Be Long Reality
Last week’s HAI was titled “Won’t Get Fooled Again.” The title was a hat tip to rock band The Who’s classic 1971 song, and specifically the song’s famous line, “meet the new boss, same as the old boss.”
HAI‘s point in the reference was that both Treasury Secretary Bessent and Fed Chair Warsh have recently been proving with actions that, contrary to their words, they’re very much the same as the old boss. As a pair, the new boss is equally constrained by the same straitjacket of inflation combined with excessive debt and deficits as their predecessors. In other words, despite the rhetoric, in HAI‘s view, they are just as trapped as ever.
In HAI‘s view, the United States has firmly reached a state of fiscal dominance. That means that the government’s massive debt and budget deficits are forcing the central bank and Treasury Department (whether they admit it or not) to prioritize government financing over inflation control.
In fact, all that’s changed under the new boss is that the numbers have worsened and the trap has deepened. U.S. debt has now (as of two weeks ago) ballooned past $40 trillion, the forward projection of deficits continues to march higher with every basis point increase in U.S. Treasury yields, and the number of months the Fed has tolerated inflation well above target (now at 65 months) continues to stretch.
All that said, just a week after HAI‘s last title, Kevin Warsh (this week at the annual Jackson Hole Symposium), is back at it. He’s trying to fool us again.
On Friday in Jackson Hole, Warsh came out swinging. Clearly leaning towards endorsing a future Fed rate hike, Chairman Warsh signaled his hawkishness (despite his apparent war on forward guidance) when he said, “I would be hard pressed to describe broad financial conditions as restrictive… We must be confident that underlying inflation is moving to our objective, clearly and at sufficient speed. Otherwise, we have work to do.”
As a hawkish cherry on top, Warsh said that, “while this summer’s PCE and CPI readings were better than expected, they do not tell me that underlying [inflation] trends have meaningfully improved.”
Okay, Kevin Warsh, hats off, you’re a verbal hawk—but will you be an active hawk? HAI strongly doubts it. Yes, if Warsh wants to prove something, he can certainly raise rates by 25 basis points once, maybe twice—before quickly reversing to cuts again.
However, can Warsh implement the sort of sustained aggressive rate hike campaign needed to walk the walk of the talk he’s now talking? In HAI‘s view, absolutely not—full stop.
If Warsh hikes to really fight inflation, he’ll initiate a sequence of events that puts a match to the powder keg of the extremely precarious U.S. fiscal position. As the U.S. dollar rises, 10-year Treasury yields in the U.S. and across the West will rise sharply, U.S. government tax receipts will fall with the financialized economy and equity markets, and foreigners will sell U.S. Treasuries to service trillions in U.S. dollar-denominated debt and defend their own currencies.
In other words, if Kevin Warsh is going to raise rates to squash inflation back down to the Fed’s two percent target, he’ll have to sacrifice the bond market, the stock market, the economy, and the government fiscal position to do it.
Now let’s contrast this hawkish Warsh doctrine with the recent actions of Scott Bessent and the Treasury Department. Bessent just intervened to strengthen the yen (weaken the dollar) for the first time in 28 years to keep the Japanese from having to sell U.S. Treasuries to defend their own currency. Such Treasury sales would have added upward pressure to already surging long-term U.S. yields.
Then last week Bessent announced that the U.S. Treasury Department will be “increasing, by at least double, the size of liquidity support buyback operations for longer-dated nominal coupon securities.” This week he even said that the Treasury could tap the nearly $1 trillion Treasury General Account to fund those buybacks.
In other words, Treasury is quite clearly engaged in some form of soft yield curve control (YCC) policy to keep yields suppressed. Into this already soft YCC policy, we are being asked to believe that, in the name of Fed credibility and despite fiscal dominance, Kevin Warsh is going to raise rates at the front end of the curve—where Treasury has just shifted the bulk of issuance—to fight inflation? HAI isn’t buying it. Not by a long shot.
While Warsh appears to be peddling rhetoric with a sell-by date, the reality is telling—and less sanguine. U.S. true interest expense (a combination of gross interest expense, entitlement spending, and veterans benefits spending) alone represents 106% of tax receipts. Further, that combined core expense is growing at 7.5% annually while tax receipts, even at record highs, are growing at only 4% annually.
Even if the Fed is half as independent as it wants to portray, it is very likely not so independent and myopic as to outright sink the greater government ship on behalf of price stability, at the ultimate expense of both of the Fed’s official mandate (full employment), and its unofficial mandate (keeping the government funded).
HAI continues to suggest that readers not be fooled again. Fed members told us over a decade ago that this day was coming.
At the Peterson Institute in May of 2015, famed former Fed Chair Alan Greenspan said, “We need to shrink entitlements back as a percentage of the pie, and we need to resolve it before we have a crisis… Unfortunately, though, I don’t see how we are going to get out of this.”
At the same conference, former Fed Governor Larry Lindsay was even more specific: “This always ends this way—Rome, the Ming Dynasty, Zimbabwe…it’s so depressing. It always, always, always ends this way, this end game we’re all talking about. The financial arrangements of the state are no longer sustainable… It is a matter of political liberty because government will not voluntarily let itself go out of business… It will use all its powers available to government to fund itself.”
Lindsay is describing an aspect of history’s arc of the hegemon. In HAI‘s view, we’re there now, caught in fiscal dominance. In that context, we’d be wise to expect that government will use all its available powers to fund itself.
So, what’s an investor to do in such an environment? Well, according to former Goldman Sachs Global Head of Commodities Research Jeff Currie, you want to own hard assets. HAI agrees. In a podcast this week with Mario Nawfal, Currie said of hard assets: “At this point you just want to be long the whole entire complex. Own the energy. Own gold. Own silver. Own grains. Own copper. Own every single one of these markets right now.”
Amid fiscal dominance, the Fed and Treasury are now increasingly under the microscope. That makes it a good time to recall the words of Jim Grant, who once said, “the Fed can change how things look, but not how things are.” Similarly, the Treasury can buy back debt to suppress yields, but, as Rabobank wisely noted a week ago, “it cannot buy back geopolitical risk, inflation risk, or fiscal arithmetic.”
The tension between rhetoric and reality is particularly on display in our modern moment. In HAI‘s view, this is the time to make that distinction, and then be long reality. The reality trade is hard assets. As Jeff Currie advised, “at this point you just want to be long the whole entire complex.”
Weekly performance: The S&P 500 was up 0.49%. Gold was down 3.33%, silver lost 3.78%, platinum was off 3.26%, and palladium was up 5.63%. The HUI gold miners index was down 2.81%. The IFRA iShares US Infrastructure ETF was down 0.85%. Energy commodities were volatile and up on the week. WTI crude oil was off 4.22%, while natural gas was up 3.88%. The CRB Commodity Index was flat, up 0.03%. Copper was off 0.55%. The Dow Jones US Specialty Real Estate Investment Trust Index was down 1.32%. The Vanguard Utilities ETF was off 0.15%. The dollar index was up 0.85% to close the week at 99.68. The yield on the 10-yr U.S. Treasury was down 1 bp on the week, closing at 4.72%.
Have a wonderful weekend!
Morgan Lewis
Investment Strategist & Co-Portfolio Manager
MWM LLC
