investors. Some of the biggest flows are associated with the Cayman Islands, Luxembourg, the UK, and other offshore financial centers frequented by the global leveraged speculating community. So I don’t have a good feel for how geopolitical factors are affecting US capital flows, and I would sure think that potential US turmoil, that it has the potential to impact capital flows. Why wouldn’t it?

So far, though, such risks have been disregarded by the stock market while overall financial conditions remain exceptionally loose. With markets, their focus is on this incipient Fed easing cycle. I would expect a de-risking/de-leveraging event could spark major financial flow instability.

One of the analytical challenges of this period comes with the realization that there are myriad bubbles around the world, right? That’s why I say global government finance bubble. Virtually all major economies have serious structural issues, excessive debt, asset bubbles, economic maladjustment, and social and political instability. So in a way it’s a relative game. Who is in the worst shape? Most vulnerable? Who hits the wall first?

But I’ll say that I believe the US likely has the greatest vulnerability to a destabilizing de-leveraging fragility that is created from all this faith in invulnerability. I fear the Treasury market is the king of levered markets, and I believe this creates unappreciated vulnerabilities for our asset markets and for our deeply maladjusted economy.

At the same time, crises typically erupt at the periphery and then gravitate toward the core. The US and the Treasury market are the core. So we shouldn’t be that surprised if we initially somewhat benefit from international financial flows if crises erupt at the periphery. We will just be following this, literally, hour by hour. But thank you for your question.

David: Yeah. Just to reiterate what you said, the capital flows into US dollar assets have remained strong. The rest of world Treasury holdings still sit north of 8 trillion, 8.3 trillion. And as you mentioned, there’s sort of an unaccounted for number there in the Caymans, Luxembourg, and the UK. If that is leveraged Treasury positions, if they’re at all related to the basis trade, then you can see those numbers flip pretty dramatically just on the basis of stress and strain in the financial markets.

We talked about the BRICS and de-dollarization earlier, and a lot of the conversation is reaction to or response to the weaponization of the US dollar, with the US in 2022 taking 300 billion in Russian assets and just saying, ‘What was yours is now ours.” The idea that we’ve weaponized the dollar has made the dollar, in the long term, less attractive to own, or dollar assets if they can be seized.

And there is the potential that the BRICS, some combination of the BRICS—Russia, and China come to mind first and foremost—do the reverse, sort of a mirror of the weaponization of the US dollar instead of that weaponized Treasurys instead. So we need that 8.3 trillion to sit and to not move. And we have new debts that need to be financed. We’ll be rolling over 9 trillion next year of existing debt in addition to say another 2 trillion in deficit spending, barring a recession it’ll just be in the neighborhood of 2 trillion. So we’ve got to find new buyers. Maybe we monetize some of that debt. All of that is a recipe for vulnerability. And if any of the 8.3 that’s currently sitting in the rest-of-world category starts to come to market, then you’re talking about real pressure in the Treasury market. So it’s something to watch. Right now it has not negatively affected capital flows, but it certainly could.

As for the second part of the question, the current political division and potential turmoil inside the US, I think this is something that our foreign creditors do watch. Do we have the ability to pay? And perhaps that is what we’re at the front edge of seeing with rates rising, even though the Fed funds rate is coming down. The question of whether or not we can pay is beginning to be a reasonable question.

Doug, you mentioned 1.133 trillion in interest, and I believe it was the Congressional Budget Office that pencils out 1.3 trillion for 2025, which would make it the number one line item on our budget, exceeding even Social Security for 2025. Again, those are things that, if you were a foreign creditor, you would look and say, “I’m not sure it’s the same risk-reward proposition as it used to be. I’m not sure it’s the same risk-free rate that the US Treasury used to be.”

And I’ll mention Ferguson’s Law. Our colleague Morgan Lewis brought this up in conversation with our clients recently. Niall Ferguson states that any great power that spends more on debt service—that is, interest payments on the national debt—than on defense will not stay great for very long. And he references the Habsburgs in Spain, the Ancien Regime in France, the Ottoman Empire, the British Empire, all of whom, they all had similar dynamics where the burden of interest exceeded defense, and it was one of those telltales of a fading great power.

So do we give, in our politically divisive environment, do we give further reasons for others to suspect that we are fading? I think that’s a reasonable concern. Back to financial markets, to the degree that a financial unwind is global in scope, we can make a case against the US dollar assets, but dollar demand in the context of liquidity crunch, dollar demand increases. It’s just the expression of a liquidity preference.

So how we address fiscal concerns, fiscal dominance issues going forward will tilt the flows towards or away from Treasurys. And US turmoil, if that increases and rates continue higher, I think you could probably fast-forward a decade. I think the old moniker “certificates of confiscation” may apply once again to the long bond.

Robert asks this question, Doug, “How may a Tactical Short strategy impact a portfolio already having precious metals, relatively low-risk corporate and municipal bonds in your hard asset portfolio where exposure to traditional equities is limited? How liquid is the strategy?”

Doug: Thank you for your question. The easy part first, the strategy is highly liquid. Full transparency. New account holders have their own separately managed account at Interactive Brokers. They see every trade, every position. And with a simple phone call, we can quickly reverse short positions. We’ll only do liquid short positions so we can quickly reverse short positions, and the account would then be a hundred percent cash.

Tactical Short is a product to hedge market risk. We don’t want anyone to make big bets against the market. It is generally appropriate as a part of an overall investment portfolio. We often say anywhere between 5% and 20% of a portfolio, based on various individual factors. You stated that you had limited exposure to traditional equities. That makes a lot of sense to me in the current environment. So there’s not a lot of traditional stock exposure to hedge, but as I look at my Bloomberg screen today, I do see the precious metals and resource stocks, at least for a day, correlated with the equities indices.

And with corporate bonds vulnerable to bursting bubble risk, I believe Tactical Short performance could be negatively correlated with corporate bond returns if we see the kind of upheaval I think is unfolding. So there may be a role for a Tactical Short allocation to lower the volatility and the risk of your overall investment portfolio. And David, I thought maybe you had thoughts on this as well.

David: Well, I think I’ll address it and tie it to the next question, which is, “At the present time, if you had a clean slate, how would you position your resources? What percent would you have in cash, gold, silver, stocks, Tactical Short.”

In an age where cash is trash according to Wall Street, we see it as a great asset. You maintain a tremendous amount of optionality, and I think that becomes of higher value in the right environment. So cash, I would say minimum 30%. Precious metals, and we’re talking about liquid assets, not net worth here, cash a minimum of 30%. Precious metals, maximum 30%. If you’re starting out as a clean slate, starting today, I would have to leg into the metals in tranches, three or four tranches, and I think maybe, hopefully we have a correction here that accommodates you at lower prices. Stocks of any sort, 30%. And in Tactical Short, I would say a minimum of 10%.

Now you mentioned this range of 5 to 20, Doug. If we look at say a 10% exposure, and we’ve got a 30% equity exposure, that suggests that, in my opinion, Tactical Short could now be equal to one third of your equity exposure versus your typical 10 to 20. On the low side 5, upwards of 20. I think it could be higher in this environment, but that’s a defensive posture to say the least. Metals, limited equities with a healthy hedge on those equities, and healthy Tactical Short exposure. That’s what I would do.

Carl asked this question and I think we could both probably add to it. “If the assumption is that more rate cuts are coming to make government debt service cheaper, wouldn’t that mean that future rate cuts are coming too, or at least lower rates for longer are needed to continue to keep interest costs lower, then Paul Tudor Jones is correct in saying that all roads lead to inflation.

If that happens and higher real inflation is here to stay, wouldn’t long bonds become investable? If that were the case, where would this capital go? Gold, real estate, bitcoin, undervalued equities, what else? Wouldn’t these asset classes need to grow significantly larger? How long could this last, years? Thanks for the education and guidance in these interesting times.”

Doug: Yeah, I can give it the first shot here, David, if you want.

David: Sure.

Doug: Yeah. So thanks for your question. Such an important issue. As I highlighted earlier, bond yields, they’ve jumped since the Fed rate cuts. This is not what the markets or the Fed expected. I’m confident saying that the Fed will have no alternative going forward than purchasing trillions of Treasurys. When there’s a big deleveraging, they are the designated buyer of last resort. Fed rate policy, that’s not as clear. It’s not as clear at all. I know they would plan on aggressively slashing rates in the event of market and economic crisis, but do the inflation backdrop and the demand for Treasurys impact their decisions going forward? Does the stability of the dollar at some point enter into the equation? There are a lot of unknowns here. I think in the near term, the Fed will hesitate to aggressively cut rates if it perceives this would be negative for bonds.

All bets are off, though, in a major de-risking/de-leveraging episode. They will cut rates and restart QE. But will this work? I’m just not so sure. I remember clearly how it took several rounds of big QE announcements back in March of 2020 to reverse deleveraging. But now, leverage, outstanding debt, and inflation are all more problematic.

I think all roads do lead to inflation, but it could be a rather windy trip. There is the potential for a major de-risking/de-leveraging episode to spiral out control. This trip could see deflationary fears along the way. Treasurys could even benefit from safe haven demand in the event of dislocations in the stock, corporate bond, and derivative markets. I really try not to get too far ahead of myself on this type of analysis. Just come in every day, monitor and analyze.

And I’ll try to address your question now. Where would this capital go? I don’t use the word capital in this context. We’re talking about a massive global general ledger of electronic debits and credits. And this is my old CPA hat on here. Electronic debits and credits, with much of it not backed by real wealth or capital-producing assets. And when I discuss deleveraging, this is where levered players sell assets held on leverage and pay down borrowings that financed the original purchases. Liquidity is created when these levered trades are created, when they’re put on, and liquidity disappears when the leverage is unwound. So it’s not as if these sales of levered Treasurys create buying power elsewhere. It is just a contraction in liquidity in general, and major de-risking. I would expect most markets to suffer from illiquidity. That’ll be a big surprise. As for duration, we’ve kicked this can down the road for so long, for decades, for decades, that I fear it will be a most protracted adjustment period. And thank you for your question.

David: Just coming back to where I started with the quote from Carmen Reinhart, the interview that I did with her, this is many years ago, I don’t think it made the interview. It was just comments that we had and shared after the recording was finished. And I asked her what made sense to her just on a personal basis, not from a policy perspective or what she could prescribe to individual investors. And again, roll the clock back a decade because it’s been almost that long since she was on the Weekly Commentary. She said, “Gold makes sense and I want to have all my real estate paid off.” And she was talking about the real estate she lives in. Being debt-free, having a hard asset in the form of real estate, having a few ounces. It’s interesting that, you know, the IMF, World Bank economist, the co-author with Ken Rogoff of the book titled This Time Is Different, it’s interesting that that’s where she would go.

I do think that gold and real estate, undervalued equities, maybe bitcoin, these are all things that people would consider. Real estate’s a bit of a difficult one because there’s so much debt attached to the asset class. We see 2025 as very unsettling within the commercial mortgage backed space. There’s a lot of debt that has to be rolled over, not just in office space, but also multifamily. And that’s going to create another round of stress within the real estate markets.

So is that where you go? Is that where capital goes? I think capital, as I mentioned earlier, has a liquidity preference, and that’s one of the reasons why gold in particular in the context of extended crises tends to do well. It is incredibly liquid and it’s a financial asset that’s outside of the financial system, which means that in terms of it’s being encumbered or leased, loaned, what have you, it’s away from the world of debits and credits. It’s away from the world of hypothecation or rehypothecation. It’s away from anything that represents a double claim to the asset. So I think it will see perhaps an outsized benefit. So I think it’s spot on.

I would look at hard assets. I would look at hard assets with cash flow. I think they have intriguing appeal during a period of higher real inflation for a longer period of time. How many years? If you take a cue from interest rates and long-term interest rate trends, when interest rates begin to shift directionally, it’s not— I think most people think in terms of the small scale, what happened in the last six months, what happened in the last two years, when in fact the longer term trends, the secular trends in US history have never been shorter than 20 years, have never been shorter than 20 years. So putting in a low, if we said 2020, 2021 was the low in interest rates, we have a long stretch ahead of higher rates. And that might be reflective of many factors, but perhaps inflation is one of those where nominal yields have to keep pace with inflation to some degree. And so, in terms of a timeframe, I think we are looking at a long stretch back to hard assets with cash flow.

I think about some of our favorites, pipelines as an example. They’re essential for providing energy. Of course, energy prices can swing, but the nature of long-term contracted flows, they make the payouts far more stable than your typical dividend. That kind of a thing continues to play out irrespective of a green revolution. That, too, is a transition which takes a long, long time. Or you could consider the precious metals mining companies, something like gold with yield. They have vulnerability in what Doug described as sort of a deflationary pressure where all stocks can come under pressure.

But as free cash flow improves for these companies and dividend policies are enhanced, now you’ve got something very special in that all-roads-lead-to-gold scenario. Think about it as gold with yield.

So, love the time that we’ve spent together. Thank you for taking the time. Tactical Short is an invaluable tool in the process of mitigating risk within your equity portfolios. I would encourage you to reach out to us and explore how it can be integrated into your total portfolio mix. Creating liquidity in a market downturn, I think you’ll look at the optionality of that liquidity as a force multiplier for growth as you seek to preserve assets in the present, and grow them well into the future from one generation to the next. So thank you for joining us. We look forward to brainstorming how to integrate those tools into your overall mix. And until next quarter, we say adieu.