Podcast: Play in new window
- Inflation fears showing up in government bonds
- How liquid is your ETF when everyone wants out?
- Biden’s “most radical departure from prevailing economic policies”
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Broken Promises & Unforeseen Events
February 23, 2021
The reality is we don’t learn from our mistakes. We just move on and hope the next time is different. Texas had four million people in the dark just a few years ago. And the only thing that is really different today is the scope and scale of the crisis, and I think that’s basically what we’re looking at in terms of the financial markets. We haven’t learned much. All we’re looking at is repeating, but with different scope and scale in view. — David McAlvany
Kevin: Welcome to the McAlvany Weekly Commentary. Now, I’m Kevin Orrick, along with David McAlvany.
Just watching the news and just listening to the chatter right now, I’m thinking there’s an awful lot of promises being made. Promises are fine until promises are broken.
David: And sometimes promises are not broken in a nefarious way. They can just be an expectation that was created and then not completely fulfilled.
Kevin: I was looking up from the Cambridge English Corpus, actually it was on the internet, but it says, “The fault may lie in a broken promise, not in the promise keeper’s intention, but the unforeseen event beyond the promise maker’s control.” I think about unforeseen events, we can build a very large dependent infrastructure and immediately when it gets a little cold or a little icy in an unexpected way, it can shut everything down. Yeah. I think about our friends in Texas.
David: Yeah. And family too. It was a stressful week full of uncertainty and raw exposure to extraordinary challenge.
Kevin: Did your father-in-law lose any of his cattle?
David: Yeah. Unfortunately there was a little bit of that. So the Texans that we know are a tough lot and they tend to take loss in stride. My in-laws did lose some cattle, but as always the vulnerability concentrates, it seems, at the far ends of the life spectrum.
Kevin: Well, and Texans are about as close to Alaskans as they come. Remember when we went up to Homer, Alaska? It seems like every day these guys are facing some sort of event, and it doesn’t matter, liberal, conservative, it really doesn’t matter the bent, these people are very independent. Now Texans have a little bit of that too.
David: Yeah. I mean, resilience, independence, an ability to take care of themselves. I mean the independent streak across the state in Texas reminds me of many of the friends I have in Alaska. Except my friends in Alaska seemed to expect every day to be a direct struggle with some aspect of nature and its ferocity and its intensity.
Kevin: They’re pretty resilient people.
David: Last week’s energy debacle was a wake-up call for anyone mindful of areas of system dependency. And ironic, perhaps that Bitcoin was making new highs even as the lights went out across the second largest state in our country.
Kevin: Isn’t that amazing. It really doesn’t seem to apply right now to the news. There still is that greed impulse that’s going on in a lot of the markets.
David: Well, and of course it’s a solid reminder that infrastructure has its vulnerabilities and frailties, along with anything that is sort of next in line or dependent on that infrastructure, even when it’s well engineered.
Kevin: I think sometimes we forget the cost, when there is an emergency, of things that we just take for granted.
David: Well, you got a decline in power supply that hits the energy spot market. And if you own that fabulous electric vehicle, thinking of a Tesla, to charge a Tesla in Texas went at a moonshot from $19 to $900. And again, that’s as energy spot prices spiked across the state. I can imagine a rancher, too, grateful to have that 500 gallon gravity fed diesel tank on the property. Except, in Texas, it’s not that common to winterize diesel fuel. And if you don’t, then it becomes a useless goo. So this is kind of the crisis domino effect. Whether you’re the Tesla Texas driver or the diesel Texas driver, last week was not all that fun.
Kevin: When I first started working here, back in the ’80s, Dave, we talked to a lot of clients about preparedness, just looking at what your vulnerabilities are. I was 24 years old when I started here. My daughter was born not too long after I started. I remember when the power went out, you find a lot of your vulnerabilities when power goes out, or water, or what have you.
I was telling a story to a client yesterday. I said, “This is very embarrassing because I had been talking to a lot of clients about preparedness because that’s what your dad said to do. And when our power went out, when we were in Highlands Ranch in Denver, all I had was my daughter’s Fisher-Price vacuum cleaner to push around. It had a light on the front and I couldn’t find anything. It was pitch black. So here I am pushing a little Fisher-Price vacuum cleaner just to find a flashlight.” Now, since we’ve moved down here, I’m dependent on a well and what have you. So I have a generator.
David: Yeah. And in a sense I’m grateful, this last week my wife gave a green light for a generator. I’ve been talking about one for years, and system dependency is not an issue if you maintain redundancies and backup plans and things like that.
Kevin: I run that generator every week for 10 minutes, just to make sure that everything works just fine.
David: Well, March is approaching, and so is the beginning of a 14th year for the Commentary.
Kevin: Can you believe that? Wow.
David: I’ve been a father only slightly longer than an explorer, that’s kind of the way I think about it with a venue to discuss sort of the worldly Johnson journeys in an online audio format. So I think the key element, which has continued to drive this for 14 years now, or 13, entering the 14th, an active curiosity, and the markets are like a constantly shifting Rubik’s cube. It’s a riddle. It’s ever changing. It’s confounding. It’s inspiring. And each week it brings a certain discipline to not only our dialogue and the opportunity to exchange ideas, but also continue to read and learn and grow.
Kevin: One of the things that’s been a real riddle to me over these. . . . You talked about 14 years, but really the last 10 years, the markets have been strange because if you’re too big to fail, you’re treated a little bit different than the middle guy or the little guy.
David: March is also a month that the Fed is scheduled to phase back in the SLR, which stands for supplementary leverage ratio.
Kevin: Well, and that’s what I’m talking about. It affects too big to fail.
David: Yeah. And this came into existence after the “great recession,” 2008, 2009, to ensure that banks have sufficient capital relative to both their on– and off–balance sheet commitments. So yeah, 3% extra cushion doesn’t sound like much, but that’s an added reserve. And if you’re in the too big to fail category, there’s an extra 2% on top of that that’s also required. But when the markets went into meltdown mode last April, the SLR was suspended to allow more liquidity to flow into the system and out of bank reserves. So that suspension ends on March 31st, kind of amazing to think about some liquidity provision ending, any liquidity provision ending. Again, this has been 10 years of activism, central bank activism. And I guess, the question is how will the markets adapt or respond?
Kevin: Can you believe it’s also been 18 months since they started coming in and intervening on the repo markets? I mean, the liquidity in the repo markets we talked about back in September of 2019, and that looks like that’s possibly going to change too.
David: That’s right? Well, a system that is dependent on an excess liquidity is also vulnerable to a change in the direction of flows of liquidity. When banks reserve more money, they lend less. In essence, they’re shrinking their assets, and there’s people within the financial ecosystem, which are affected by that shrinking of assets. Maybe the reintroduction of SLR, it turns out to be nothing, but as Jim Grant speculates, the re-imposition of SLR may prompt banks to reduce their repo market lending.
Kevin: Right.
David: Again, going back to last September with many knock on effects, it gets. . .freeze the pipes, as we learned this last week, and things blow. The repo markets are for collateralized lending and sometimes the collateral that’s used as government paper, but lots of different kinds of assets can be used. We have, as a company, use the repo markets for physical metals. And, in that sense, we remain mindful of shifts in those markets, shifts in available liquidity, shifts in the terms changing on short notice.
Kevin: One of the things that you’ve prepared for though, Dave, is you hate debt. And a lot of companies don’t. A lot of companies run full tilt with debt.
David: Yeah, well the repo markets I’m personally most familiar with are floating rate. So when there is a shift of any kind, carrying costs can be immediately impacted. And we know one gentleman that had his loans called with the assets involved in that unhedged, again, these are the assets that were collateralized, and in that case forced to liquidate at a lower number than originally owed. So this gap, you owe more than you actually have to bring to the table. And repo markets are a very useful part of lending infrastructure, but not without a risk.
Kevin: Well, and see, that’s what I wonder. Again, I feel a lot of empathy and sympathy for those in Texas, but they are running in a way that the unknown can hit them very hard. I heard what little infrastructure for snow and ice existed in Texas. I’m wondering if the economy isn’t also looking like this. We’re getting used to this. 18 months ago, repo markets, if there’s not enough lending money, government just steps right in.
David: So March or the end of March is nearly here. And by that time, again, as you said, it’ll only have been 18 months since the repo markets had that indigestion, had the spike in overnight lending rates required a massive Fed intervention. We’re talking 250 billion, 500 billion in overnight peace and calm, if you will.
Kevin: Well, I know one of the things that you watch in the economy is the credit default swap market, because that’s sort of the way the big institutions can insure against an unexpected event.
David: Yeah. Well, and it’s funny because basically every tool that is used as insurance is also these days used as speculation. So, we watch a whole variety of risk indicators. Today, looking at those, it would suggest that all is reasonably well. All is calm within the world of finance. Insurance costs are low for anyone concerned about default, that is, CDS pricing is low, and credit default swaps, and are only showing the slightest bit of change at the periphery. If you’re looking at the periphery of sort of developed markets, and then European periphery, what we lovingly know as the PIGS, Portugal, Italy, Greece, and Spain.
Kevin: Last week you had made the comment that there’s just a real appetite for junk bonds, but the interest rates on the government bonds have been rising, that continued this week.
David: Yeah. So while there’s peace and calm in the credit default swap market, and in a number of our other indicators, interest rates were the most intriguing movers last week. And it was not only the 10-year treasury, which we talked a bit about last week. It rose another 14 basis points last week to 135 basis points or 1.35%. And really, it was everything, everywhere, on the move. Japanese government bonds, German bunds. I mean, these are ones that have been sort of cryogenically frozen for a decade or more, but you had, again, four basis points in Japan to positive 11. Again, doesn’t seem like much. But 12 basis points in Germany to negative 31. So up to 31, and it’s weird to say—
Kevin: Negative.
David: Up to 31 in a negative world. Recall that a few months ago, German bunds were in the range of negative 60 basis points. Spain moved up 20, Italy moved up 15, Portugal 15, Greece 14, South Africa 31, 34 in Brazil, 53 in Russia, 46 basis points, almost a half a percent in Mexico.
Kevin: Well, going back to. . . Okay. So negative rates when a person says, “Well, gosh, you’re talking about interest rates rising, but the rates are still negative.” That still creates great pain in the bond market. It doesn’t matter whether you’re above or below zero, if interest rates are rising and you’re owning bonds, your bond principle goes down.
David: That’s right. And one of the big losers this year has been the exchange traded fund TLT, which is basically a play on the long U.S. bond. There was a lot of pain in the bond market last week. It’s a little early to call it a real tightening of financial conditions. I mean, it was, but not to any thresholds where you would begin to see equity investors double clutch or corporate debt begin to sort of bleed out or to implode. Investors are still in sort of a frenzy to buy higher yielding corporate credit. So the pain thus far has been felt and concentrated in government paper. Corporate debt has been resilient. Junk, even without flows last week, is still sitting near all time highs. A few dollars came out of the junk market last week, about 1.35 billion in outflows.
Kevin: But it’s not a panic. I mean, as far as the CDS market, you’re just saying all is well, and there’s almost a greedy feel still in the market. Isn’t there?
David: Yeah. Because corporate credit is relatively stable, the CDS market is not all that concerned. But Bloomberg reported a J.P. Morgan study this last week as saying global investors are the least fearful they’ve been in decades, and perhaps the most greedy. Their gauge of cross asset complacency, as a Bloomberg article wrote, is close to levels reached just prior to the dot-com bust. And what the article was highlighting is sort of a get rich quick spirit is on display almost everywhere here in early 2021. And they cite Bitcoin, the craze for cannabis stocks, and sort of a feverish buying of penny stocks is just a few indicators of a get rich quick spirit.
Kevin: And this is important for us to look at, Dave. Because last week, when you talked about this appetite for junk bonds showing with the interest rates dropping, they’re quite different than government bonds. Why the pressure on government bonds? Why are the interest rates. . .why are governments having to pay a little bit more than they did last week?
David: Yeah, it’s a good question. There is sort of a recalibration amongst fixed income investors. And as I mentioned, the rise in rates, it was broad-based. I mean, we’re talking about Central Europe to the periphery of Europe to South Africa, and what is colloquially known as the BRICS. It was kind of everywhere. Chris Giles at the Financial Times is describing Joe Biden’s strategy for the U.S. economy as the most radical departure from prevailing policies since Ronald Reagan’s free market reforms 40 years ago.
I think this factors in, Kevin, because what we’re talking about is an experimentation. If it works for us, it’ll be implemented virtually everywhere. And Giles goes on to say, with plans for public borrowing and spending on a scale not seen since the Second World War, the administration is undertaking a huge fiscal experiment. It will put government back at the heart of economic management.
Kevin: It just is almost humorous in a sad, mournful way, unfortunately. They’re calling it a new experiment, MMT, Modern Monetary Theory. This is not an experiment that hasn’t been tried before. Okay. This is an experiment that’s been tried almost by every government throughout history, and it always ends the same. Why do we keep experimenting this way?
David: Yeah. And I think there’s a balance and a conversation to be had here. Certainly Texas is right in the middle of this. How much do you want government or central government in the middle of decision-making? Would there have been a different set of decisions made in terms of the fortification of infrastructure in the energy grid, had that been concentrated federally versus more on a local Texas basis?
Kevin: Is there a concern about inflation, though? I mean, they have to print money to do that.
David: Yeah. And I’m not convinced that there would have been any different decisions made. It’s easy to look back in retrospect and say, “Well, it would have been done different had someone else been making the decision.” But oftentimes the decision trees end up being the same, and the path taken the same.
But yeah, as it relates to government bonds and why the pressure there, is there a growing concern with inflation? I mean, perhaps. But if Giles’ suggestion from the Financial Times is true, the Biden administration is looking for real time evidence that Modern Monetary Theory works and that we’ve been too inflation-obsessed for the last 30 years. So embracing a form of austerity and causing people to suffer unnecessarily will be the rewritten history of the last 30 years if this MMT experiment in real time goes off without a hitch. And it’s my firm opinion that this experiment will do irreparable harm to both the dollar and the U.S. bond market. And at least we have some small indicator that the bond market would agree with me.
Kevin: One of the things I think we really need in this mix. . .I think about it anytime I talk to Jim Deeds because I talked to him yesterday. He gives me a call. . .he’s almost 90 years old, and he has been a lifelong learner. So he has learned from his mistakes, but what we need are 80– and 90–year-old Germans who would speak up. Because remember when the euro came around, one of the voices, country-wise, was Germany, saying, “We’ve been through a couple of these hyperinflations; we don’t want to do this again.” But those voices are fading into the distant past, partially because a lot of them are passing away.
David: Yeah. So is there a recognition in the global government bond markets that the sort of do-whatever-it-takes mentality? . . . That’s a kind of quote coming from Mario Draghi, who, 2011, was leading the European Central Bank, and is, uh–oh, now Italy’s prime minister. But anyways, do whatever it takes. That—
Kevin: Which is the I in PIGS, by the way. So when we were talking about the problems in the PIGS a few years ago, the I in the PIGS was Italy.
David: Well, and by the way, it’s not as if interest rates are coming down with Mario at the helm. There is an understanding that he might be just as creative on the fiscal side as he was on the monetary.
Kevin: Well, where are we in debt? I mean, worldwide, we talk about the U.S. all the time. Where are we in worldwide debt with the do-whatever-it-takes mentality?
David: Yeah. Because I think that’s what’s been universalized in recent years. Total global debt, 281 trillion in aggregate, that may carry consequences with it. And interest rates are one way of measuring the consequence of having too much debt. The Institute for International Finance puts the new math of global debt to global GDP at 355%. There was a one-year surge of 35 percentage points, getting us to the 355 number. So with 2020, we look at sort of inclusion of $24 trillion in fresh obligations, with governments around the world being one of the keystones holding things together there. So fiscal promises continue to proliferate. This is where inflation may continue to grow as a concern, along with the promises of largess which are on the horizon.
Kevin: Okay. So we started with that. We started with promises. Oftentimes, if you look at promises, the word broken is not too far away. And the fault, like it said, in the Cambridge English Corpus, the fault may lie with unforeseen circumstances creeping up, not necessarily ill intentions.
David: Yeah. Well, it’s a concern over the legitimacy of promises.
Kevin: Right.
David: We think debt, we think loans, whatever we use, credit, these are words, right? What we should use in their place is financial promises. And where you see social scarring in the financial markets, it comes from the breaking of promises. The de-legitimizing of leadership and trust in a system is in so many broken promises.
Kevin: And we’ve got to make sure that we don’t count on that. It’s like we talked about the generator works a whole lot better than the Fisher-Price vacuum cleaner.
David: Well, I mean, first we are going to see more money flow. And I think Texas serves as an illustration of the need to reinvigorate our infrastructure. I think certainly that’s going to be used as exhibit A as to why government dollars need to be spent. There’ll be a lot of sort of rhetoric leveraged off of that incoming months. But what continually galls me as I listen to governmental rhetoric is the duplicitous nature of politicians who, under the cover of panic or an excuse or some sort of exhibit A, go about a whole host of initiatives that are well beyond the scope of a related crisis.
As far as we can tell, the best accounting for the $1.9 trillion Biden proposal, and this isn’t even getting to infrastructure spending on the horizon. But they’ll spend a little less than a trillion out of the 1.9 on economic recovery. And the remainder goes as handouts to the base, to pet projects, to what I think of as an Americanized, semi-whitewashed corruption. It’s a benefit to friends. Yep. Biden’s been a part of this system for 40-plus years as a professional politician. And this is really not outside of the scope of work operating like the big man he is. I wish I could say there was a dime’s worth of difference between Republicans and Democrats. But if you look at the record, government budget initiatives prove otherwise.
Kevin: Well, I’ve been here at this company since Reagan was in office. But Biden actually started in his political career back when Nixon was in office. The only four years he wasn’t in politics, they say, was the four years before he was elected president. So pork barrel, I’m wondering if that’s something that flows right off of his tongue, pork barrel.
David: Yeah. Well, I can only imagine the infrastructure spending soon to be rolled out. I suspect there’s going to be enough pork in it to feed China for a decade or Hunter for a century.
Kevin: Yeah. But they’re telling us that we’re too worried about inflation. It’s now. . .they’re apologizing and they’re using MMT as the apology.
David: That’s right. I think modern monetary theory is the foundational apology for past austerity. And it’s also the excuse for future fiscal liberality. And I think that’s maybe what government bonds are rightly concerned about and have under suspicions.
Kevin: You’ve talked often about passive investing. A lot people, we, using Texas as an example, you can rely on a lot of systems that can go down very quickly. Passive investing is the same type of thing. ETFs, I get the question often, Dave, well, why would I buy gold or silver if I could just buy an ETF that does the same thing? The same question comes in with stocks. The same question comes in with bonds, ETFs for government bonds?
David: Yeah. Well, and I think this is where having the right product matched with the right structure. You’ve got to make sure that that’s the case. And frankly, gold is a very liquid asset, is not inappropriately mismatched with the ETF structure, neither are government bonds. But where you’ve begun to have problems is with less liquid assets being put into that kind of structure. I found one data point from last week mildly disturbing, and wildly capable of causing the next asset purchase of corporate debt by the Feds. So if we’re looking for sort of balance sheet expansion 4.0 and where they’re going to have to spend to buy peace and calm in the market, yet again, Bloomberg reported a 15% short position on LQD. LQD is the three-letter ticker symbol for a $48 billion corporate bond ETF.
Kevin: So very different than government bonds.
David: Yeah. So betting against an illiquid asset. Again, this is 15% of the total. $48 billion is a bet against this illiquid asset. We’re talking about, in the form of an ETF, which has implied liquidity because of its structure, because you can point and click with a mouse or what have you, but cannot in fact, take on a massive quantity of liquidations. It’s a real concern. The Fed, I think, will be invited to participate in that cleanup, which is likely a 2021 debacle.
Kevin: Yeah, I remember back in 2013, April 12th, 2013, when Morgan Stanley and Goldman Sachs dumped 400 tons of gold in the markets. The largest gold ETF at that time within two days on April 12th, Friday, and then Monday, April 15th, tax day, gold had come down a couple of hundred dollars. That ETF, the largest ETF out there for gold, had to sell over 700 tons of physical gold.
David: Yeah. Between 700 and 800 tons.
Kevin: But they didn’t have a problem doing it.
David: No. In fact, it proved out a point of structural integrity. Whereas what we’ve seen both in the repo markets going back 18 months ago and in a product like LQD, we assume there is a lot more liquidity from LQD, you can imply it even in the way they’ve spelled that out, but it’s not actually there.
Kevin: So you’re saying this is an infrastructure issue, just like Texas.
David: It is. It’s been built inappropriately, and it cannot handle that kind of pressure. So again, this is an infrastructure issue reminiscent of Texas last week. We know that certain products are not well-suited to ETFs because assets won’t flow through frozen pipes, but we jam billions, in this case, tens of billions into the system, and either hope for the best or hope for the bailout.
The short position was at 5.9% at the beginning of the year. Now more than 15%, this is dangerous. If LQD blows, so does the whole junk market. Everything downstream in terms of credit, credit-wise, would be affected by a blowup in corporate credit. LQD is at the heart of investment grade corporate credit. It is all a bit convoluted. But if you think about this, to the degree that you re-price corporate credit, you begin to see a major cascade into U.S. equities. So the equities indexes, they do not come away unscathed by a major hit to corporate credit. And LQD is building up a bit of a logjam. I think when it breaks, there’s going to be, shall we say, hell to pay.
Kevin: We talk about unintended consequences. Texas, you would think that the power was the issue, or the ice on the roads. But actually at this point, they’re crying out for plumbers to come from all the other states around, because at this point it’s not the power that’s off, it’s the water that’s off, all those broken pipes.
David: Again, there’s this idea that perhaps things would be done differently and more efficiently if it were centrally controlled and centrally planned, if we just handed it over to the federal government. I just don’t think that’s the case. If you’re looking at the creation of something like LQD, and you say, “Well, it’d be better if we just nationalize the markets.” Well, good luck with that. Good luck with that.
The reality is we don’t learn from our mistakes. We just move on and hope the next time is different. Texas had four million people in the dark just a few years ago. They were in the cold. This is the last time the system experienced a deep freeze. And the only thing that is really different today is the scope and scale of the crisis, and I think that’s basically what we’re looking at in terms of the financial markets. We haven’t learned much. All we’re looking at is repeating, but with different scope and scale in view.
Kevin: You’ve been listening to the McAlvany Weekly Commentary. Now I’m Kevin Orrick, along with David McAlvany. You can find us at McAlvany.com, M–C–A–L–V–A–N–Y.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._
