Podcast: Play in new window
- Iranian Drones Say Nope To UAE
- De-Dollarization, De-Globalization, & Destabilization
- Deutsche Bank Analyst Calls For $8,000 Gold
“A Treasury refunding announcement is not as dramatic as warships smoking Iranian speedboats, but sometimes the mundane becomes the most important thing to watch. And so, frankly, as our fiscal position deteriorates, publicly held Treasuries are now north of 102% of GDP. And if you count all the Treasuries, not just those held by the public, it’s north of 122%. I half wonder if the central bank purchases of gold are not in some way a reflection of a succession plan.” —David McAlvany
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Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick along with David McAlvany.
David, latest news, the UAE dropping OPEC and Iran’s response to that. Would you give us just a little bit of your thoughts on the energy market right now based on that?
David: Yeah, the news hit after we recorded the commentary last week, and certainly it frays the power and influence of OPEC. That was already happening with a number of other members dropping 2019, 2022. But this is the big one because it’s the number three OPEC producer. And four million barrels per day is current capacity. They’ve been investing to get it up to five. And what we mentioned last week with Fujairah being the pipeline that takes their oil to the port south of Hormuz, southeast—
Kevin: It’s a bypass away from the choke point.
David: They’re away from the choke point. So that was last week. And then Monday of this week we see a reengagement. We see a redefinition of the area of control by Iran. It’s not just Hormuz, it’s the whole region, including Fujairah. And of course, they hit Fujairah with drones damaging that pipeline infrastructure and export infrastructure.
Kevin: Isn’t it amazing how much damage can be done with drones? We were just talking to someone about Ukraine and the power that they have right now over Russia, just based on inexpensive drones. We’re not talking hypersonic missiles here. We’re talking drones.
David: Right. That’s a game-changer.
Kevin: Well, let’s go to gold now because the gold price, a lot of people are saying, “Well, what’s been happening to gold? Is everybody selling gold?” But the central banks have picked it up.
David: Yeah. Central banks alone seem to have noticed the gold price decline in the first quarter and took action. Retail interest is often blown this way and that by sentiment, by feelings, it’s like a ragdoll being pulled between the playmates of greed and fear. So whichever impulse pulls harder gets to keep the retail investor dolly. And today greed is best expressed in the “AI solves everything” belief.
Kevin: Isn’t that amazing? It’s the new drone. AI just does everything.
David: Very much in play. The uncertainty stirred by a massive oil shock, set that aside. Splintering of geopolitical interests in that landscape, you can set that aside. But in this context, while retail investors are interested in AI, not gold, central banks alone seem to see the forest for the trees and understand the structural changes afoot. So yeah, the fact that they came in hot and heavy in the gold market, very significant. There were some notable liquidations, which we’ll get to in a minute, but if you look at the net numbers, this is a big quarter.
Kevin: Okay. So the people who are liquidating, let’s say, to pick up because of what’s going on in Iran and the whole Strait of Hormuz thing, those liquidations are not equaling the increase in gold buying by the central banks. They’re actually underneath it. Even net numbers are coming out positive.
David: Yeah, net of those liquidations, 125 tons of liquidations. You still ended up with 244 tons of net purchases. So that’s Qatar, rumored to have sold for cashflow needs. Turkey to intervene in the lira. Again, very circumstantially driven, not necessarily a position that they’re taking that we need to now reduce our holdings. In fact, the overwhelming trend is central bank purchases.
Kevin: Just the misunderstanding of what’s going on in the markets is amazing. The conversations that I’ve been having, Dave, with clients about the stock market, the stock market right now is in the top 1% of being more expensive than any time in history. It’s just 1% of the time that it’s this high? The markets don’t seem to be reacting the way they used to. And there are times, we always know there’s a— You talk about a reversion to the mean, but we’re not really reverting to the mean right now. So what is it? Is it just a hypersensitivity or a hyper greed toward artificial intelligence and energy?
David: Yeah. Bloomberg, I think, summarized it well saying that the normal cycles of investing, finance and the economy seem almost inoperative.
Kevin: I feel that.
David: They’re overwhelmed by two huge shocks: the money pouring into making artificial intelligence a reality, and the hit to global oil supply from war and Iran. The former is somehow still outweighing the latter to leave US stocks near all time highs.
Kevin: Yet central banks, what you’re saying is the net buying of central banks, it’s overwhelming the sales right now. You wouldn’t see it in the price necessarily, but they understand.
David: Yeah. Central banks are not dilly-dallying with their gold purchases. So adding at the fastest pace in more than a year, they represent the strong hands accumulating. Yes, there were the central bank liquidations in the first quarter, but net of those liquidations, official sector purchases totaled 244 tons, up from 208 tons the previous quarter. Again, had there not been those circumstantially driven 125 ton liquidations, you would have been 360, 370 tons, which would have been the largest quarter, if I’m not mistaken, on record.
Kevin: Wow.
David: So the retail public is oblivious to the fact that you’ve got an all-in move by central banks. Again, if you set aside the exigent circumstances of the liquidations from Turkey and a few others.
Kevin: And that is informed, hard— That’s money with what you would call strong hands.
David: Oh, yeah. The World Gold Council tracks those numbers and were they waiting for a pullback? Yeah, I don’t know. They’ve added opportunistically. There’s no doubt. So retail investors, not so much. Retail investors appear to be rearranging deck chairs on the Titanic, and they’re loading up on semiconductors and anything AI. Fascinating. Last week we even had a sneaker company rebranding as an AI firm, and on the day they rebranded, their stock was up almost 600%.
Kevin: That’s amazing. It’s so dot-com, Dave. All you had to do was put dot-com behind anything back 25 years ago and it went up.
David: Now, that company gave back 60, 70% of that gain over the next three days. So it’s not real, but the enthusiasms and the sentiment are certainly sizable. Yeah. I think the smarter money is paying attention to the structural shifts with a very long tail.
Kevin: So let’s go back to central bank buying, though, because that’s geostrategic, geopolitical. We’re talking about large scale, long-term thinking. We’ve talked about the end of globalization, okay? And the markets that we’ve been in over the last, what, 30, 40 years have pretty much been dollar-denominated. And I’d like to talk about what Francis Fukuyama predicted back in the ’80s and whether that’s actually coming true.
David: I’m looking for The End of Globalization,the book that we read a number of years ago, dates back almost 20 years, but these are big trends and they take a long time to play out. Deutsche Bank commented last week that the world is back in a superpower struggle.
Kevin: Oh, that means the James Bond movies are going to start getting better.
David: We might be able to tell who the good guys are and the bad guys are. It’s not just an internal psychological conflict. They say the US is retreating from free trade alliances and security provision, the great economic moderation is behind us, and the dollar banking system has been weaponized. The return of history has big implications for gold and the dollar. Deutsche Bank goes on to say it’s notable that the value of above ground gold exceeded the total value of marketable US securities, US Treasury debt last year for the first time in 40 years.
Kevin: That’s amazing.
David: In other words, gold is now a bigger asset class than the world’s main safe haven.
Kevin: Dave, my entire career here, which spans almost 40 years now, has been that the Treasuries, the outstanding US debt, has exceeded the value of gold. It’s reversed. It’s reversing right now.
David: Yeah. Treasuries—and the 10-year in particular—was known as the benchmark for the risk-free rate.
Kevin: Well, that’s your safe money with interest, right?
David: That’s right. Yeah. Deutsche Bank concludes that, “the return of history is here, and we can now see a future in which gold can rise to $8,000 over the next five years.”
Kevin: Wow. That’s a bank saying that.
David: We’ve got a whole host of banks pegging silver at higher prices, gold at higher prices. The retail consumer is interested in the latest, flashiest, sexiest story. And frankly, they’re also interested in anything that gets them rich quick.
Kevin: Sneaker companies that decide to go AI.
David: Rebrand as an AI database, whatever.
Kevin: And how long did that last?
David: Less than a week.
Kevin: How did that work out for you?
David: Right. So when you think of gold, rarely do you have a setup this compelling. Yes, as I mentioned last week, equities in general face extreme headwinds in the quarters and years ahead. We’ve talked about valuations and how important that is in terms of knowing where you’re at on a journey from overvaluation, ultimately to undervaluation, and back again. These things run in cycles. And yet there are carve-outs within the equity markets. There are carve-outs of opportunity where capital has and will continue to flow and it’s tied to this fundamental unfolding of global dysfunction.
Kevin: Morgan was just talking in our meeting about the possibility, they can’t actually say it out loud, but this de-dollarization, this campaign of de-dollarizing the world could also be the goal of like the Scott Bessents and Trumps out there because we’re trying to become more competitive.
David: Yeah. Well, the issue is we can’t produce what we need.
Kevin: We can’t afford to produce.
David: So through the great moderation, we had what was thought of as labor arbitrage, where if you can produce something cheaper in Vietnam or China or Malaysia, anywhere in Asia, Mexico, anywhere, that’s where you built your factories, and you lower your labor input cost and can produce goods cheaper. What we gave up was independence and the ability to manufacture goods. And that now becomes a risk factor for us, which the Department of Defense is keen on.
Kevin: [Unclear] war.
David: Yeah. What the Chinese can replace in a matter of weeks or months will take us years in terms of the munitions we’ve spent up or run through in this conflict with Iran. There’s a reason why we’re in a ceasefire. We can’t, at the pace we were going, continue to spend the limited munitions that we have. Just before the ceasefire we’re moving things from South Korea, removing missile batteries from South Korea to the Middle East because we don’t have the supply chains that support recreating what we just spent. That this is a threat or an existential threat is understood by this administration.
Kevin: What’s the why?
David: Which is why they want to bring back manufacturing, which is why re-industrialization is so key. And we cannot re-industrialize if the dollar maintains the strong position that it has for many years.
Kevin: Got to make more bullets, right? Not just bullets, but you got to make the things that you need to be able to function without being a slave. It reminds me of the Dirty Harry movie. What’s the line he says? “Do you feel lucky, punk?” Are we out of bullets?
David: Do you feel lucky?
Kevin: Yeah. Do you feel lucky? We don’t want to run out of bullets. So let’s go back to this de-dollarization because maybe it is not just the goal of the central banks worldwide and the BRICS, but the United States itself.
David: Again, these trends are multi-decade in nature, de-dollarization, deglobalization, destabilization of the post-world war institutional frameworks. They argue for—and this is where many of our trade partners/competitors, they want to see a rebalancing of trade, a rebalancing of global security, a rebalancing of capital flows. And central banks are keen to set a financial foundation in the asset class that aids in transition to a newly imagined world in a freshly constructed global order. That fundamental foundational asset is gold.
Kevin: We were always talking about price. It wears me out to just talk about price and watch prices of things when really the question might be, what are the central banks actually buying for? Actually, what they’re doing is they’re increasing their percentage of allocation to something that they know long term is going to give them more freedom, more autonomy—gold. And so the question shouldn’t necessarily always be, well, do I add based on price? The question should be, do I have the right allocation to something that I’m going to need over the next two, three, four, five years rather than paper currency?
David: Yeah. I was interviewed last week on the topic of gold and silver, and shared that building a position in the metals and metals related assets, including their equities, it entails averaging a cost basis.
Kevin: And building that percentage.
David: Yeah. And so lower prices are better than higher prices as you’re building a position. Look at it as a gift. Though how low the price drifts, no one can know until after the upside momentum resumes. It’s best to layer in purchases on weakness. Just as you might at the other end of the secular cycle incrementally sell tranches to capture gains. You’re easing in, you’re easing out, you’re averaging your price. And if you have the opportunity to pay less per ounce, then perhaps you should consider it. But I agree there is something missed in just focusing on price. To some degree, price is irrelevant. You have a requirement to de-risk a portfolio. You can do that either by being out of the market— If you’re out of the market, you’re now in cash and now you are sort of handing over the reins to whoever’s managing that money system.
If in fact the dollar system is being deliberately guided lower, your best means of reducing risk is just taking on a different form of risk. You may not have market volatility, but you have currency decay, and that has to be addressed as well. So what percentage of your assets do you have in physical metals? This is very relevant, particularly in a period of de-dollarization, deglobalization, and destabilization.
If you’re not asking the question, what’s the healthy percentage and have I gotten there yet?, I think you’re asking the wrong questions.
Kevin: So when a financial planner says, “Well, maybe 5%, maybe 10%,” that’s an under-allocation given the environment that we’re in right now.
David: It’s great information. It’s great information for you to appreciate that that person doesn’t have a clue what’s going on in the world around them. Things that will ultimately impinge on the performance of stocks and bonds. And what they’re communicating is, “Well, I have to agree with the client because it would be embarrassing to just flat out disagree, and I don’t want them to be embarrassed. So we’ll come up with some low nominal number, 1%, 2%, 5%.” What it communicates is you really don’t understand what’s going on in the world.
Kevin: Yeah. It’s sort of demeaning when a person says, “I would like gold in my portfolio.” And it’s like, “Okay, we’ll do a few percent.”
David: Yeah. I mean, central bank purchases have reflected a reticence to chase the all-time highs. We saw at the end of the fourth quarter and really the first month of the second quarter, a slowing of the pace of purchases.
Kevin: What was that? 208. You said that first quarter was 208 tons or the quarter before that?
David: That was Q4. Yeah. But they have definitely added on price weakness.
Kevin: And that was 244 and that was—
David: Net of the 125 tons in liquidations. 244 is the net number. Again, had there not been circumstantial reasons to raise some liquidity, you would have been in the 350, 360 in terms of tonnage, which would have been, again, I think all time highs in terms of bank purchases in a single quarter. So I think you should do the same. Adopting disciplines that favor long-term investment success. You don’t have to chase a price.
Add on weakness, particularly in assets where a long-term trend is compelling. And I think gold has that behind it. I can think of no more compelling allocation today than precious metals. Perhaps energy related assets. I mean, if you’re looking at building allocations, that would be a close second. Not because of what’s happening in the Middle East today. That is for us a little bit of noise, but your long-term supply demand fundamentals for natural gas and oil, I think, play out very positively over the next three to five years.
Kevin: Okay. So let me get you to repeat that because that’s important. I think a lot of people are saying, “Well, once this thing is solved in the Middle East, if it is anytime soon, energy’s just going to plummet.” That’s not what you’re seeing long term.
David: I think in the immediate aftermath, if there is a resolution, you could certainly see prices drop on the news. There is of course the issue of not being able to bring back those supplies immediately. And so you may have a two, three, four year period of bringing on Middle Eastern supplies. The bigger issue is that the marginal source of production growth has come from the oil patch here in the US, the shale patch. And as those fields roll over in terms of production growth, you are talking about drop in supply, and unless there’s something radical to damage demand, you’re talking about a very positive setup for oil and gas.
Kevin: So for the long term investor.
David: Well, when we talk about markets broadly being at a negative inflection point, that is not to cast everything into the same category. I think energy is a carve out. I think the metals miners are a carve out. There are places that you can go that still have tremendous value and upside in spite of what happens to the S&P, in spite of what happens to the NASDAQ, in spite of what happens to the AI trade and the semiconductors as the air comes out of that balloon.
So all that to say, in spite of a generally negative appraisal on the equity markets, there is a place where capital should deservedly flow. We’re adding incrementally on weakness as an asset management company, and we’ll add more in the face of greater weakness, though that opportunity is not guaranteed. We don’t think we have to see lower prices in the metals in particular, but a cyclical lull in a secular bullish trend in the miners and metals is a gift if you will receive it.
Kevin: So let’s address what Deutsche Bank was saying about gold because they did produce a prediction of $8,000 gold. Now they said over the next five years. Morgan Lewis made the comment that he thinks it’s probably going to happen a lot quicker.
David: Yeah. So I mean, on the one hand, we agree with Deutsche Bank that the door is open to 8,000 an ounce, but as Morgan Lewis wrote over the weekend, in HAI’s view, it’s Hard Asset Insights. In HAI’s view, $8,000 gold is better thought of as a base case minimum. And the timeline on that $8,000 benchmark could be closer to one to two years.
Kevin: I know we’re talking about the end of globalization, but could we say that this is the replacement and the failure of the experiment of this fiat currency dollar reserve system, this Bretton Woods system? That’s why gold’s predicted to go up because we’ve got the BRIC countries, we’ve got the central banks. Actually, we should have the retail investor at some point trying to find out some way of not being a slave to a system that’s just extracting buying power.
David: Yeah. I mean, between trade invoicing and reserve management, the system is in flux. The question is, what currency do you put your confidence in? There are not many alternatives to the dollar. Would you want huge reserves in Japanese yen? I mean, just last week we had the Bank of Japan intervene with close to $35 billion to prop up the value of the yen. At 160 to one relative to the dollar, you’re talking about a currency that’s on the edge of breaking down. Is that really where you want your reserves? How about the euro? It’s a Frankenstein currency. You don’t have a unified fiscal policy. You’ve got a somewhat unified monetary policy, but with very divergent political interest from one country to the next. And ultimately, in democracies leadership kowtows to their constituents. So if you take those two out, how about the British? Well, their debt to GDP ratios are in as bad a shape as ours are.
Kevin: Sure. You’re not going to reserve in yuan. I mean, they’re having to convert that to gold every time somebody does a transaction.
David: No, and that is potentially a future leader in terms of reserve currencies or a currency in a reserve basket, but there’s not enough depth. And this is one of the things that makes the US Treasury market so unique. There is enough liquidity within the US Treasury market for it to support the role that we’ve played as the world’s reserve currency. There’s not enough liquidity in any other currency. And so how gold factors in is you don’t need to place trust in the monetary managers in Europe or in any particular country in Asia. Gold is sort of this neutral monetary asset which is unmanaged and it doesn’t have a yield. So many people have said, “Well, that’s one of the reasons you should avoid it.” No, in fact, it’s just expressing it’s bona fide.
Kevin: Right. If you have to pay somebody to hold your currency that already shows that—
David: It’s an indication of risk.
Kevin: Exactly.
David: And so one or two percent, good risk, 10, 12% obviously is marking to market a risk. People are afraid of not being able to be paid back. You pay 29% on a credit card, it’s because they’re assuming a certain default rate amongst consumers. So they have to charge 29% because you’re going to collect zero on a certain number of consumers, and then you’ll collect the full boat on others, and it averages out to be a viable lending business, but the rate that you pay is an indication of risk. That there is no rate paid on gold is an indication that it is the better benchmark for the risk-free rate. What’s more risk-free? What has less risk?
Kevin: And it’s being accumulated by the central banks who know what’s going on.
David: Going back to Deutsche Bank’s comments on end of history, Robert Kagan wrote a book in 2008, which I quickly devoured when it came out called The Return of History and The End of Dreams. I highly recommend it. It’s probably not more than 120 pages.
Kevin: And that was his response to Fukuyama’s book, wasn’t it?
David: That’s right. He responds to Fukuyama’s idea that with the collapse of rival ideologies, most notably after the Cold War, the world was moving towards a final form of political and economic organization: liberal democracy paired with market capitalism. And so from Fukuyama’s perspective, this was almost utopian. While the West won the ideological contest, it may now face the subtler dangers. And he did talk about this, dangers of complacency, moral drift, and a loss of purpose.
Kevin: It’s working so well we get fat, dumb and lazy.
David: Yeah. History in Fukuyama’s sense doesn’t end with a triumphant crescendo, but it settles into a quiet plateau where the absence of great conflict risks produces a society that’s very rich in material wealth and yet starved for meaning, and leaves the door open for disruption from the edges.
Kagan’s central conclusion is that the world has— And this goes back to 2008. Obviously we began to see the fracturing of the EU in the years that followed ’09, ’10, ’11, and ’12. But Kagan’s central conclusion is that the world is reverting to its older, more familiar pattern of great power competition, where authoritarian states like Russia and China actively challenge the liberal democratic order. In this case, you’ve got a combination of the US wanting to undermine the liberal democratic order. At the same time, others are saying, “Yes, please.”
Kevin: Isn’t that something?
David: That’s what we had in mind. Now we have a different motivation. We would like to reindustrialize. We would like to have a security apparatus that is reproducible, and we can’t do that today. Whether it’s critical minerals or actual production capacity, we don’t have either.
Kevin: And so what Fukuyama was talking about, he really was saying, “Once we outsource things to where we all need each other, it’s just going to sort of go to a peaceful situation, a non-competitive situation.” We’re returning to a highly competitive situation.
David: Yeah. One of the things that I think Fukuyama— I don’t know if he was assuming this or not, but, “If everyone could just be content with GDP growth statistics—”
Kevin: Can’t we all just get along?
David: Can’t we all just get along?
Kevin: Yeah. Right.
David McAlvany
And Kagan is more of the realist, saying, “That’s really not the historical record. We don’t just get along. Even when we have the opportunity to, we always want a larger slice of the pie. And contentment is not something that comes easy. It’s not something common to the human condition.”
Kevin Orrick
Right. Well, and then you get to Triffin’s Dilemma where the reserve currency that has allowed that “can’t we all just get along?” It reaches a point where you can’t afford the interest on the debt.
David: Right. Well, and that is a problem.
Kevin: That’s where we’re at.
David: So what we’ve argued for some time is that great power competition includes a re-imagining of global institutions, a realignment of global economic interests and a re-engineering of the global monetary system. Gold is an essential component to that last bit, where trade and capital flows have a neutral anchor, and reserve assets are not controlled by the West.
Central banks, I think, were a little bit naive coming into 2022 that somehow sitting in Treasuries, you were in a more or less neutral reserve asset. And as it turns out, when we took $300 billion of Russian capital, central banks said, “Actually it’s very much controlled by the West.”
Kevin: That’s a wake-up call.
David: And that’s a risk factor, not something that we had factored into our own calculus. So beyond the economic incentive to add to gold reserves at lower prices, there is the geostrategic imperative, insulate capital from the control or the influence established in the unipolar system. And what are they wanting? What are they striving for? A new multipolar order.
Kevin: Right.
David: That’s what it is in the process of emerging. And yes, gold is central to it.
Kevin: Well, and as long as we use the dollar—the power of the dollar—right now as a weapon, it just accelerates the whole process. And I think a lot of these people are saying, “I don’t want to be a slave to whether we’re a favor to the United States or not on any given day.”
David: Yeah. I mean, in that sense, gold is more than a portfolio allocation, and it’s more than an insurance play. Those are ways that an individual investor can think. It is a critical ingredient in self-determination. If you want to go from the particular to the abstract, I think it’s helpful to do that. It’s a critical ingredient to self-determination.
Kevin: Autonomy.
David: And that applies to the individual and for the nation state. Owning gold is an expression of self-determination for the state actor just as it is an enabler of agency for the individual. Future planning, whether it’s for the state or for the individual, future planning requires a degree of stability which you can now argue is not implicit to the Treasury market.
Kevin: So just to restate, the demand for gold by central banks really doesn’t have a lot to do with price. They may slow their buying down when it’s high, and then they’ll increase their buying when it falls, but they’re not really playing price.
David: What’s the percentage of reserves that we have today and what’s the target reserve allocation?
Kevin: So this $8,000 call by Deutsche Bank is really nothing?
David: It’s a base case minimum.
Kevin: Okay.
David: We don’t know the precise timeframe, but for the patient accumulator, I think the benefits of agency, liquidity, and distance from the fray are all a part of the benefits of ownership. Central banks don’t buy with a price target in mind.
Kevin: Right. Or sell with a price target.
David: Yeah. They buy because the savings of a nation are a non-trivial tool for growth and development, and an essential means of insulating a balance sheet from chaos and desperation, be that of an economic, financial, or geopolitical nature. So the legacy-minded investor I think is similarly aligned. How do you better balance a portfolio for financial market contingencies, politically concocted pressures and economic compression? Today, it’s not by helping the Treasury Department finance their debt. It’s not by investing in long-term Treasury bonds. Our fiscal policies are a part of the problem, not a part of the solution. So, I mean, short-term Treasuries, granted, they’re a carve-out from an otherwise ill-advised allocation to IOUs.
Kevin: Yeah. So if you’re going to own some cash, have it in short-term Treasuries.
David: Short-term deals.
Kevin: We’re not knocking short-term T-bills. But even with a short-term T-bill, you have to get enough interest to not completely get devoured by inflation.
Those inflation numbers, let’s talk a little bit about the inflation numbers because they have been picking back up.
David: Yeah. We mentioned PCE last week. It was higher in March by 0.7 of a percent. This is the Fed’s preferred measure of inflation.
Kevin: Okay.
David: Annualize the 0.7 and you’re on track for a full year, 8.3, 8.4% inflation rate.
Kevin: Wow.
David: That’s the worst spike since June of 2022.
Kevin: Right.
David: And I didn’t hear a lot of discussion about that last week. Of course, that was when inflation was surging in its first wave back in 2022. Average it out, I don’t think we’re going to have 0.7 each month going forward. So it’s not going to be that big, but I’m telling you, 0.7 was noticeable. And also note that inflation was accelerating in December of last year and in January and February as well. And these are all months prior to the spike in energy. So inflation was already running towards 4.6% pre-conflict. So think in terms of a spike on top of an already upward sloping trend.
Kevin: So you have brought up in the past, we went back to the 1970s on a show a year or two ago where you talked about how inflation can spike and then look like it’s really falling and then spike again.
David: Second waves are very common when you’ve got an inflation problem.
Kevin: And this doesn’t have to do necessarily with energy. So pay no attention to the pundits that would be saying, “Oh, well, this just has to do with the Strait of Hormuz.”
David: Well, I think energy catches the headlines and energy takes the blame, but it’s more than that. We can look at components like core services up 4%, annualized. We can look at durable goods up 5%, annualized. Or if you want, we could divert the conversation to Fed quantitative easing in that 40, $50 billion a month range now.
Now, granted, some will argue that the Fed’s purchase of Treasury bills is materially different than their purchase of notes and bonds and is not QE. It’s just “reserve management.” But it’s still a balance sheet expansion.
Kevin: Right.
David: So when you think of a few trillion in fiscal demand management, which is a fancy way of saying deficit spending, when you add to that a few hundred billion in liquidity into the T-bill market, there’s plenty of juice to goose both asset prices and consumer prices even before you cut 20% of global energy supplies out of the picture and have that as a new input into the inflation statistics.
Kevin: I talked to a client yesterday who, he and his wife own quite a bit of real estate, but they don’t fully own it. Their goal over the next five years is to get it almost completely paid off. And it’s a great goal, but he’s really needing interest rates to come down because if interest rates rise, it’s all on variable rate loans right now. And I had to break the news to him. With inflation and with just the general direction of interest rates, we probably should expect higher interest rates over the next four to five years, that goal period that they have.
David: Yeah. Well, we said it last week, I think it’s worth saying it again, global bonds are showing some inflation pressure.
Kevin: Increase in interest rates.
David: And there are particular markets that are also showing a weariness with oversupply and they’re struggling on the demand side. Now, counter example, Meta, they brought to market $25 billion in bonds, and that offering was oversubscribed four times.
Kevin: Either they were paying the right interest rate or people think Meta’s probably a little stronger than the United States.
David: Yeah. The US Treasury brings notes and bonds to market and they can’t line up enough buyers. So the Fed steps in and it’s like a cleanup operation, right? So if you don’t have enough buyers, that pressures rates higher.
Kevin: So what do you do when you’re in the position, Dave, of having to manage this here in the United States? You talked about quantitative easing, $50 billion, and they say, “Well, it’s not really quantitative easing.” But you’ve talked about yield curve control.” Okay, that’s another form of, I just call it all printing. It’s spending money that we don’t have, right? So what do you do? How can they manage this away or at least delay it?
David: Well, I mean, I can answer that for the individual investor, the asset allocator, better than I can as a system administrator, but I would avoid duration.
Kevin: Okay. So explain duration.
David: The amount of time that you’re loaning money for.
Kevin: Okay.
David: So the longer timeframe, that’s the longer duration. And as you look at a yield curve, you’re compensated more the farther out you go on a yield curve because you’re taking more implicit inflation risk. Not a surprise to see a 30-year bond paying more per year than a 30-day T-bill.
Kevin: Okay. If you avoid duration, what you’re really having to do is you’re having to refi over and over and over during that cycle if you’re using short-term debt.
David: If you’re a borrower, that’s true. If you are a lender, which you are, if you’re buying a bond, you’re lending some entity money, whether it’s Meta or the US Treasury Department, you avoid duration if you’re a lender. And you buy duration if you are a borrower.
Kevin: I was mishearing you. So avoiding duration, you’re talking about as a lender?
David: As a lender, because you’re going to have your head handed to you from that inflation surprise. That wave to inflation is going to hurt you badly.
Kevin: So loan on a short-term basis—
David: But borrow on a long-term basis.
Kevin: Yeah. But borrow on a long—
David: And fix your rates.
Kevin: There you Go. Okay.
David: And if you can’t fix your rates, you shouldn’t be borrowing. Because you now are in the lending crucible.
Kevin: Right. I asked them if they’re positive on their real estate right now as far as the— and they’re like, “Yep, just barely. If interest rates rise anymore, we’re not.”
David: That’s a bad place to be.
Kevin: It is a bad place to be.
David: So key this week, and we talked a little bit about the UAE and OPEC earlier, there’s probably more to explore there, but I think the key this week is the Wednesday Treasury refunding announcement. This happens quarterly, and the Treasury basically lets the market know what IOUs they’re going to be issuing. And are they going to be shorter term, longer term? They’re going to be forcing the duration in the market.
And so this one has the spotlight for me this week, and I think it could be critical for the year. By the time you’re listening to this, the number will be out. I think the key question, how much duration is the Treasury willing or able to push out into the market? It’s constrained, right?
So first of all, what’s the scale of the financing needs? Is it going to be 115 billion? Is it going to be 150 billion? Is it going to be 200 billion? 115 would be normal. 150 might be high. Anything pressing to 200 billion will be a surprise to the market. Like, oh, they’re trying to borrow more money. Why? Is it because they need to accommodate the war effort? What’s going on here? They’re asking for a lot of money.
So how much duration is the Treasury willing or able to push into the market? What is the scale of the financing needs? That is a reasonable detail. More debt may be needed. Or if it’s less, that’s also an important market signal. Or is it right in line with what was expected? And will it be squeezed into shorter-term paper? Again, this is the duration question framed a little bit differently.
If they have to squeeze into short-term paper, it’s because they can’t afford the higher rates that come with a longer duration. And you see that. Currently, the average interest cost I think is like 3.33, 3.34%. If you look at all the durations, that’s the interest we’re paying on average, whether it’s the short-term bills or the 30-year bonds. And if you’re going to extend the duration, you’re going to pay more.
We can’t afford to do that. We already know that our interest cost is higher than our military spending this year. That is not a good thing.
Kevin: Again, that’s Triffin’s Dilemma. You just get to the point where you can’t afford your debt anymore.
David: So that’s going to be important. Are they going to be squeezed into shorter-term paper to save on the coupon payments, or will the duration be pushed out? This is all on the supply side. If you’re thinking about what’s coming to market and what price, that’s all supply side. Demand side, how much will the market absorb, and at what price? Now, we’re talking about at what interest rate? What’s our compensation for extending our duration?
A rise in rates to justify the duration and inflation risk has a significant impact into other markets, not just the Treasury market. And again, this is where if you end up with higher yields, that is the same thing as tightening financial conditions. And so who is going to be the buyer? Is it going to be a foreign buyer of Treasuries on the demand side? And what interest rate will they demand for extending durations?
Commercial banks will be pensions, insurance companies, individual investors. Or as we’ve seen with near-failed Treasury auctions in the last several months—
Kevin: The Fed just buys it all up again.
David: Yeah. And manage and massage rates lower. What they’re doing with T-bills, and again, I understand the distinction, the fine distinction, maybe that can’t be categorized as QE, but they’re trying to cap rates. It’s QE, not QE. Is it QE and we just pretend it’s not QE? We’re dealing with demand issues. At the same time, we’ve got bloating supplies.
And that’s where that country-specific distinction— We have global bond yields rising, but particular countries which are under more scrutiny because their balance sheets are already screwed up. And if they’re going to make an even bigger mess of them, well, that’s fine. It just has to be reflected in the price, which when we talk price, that’s really the interest rate, the price of time.
Kevin: Well, and this is why I give you a hard time, because I’m looking at books behind you on interest rates. Hundreds and hundreds of pages, probably hundreds of hours of you studying interest rates. And you’re not going to see a Top Gun movie about interest rates. You’re going to see a Top Gun movie about a jet, right? But interest rates may actually have more of an impact than boats shooting at each other in the Strait of Hormuz.
David: Well, so, again, I grew up in an odd family. Not in a bad way, just different.
Kevin: It’s a great family. But it is, it’s unique.
David: I forget what year it was when I was in grade school and we watched Jane Fonda in the movie Rollover.
Kevin: I think that was ’79 or ’80 when that happened. Yeah.
David: I was young, very young, but that came up in conversation around the dinner table a lot. What happens if folks in the Middle East aren’t willing to roll over their debt? And all of a sudden, you’ve got supply which is ample, but demand becomes scarce, interest rates go higher. It’s game over for real estate.
Kevin: And I think one of the lines at the very—
David: It’s game over for stocks.
Kevin: One of the lines at the very end of that movie is, “Gold just hit 3,000.” I think that was one of the last lines in the movie, but you’re right. What happens if they don’t roll it over?
David: Well, so a Treasury refunding announcement is not as dramatic as warships smoking Iranian speedboats, but sometimes the mundane becomes the most important thing to watch. And so frankly, as our fiscal position deteriorates—publicly held Treasuries are now north of 102% of GDP. And if you count all the Treasuries, not just those held by the public, it’s north of 122%. I have wondered if the central bank purchases of gold are not in some way a reflection of a succession plan.
If you could see the leader of the free world, United States, and the dictator of capital flows, if you could watch them dancing on the edge of an abyss, and you also had, in Kagan’s conclusion, that the world has reverted to an older, more familiar pattern of great power competition, where authoritarian states like Russia and China actively challenge the liberal democratic order, maybe owning gold is just succession planning.
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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.
