EPISODES / WEEKLY COMMENTARY

Carry Trade Heaven now Hari-Kari Hades

EPISODES / WEEKLY COMMENTARY
Weekly Commentary • Nov 16 2022
Carry Trade Heaven now Hari-Kari Hades
David McAlvany Posted on November 16, 2022
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  • Crypto carnage as FTX declares bankruptcy
  • Recession looms while stock market celebrates 7.7% inflation
  • Learning the art of living backwards

Carry Trade Heaven Now Hari-Kari Hades
November 16, 2022

“So the markets are a daily engagement. Last week’s activity was so radical in nature as to the off-the-bell-curve-centerline and more out on the edges of professional experience. We reflected many times midweek, the whole team, about how only once, twice, maybe three times in your professional career, in the context of money management, do you see this kind of radical behavior, interest rate volatility, currency market volatility, equity, digital asset volatility, all on a spectrum that was fitful and very atypical.” — David McAlvany

Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany. 

It’s amazing, Dave, you sent me notes this morning. We didn’t get a chance to meet last night, so you sent me notes, just scribbled notes, actually typed notes from the Dallas airport, and I had my assistant print them from Phoenix into the Durango printer. I came in and it’s like, oh, so Dave’s trip to Dallas went well. You landed at 10:15. It’s noon now. We’re recording. It’s just— Technology, it’s amazing how we can pull these things together. You from Dallas. The recording studio is up in Idaho. We were just talking to John in the recording studio. The notes were printed from Phoenix to Durango. All this stuff comes together and it sounds almost like we’re just sitting in the living room, doesn’t it?

David: Everything is speeding up. You had Moore’s Law, which explains some of how things are moving faster and faster and faster.

Kevin: How about volatility in the markets this last week? Have we ever seen what we’re seeing right now? In bonds and geopolitics it just feels like something is really brewing, like the froth on the top of your espresso that you’re sipping right now.

David: Everything is speeding up, and maybe that’s a consequence of getting older, and we tell ourselves that. We know that’s true, but it has this sense of speeding up. In the markets, some of this has to do with structural changes that happened in 1999, 2000. We were two decimalization from fractional shares, which allowed for a more rapid transaction to occur. We really didn’t have—

Kevin: Or transactions per second. High frequency trading, you can have 500 transactions in a second.

David: Looking at last week, markets decided to melt up, not melt down. I think it’s important to look at the context. We’ve got the bond market, which is in the middle of its worst year in modern history. You’ve got pending home sales, which have dropped 31% year over year.

Kevin: 31%.

David: And that’s as higher rates are starting to impact real estate, and I will say just starting. We passed the 31 trillion mark on our national debt as of October.

Kevin: I thought Biden said he cut that in half. Was he mistaken?

David: I think he might have misspoken. It doesn’t happen often, but we’ve since then already added a quarter trillion dollars more, a quarter trillion in less than a month. So some estimates put our 2023 interest payments at a trillion dollars. That’ll be a first in US history.

Kevin: Wow.

David: A trillion dollars interest payment for the year. Run the math on what percentage that is of our tax revenue, and you realize that this is really becoming something. The Fed is still reducing its assets by 95 billion a month and—

Kevin: Well, who’s going to loan us money then? The Japanese and the Chinese have been doing that, but I don’t know that that’s going to continue.

David: It’s a big question because we’re on track to add, next year, $2 trillion to our debt. So again, over the next 12 months, we have to find replacements for the Japanese, for the Chinese, for the US Central Bank financiers who are no longer buying, but as I mentioned, selling 95 billion—mortgage backed securities to a small degree and to a larger degree the Treasurys. So perhaps we’re extrapolating too much from the Treasury’s announcement of their quarterly borrowing for the fourth quarter—it comes in at $550 billion for the fourth quarter—but I think we can assume that there is going to be a struggle with tax receipts as we see a reduction in capital gains taxes coming in for the Treasury.

Kevin: Because the everything bubble turned into the everything collapse this year, even though it’s not quite as bad right now. Like you said, we had a melt up.

David: Well, and with the froth coming off, the top equities are still wicked expensive. Elevated price/earnings multiples. We’ve got the price to sales ratio, which is just a touch below all time highs. And also in the context, we have gold and silver which are flowing out of western investment vehicles. This is something we highlighted last week with central bank demand, but out of the western investment vehicles—these are your ETFs, exchange traded products—and into eastern vaults. So as the money moves from west to east, you’ve got physical supplies which are tightening, and they may well remain tight because you’re talking about a geographical migration.

Kevin: It reminds me of what your dad always used to say: He who owns the gold makes the rules. If the gold is flowing from the west to the east, what does that say?

David: Well, it says that the future may not be exactly like the past, and we don’t know exactly what the future holds. But when the markets melt up, I want to know what’s different. I want to know what has changed. I want to know if there’s anything out of character. I want to know what are the critical signals largely obscured by the market noise.

Kevin: And so what you’re saying is, is there something new? So the question is, is there something new?

David: Yeah. In this case, I don’t think there is. We’ve got extravagant leverage. We’ve got manic short covering, and we’ve got the retail investor, just like “The Gods of the Copybook Headings,” with that burnt, bandaged finger wobbling back towards the flame.

Kevin: Well, Dave, you just got back from Dallas literally minutes ago, and I know that you were there with a man who had written a book on wisdom, on looking at life backwards. I was thinking about it just after you had said that. Wouldn’t it be nice— Remember “The Curious Case of Benjamin Button”? He lived his life backwards. I went back and looked. That was written originally by F. Scott Fitzgerald in 1922 for Collier’s magazine, so it was a short story. I’m going to go back and read it. I haven’t read that yet. But wouldn’t you love to go through your life, start with the wisdom at the end but move it to the beginning, and be able to use that wisdom throughout your life? In a way, it’s a little like what he’s talking about. Live your life backwards. Where do you want to end up?

David: Yeah. Well, this was a fabulous and fast trip. And this man that I met, he spent years studying the idea of wisdom. He’s been teaching and refining those thoughts for over a decade. And in writing about it, he concludes that living life backwards with a consciousness of death is the entry point into living well one day at a time. And that resonates with me deeply. Not because it’s dark, morose—and actually I’m much less of a bête noir than my wife is—but working it all backwards, seeing the end from the beginning, and sorting through the decisions to the present moment. You’re talking about curation. You’re talking about cyclicality, simple repetitions that define our daily course, all pointed towards the future, but deeply informed by where we’re at, who we are with this temporal nature. To live in the light of the end is a phrase that he leans on.

Kevin: Well, you remember Russell Napier? Okay, we have him on on a pretty consistent basis, and he runs a library called “The Library of Mistakes” so that we don’t forget the wisdom of people who have ended their life saying, “These are the mistakes I’ve made. Let’s write a book.” He’s got a whole library with just that so that we can actually maybe avoid some of those.

David: Yeah. Often in the program we visit with him and get to unpack the events in the market by learning from the frailties and the foibles of the past. And so this juxtaposition of two people who live in Scotland, one in Aberdeen and one in Edinburgh: is it better to go back to then go forward or to go all the way forward to then work back to the present day?

Kevin: Jim Deeds, who we also have on and we’ve worked with for years, a great friend of your dad going back to the 1960s, Jim, through all of his market career, he said he’s learned far more from his mistakes than from his successes.

David: Yeah, I like both of these guys, one from Edinburgh, one from Aberdeen. They overlap in the middle, and I like both of their thinking. We make informed choices in the light of history and in the light of what we anticipate. And so Napier’s elevation of error and the memorialization of it in that Library of Mistakes, it points to a compelling complement to David Gibson’s book, Living Life Backward. We can do better. Our choices matter. Through time, when we look at the aggregation of those choices, what we see is something that reflects the consequence or the benefit of ideas and values. 

This venue in Dallas was significant. One of the first things I noticed as I walked in the door was this monument to Aristotle and a monument to Adam Smith, and so this juxtaposition of freedom and opportunity. And I thought it was very, very intriguing. I was unfamiliar with it. It was built by the son of Trammell Crow as a monument to those two ideas, freedom and opportunity. That’s called Old Parkland. So you’ve got this physical place crafted, similar frankly to the two men I mentioned, like a set of bookends holding together reminders of the past on the one hand and the forward looking opportunities that we pursue as we answer some critical questions. What does it mean to live well? How shall I then live?

Kevin: And you brought up also, there’s a knowledge of death that’s also built into this. And this is not to be morbid, but I was just talking to somebody the other day and I said, “The human is the only creature that knows it’s going to die.” How do we behave with the knowledge that at some point we’re not going to be here and we’re going to hopefully have a legacy? David, you wrote the book on legacy.

David: Well, a book. And as I’ve written about it, it’s a project that’s akin to being an archivist, an archivist for yourself and of your family in advance of death. So you’re keeping track of the things that have been done or left undone. Reverse engineering is my language. Like Gibson’s, it begins at the end and informs today’s directives towards that purposeful destination. We work backwards from aspiration, from the dream, from a destination to the beginning of the journey, to this day, to the next steps, and we’re always considering tomorrow, always reflecting on the past of course, again like Napier leans on, but seeking to live with wisdom in the present moment.

Kevin: I was having a conversation with my wife this morning at breakfast because I was in I Corinthians 3, and Paul is talking to the Corinthian Church, which he had planted, and the common thing at the time because the church was fairly new was to have a pastor or an apostle have a letter of recommendation sent ahead of time. And Paul said, “I need no letter of recommendation. You,” And he’s talking to the Corinthians, “You are my letter of recommendation.” I told my wife, I said, “What would our letter of recommendation be if we couldn’t write one but it was just the people around us that we had affected?” That would be the letter of recommendation. It was our challenging conversation because I don’t know that we came up with completely positive results.

David: Well, I know it doesn’t take a degree in philosophy to be inspired by the consideration of death in the contemplation of life. Maybe it’s too somber a tone to strike for dinner table conversation or too dark to wade into just in the quietude of your own mind. But I don’t know. I’m not sure that there’s a better way to elevate and celebrate in the small things, these things that are the cumulative contributions to legacy. I don’t think there is another way to begin a journey than considering first where you’re going. So that notion of destination first, now we know what steps are the appropriate steps to take. There is a certain resolve and clarity that starting from the end and working back to the beginning helps with.

Kevin: That works well with navigation too. When you’re planning a flight plan or you’re about to go on a sailing trip, you really are looking, with navigation, all the way to the end as you mark it up on a map. But you have to ask yourself, what informs my choices? When you’re walking through the desert and there’s a trail, cairns, these stacked rocks, moving from cairn to cairn to cairn, and then you’ve got to make sure that you can still see the cairns behind you in case you can’t see the one ahead. It’s interesting living out here. Navigation, that’s a lot like life, isn’t it?

David: Yeah, it was a little confusing the last time we were out with my eight-year-old. He said, “Why are we following only where the Karens went?” Of course in the modern vernacular—

Kevin: Is that how you say it, Karens?

David: No. He was thinking that we were following Karens, and he didn’t understand why we would be inspired by Karens, again with some critique of the modern usage. But no, this might all be a strange lead-in to market commentary. But like Napier, a fellow errorist—with an E, not a T, an E—we want to learn from others. We want to learn from history. We want to gain as much perspective as possible as we appraise the context we’re in for the purpose of real-time navigation. What informs our choices? 

So the markets are a daily engagement. Last week’s activity was so radical in nature as to the off-the-bell-curve-centerline, and more out on the edges of professional experience. We reflected many times midweek, the whole team, about how only once, twice, maybe three times in your professional career in the context of money management do you see this radical behavior: interest rate volatility, currency market volatility, equity, digital asset volatility, all on a spectrum that was fitful and very atypical.

Kevin: David, it’s interesting. I was doing a study on something called confusion induction hypnosis. I had come across that, and I didn’t understand what that was, but what it simply is, a hypnotist, what he can do is he can say two or three things that feel completely out of context. Let’s say you walked up to me in the street and you said, “Hey, Kevin.” And I looked at my watch and I said, “It is precisely 2:15.” And you know good and well it’s 4:00 in the afternoon, but why would I have said that? And then you say, “Well, yes, Kevin, it’s 4:00 in the afternoon.” And then I say, “Yes, and I’m going to be flying to San Francisco tomorrow.” At that point, it only takes a couple of those types of things for your conscious mind to be shifted into confusion, and that’s when you become easily persuaded. It’s a technique of hypnotists. But what we’re seeing right now, Dave, in the markets, is similar to that. It’s a little bit like, “Wait a second. Hi, Kevin. It’s precisely 2:15 in the afternoon,” and you know it’s 4:00. “I’m going to San Francisco.” And you’re like, “What are you talking about?”

David: Right. Well, I think at this point we can almost take this atypical behavior in the markets for granted. We see the behavior and can easily forget that what we have on display is an indication of system dysfunction and a frailty.

Kevin: That goes geostrategic as well.

David: Well, I think that’s why this context is— we can almost forget last week was a big, big, big deal. You’ve got North Korean missile launches. You’ve got the Russian occupation of Ukrainian lands. You’ve got the elevation of a strongman in China to dictator status. You’ve got ripples and waves in the South China Sea around the nine-dash line. You’ve got collapsing bond values across large swaths of the globe. You’ve got market operators adjusting to tighter financial conditions. As rates increase, you get a de-leveraging in the process. Maybe we ignore it, even move past the drama. So many dramatic headlines. Headlines grab our attention until, like olfactory fatigue, we lose the sensitivity to even the grossest smells and effluvia—so headline fatigue, desensitized by drama. Last week’s activity in the market, it’s just another big day up, big day down, big week up, big week down—

Kevin: Confusion induction hypnosis.

David: Well, the meaning behind the drama is too important to ignore. You reflect on and diagnose concerns, like considering death as a part of considering wisdom. It’s not intended to be dark. It’s not intended to be foreboding. We’re not just coming to just negative conclusions. But the takeaways, the actionable conclusions are choices that actually liberate. The choices we make are focused like a laser on human flourishing. Maybe the application specifically here is portfolio flourishing, but sometimes the best things in life require wading through some of the unpleasant aspects. And we can’t miss what is happening in the transaction process over the last few days and certainly last week in the marketplace.

Kevin: Do you think what’s creating the noise right now, this noise that’s so confusing, has something to do with credit and the inability to continue to pump in the credit that we’ve pumped in for the last decade or two?

David: Absolutely. If you look at the history of credit, you realize that there’s nothing really unpleasant here. This is not bad. It’s just different. And I’ve had many people tell me that as you engage on a cross-cultural basis, hey, there’s nothing bad here. This is just different, different foods, different traditions, and what’s different this go round is that we’re not used to increasing interest rates. The business community is not used to increasing interest rates. We haven’t had serious inflation here in the West in 20, 30, 40 years. So as we deal with a reversion to the mean with interest rates rising, is it unpleasant? It’s not so much that as if you’re unaware of the changing financial landscape, if you’re unaware of how things change in light of the new context. This is a new market cycle.

Kevin: You know what was unpleasant? What was unpleasant were the years where we had no volatility. There was no market. The central banks would just print money and smooth these markets out. At this point, it’s precisely 2:15 in the afternoon, but really it’s 4:00. See, that’s the thing. We’re confused because we have not had the volatility. Volatility actually is a beautiful thing if it is a reversion to the mean.

David: Well, I agree with you. A few years back, we had no volatility.

Kevin: That was unpleasant.

David: Now volatility reigns supreme across every asset class. You’ve got that uniformity which reflects the strains that exist on the underlying financial market conditions. So now, it’s the structure of the market, which is geared and set up and designed for low rates, and dependent on this enduring belief that the Fed will be there to bail out the markets, the Fed put. So the structure of the markets has been built on a foundation which is not like bedrock. Rates shift through time. Cheap rates are not a forever thing. Now they’re not cheap anymore. So after 40 years of rates getting cheaper and cheaper, ultimately, just a year ago or so, ultimately rates got to levels we hadn’t seen in 4,000 years—4,000 years! We have this strange sense of what is normal because that’s what we thought was normal. And we have this strange perspective on a status quo that is reliant on in fact the extraordinary. And so in that context, leverage has done amazing things.

Kevin: You’ve brought up in the past that leverage is like a time machine. In a way, it affects time. Leverage, or debt, brings the future into the present.

David: Yeah, leverage is an economic variable that has compressed time and can, like you said, bring the future into the present. Like consumption on a credit card. It enables tomorrow’s money. You haven’t earned it yet. Credit cards allow you to use tomorrow’s money to pay for today’s desires, so you’re bringing it into the present moment. So, too, for the leveraged speculator, taking earnings and savings from the future and investing it today alongside your existing capital to enhance returns. But when leverage works in reverse, instead of receiving the future on loan in the present, you end up destroying the future in the present. Does that make sense?

Kevin: Yeah.

David: This is particularly important as we think about the structural supports for both higher inflation and higher interest rates. You’ve got two alternative outcomes. On the one hand, when you’re using leverage, you’ve got fat gains, and that’s possible in a stable interest rate environment or a declining interest rate environment. And at the other end of the spectrum, as interest rates begin to increase, the cost of capital increases, you end up with skinnier gains and slimmer benefits. This is one of the reasons why we’ve talked about valuations, why they matter, and why they give you an indication of what your future returns are going to be over a five, 10, 15-year period. 

If you end up overpaying for assets, you end up with subpar returns over the next decade. If you get a great deal on an asset, then you have outsized gains over the next decade. So again, what we’ve done is we’ve enhanced those returns by using leverage, by borrowing money to do it. Now, that which gave us these beautiful returns over the last 10 or so years in particular, now is actually working in reverse. So we have a valuation problem in equities. We also have a cost issue because what has helped deliver some of this, the leverage, it’s going away.

Kevin: So what looks like progress becomes destruction. I remember when I was a kid, H. G. Wells’ movie The Time Machine was made. It’s an interesting movie because this time machine sat in the same place, and what he could see, talking about living life backwards, this time machine could see the progress as this room would change and the house would be built and then destroyed around him. You had progress initially. But then what happened was it started to de-progress and de-struct until finally when he got out of the time machine way in the future, people couldn’t even read. They were sacrifices to these beings that were going to eat them. It was H. G. Wells’ vision of moving the future into the present. That works as long as you’ve got sound money and you have progress.

David: This is just one of those things that people have forgotten that’s so basic as to be overlooked. The cost of capital as it turns out is consequential.

Kevin: Yes, it is.

David: Projected returns hinge on it. Operations are helped or hindered by it. Easy money, which is another way of describing the conditions which have accelerated growth in recent decades, now it’s becoming harder to procure, and at a higher cost, and it’s consequential.

Kevin: So last week’s response to the 7.7% inflation rate, it was almost elation. People were like, “Oh, good. Progress again. It’s going to work.”

David: Right. So we had the core reading, which, like the headline number, came in under expectations that set off an unwind of hedges across asset classes. Rates are moving higher still. So how does a small shift in inflation impact asset markets so dramatically? It’s because of these issues, lots of leverage, the fact that the unwind was across all asset classes. By, I mean, unwind, we’re talking about short positions which were then covered and caused a massive spike in price. Uniformity. Uniformity: remember it. Diversification is really “deworsification” when the driving force for growth is an element depended upon across all asset classes.

Kevin: So diversification doesn’t always help you when things are starting to break.

David: No. So the fury of these reversals and gyrations, it was violent, and it’s violent enough to break things. You’ve got hedge funds, leveraged as they typically are— Sometimes this helps them with returns, but this cross-asset-class violence upsets even the best-thought-out strategy. There are always hedges in the mix. You want to limit your losses and try to define where your gains are going to be pointed. And hedges of all sorts were blowing up last week. So this positive price action, to the tune of 6%, 8%, 10%, may seem to be some sort of a reprieve from the declines of the first half of 2022. It maybe even gives you a little bit of giddiness, like, “Oh good. We’re making progress back to where we were before.” But the violence of the moves is both damaging and further destabilizing. Think about all the people who were hedged and had to cover those short positions. This was a massive short covering. How do you hedge a position, and what do you hedge it with, when hedges can so quickly work against you, and at a scale that rips through the S&P like a California wildfire?

Kevin: Well, yeah, and don’t they call those short squeezes where—

David: Absolutely.

Kevin: —you’re basically squeezed into making the opposite trade that you had hedged. And so what you’re talking about is, if you were thinking the market was going to go down and you had shorts on the market, and then the market all of a sudden spikes up, it becomes a self-fulfilling prophecy because you have to go cover those shorts and it creates even a larger rise in the market.

David: And the thing is, we’re talking about a derivatives market. We’re talking about tools that are intended to help, but in point of fact can hurt on both sides. So they tend to exaggerate trends. A little bit of short covering becomes a lot of short covering. It becomes a new up trend. Maybe not a sustainable up trend, but at least a day, a week, a month perhaps. And the same thing is true on the downside. This is what we saw with portfolio insurance in 1987. Insurance was supposed to help cover against the losses in downward moving markets, and yet when the movement in the markets was downward, all that insurance did was compound and complicate the downtrend.

Kevin: So sometimes you differentiated secular markets, which are the long markets, with cyclical markets. What you’re saying is some of these short squeezes can actually alter the cyclical market direction.

David: I’m not sure I’d go that far. I think what it does is, it participates in the cyclical nature of the market. It’s part of what defines a massive move in a countertrend direction.

Kevin: So how does anybody manage in this market?

David: It’s tough. You’ve got one hedge fund manager, Elliott Management, very competent hedge fund guy. “We’re in an extremely challenging situation,” he says, “where financial extremes have made possible a set of bearish outcomes that,” and I quote him directly here, “would be at or beyond the boundaries of the entire post-World War II period.”

Kevin: Wow. Going all the way back to World War II. We talked about that with the British pound too.

David: These are extraordinary circumstances.

Kevin: This is a crazy time. But who would’ve thought? Last year at this time they were reporting 2% inflation. Who in the world would’ve thought that everybody would’ve been gleeful for 7.7% now?

David: That’s exactly right. So if inflation is less of an issue, suggested by CPI last week, then monetary policy need not remain restrictive. So that’s what we’re getting up and clapping about. You’re right to remind us, we’re not talking about a reversal of inflation, which would require a negative number, but this is just a reduction in growth. So we were at 8%. Now inflation is still growing at 7.7, nowhere near, as you remind us, where we were last year. We still have an inflation of nearly 8%. Of course, it’s a partially scrubbed number, cleaned up. But follow that market logic, lower inflation, 7.7, and a lower core equals less need to raise rates, equals a closer timeframe to quantitative tightening ending. This is again the shrinking of the balance sheet by 95 billion a month, raising the target rate, which are both iterations of tightening. All of that equals a return to the good old days of leveraged speculation and hyper-growth. Again, we’re just talking about people wanting to get back to being able to draw more of those tomorrows into today.

Kevin: Isn’t that a form of nostalgia, human nature, nostalgia where you look back and you go, “Gosh. I just wish it could be like it used to be.” Now you see this in smaller bites in the market, but people really miss making money all the time on everything.

David: Well, in an easy money environment and easy credit environment, there’s a lot of ways that you can make money, and you don’t necessarily get rewarded for stellar business plans.

Kevin: Everything bubbles. Everything bubbles.

David: So the S&P is up 6% for the week, and it seems to me to be an exaggerated response to the CPI report. The market reversal was in fact tied to short covering. It’s an unwind of hedges. That then triggers retail FOMO, fear of missing out, on the next wave higher. We’re returning to that again, hyper growth in everything that we’ve gotten accustomed to. The retail investor floods back in. The retail crowd is still incredibly bold, learning very little from the first half of the year and still very valuation blind. The hedge fund community is still overexposed, long and short, not sure where to go, how to play this market. Hedge funds were working very hard last week to not get killed. You had JP Morgan, which estimated that quant funds—these are a particular style of hedge fund—were forced to buy—and again, this isn’t a short covering—they’re forced to buy $225 billion in stocks and bonds over two trading sessions.

Kevin: Wow.

David: Unwinding short positions. So 150 that’s going into equities, 75 billion of that is going to bonds. You tell me if this is a reversal in trend. You tell me if this is a sustainable new up-leg in the equities markets or if we still have valuation issues to work through. Because what we had was a forced reckoning with leveraged speculators, an epic short squeeze, 244 million options changing hands. In fact, 2-day call option volume that’s never been rivaled—never been rivaled. That’s speculation far more than it is investment.

Kevin: So we’re talking financial markets that can do this. They can go back and forth, and they can just almost be schizophrenic. If you’re a CEO of a company, oh, I’m looking at one, a CEO of a company, you’re not going to be a CEO long if you’re nostalgic for the way things used to be without looking ahead. Talk about looking toward the end and bringing it back and actually making decisions based on the outcome. CEOs right now are not seeing the same things that the market saw last week.

David: I don’t know. Colonel Sanders and Truett Cathy, these are guys who are nostalgic about something. Recipes and—

Kevin: Eleven herbs and spices. Yeah.

David: Less attention was given to corporate layoffs last week because you’ve got this spectacular rally in everything, but less attention is given to corporate layoffs—

Kevin: Which are happening.

David: The decline in small business optimism, that’s the NFIB survey. Friday, we had the University of Michigan consumer sentiment numbers, which declined last week by 9%.

Kevin: So they weren’t buying stocks. They were out at the grocery store, still very, very depressed about the price increases.

David: So just looking at the UMich consumer sentiment numbers, we gave up half the gains from that June record low. And keep in mind, June, even to the present, at a low, low level. We’ve never seen this kind of numbers outside of recession. So consumers know inflation in a very real and tangible way. In a way that statisticians apparently do not.

Kevin: So yeah, consumers are not celebrating 7.7% inflation.

David: Oh, the concerns over inflation are in the process of sinking more deeply into the minds of the middle class, and the Fed is very sensitive to this. So while employment figures are still holding up well, we get 3.7%, there are indications now that businesses are getting out ahead of something. Is it recession? Perhaps. Last week, 50,000 job cuts announced. Meta, 11,000. That’s the old Facebook. Amazon, laying off 10,000. FedEx freight units, they’re calling jobs. But both of those last two, that seems odd to me.

Kevin: And we’re coming into Christmas.

David: Exactly. We’re leading into the holiday season. Remember 2021, Amazon was hiring tens of thousands. FedEx was hiring tens of thousands. Both of those seem odd to me leaning into the holiday season. We’ve got credit balances, looking at consumer credit cards. Credit balances are up 19% to 866 billion according to Bloomberg. Again—

Kevin: People are charging their groceries right now, Dave.

David: Average credit lines are at all time highs. They’re at the end of the third quarter. And consumers are already in that place of not doing well. So the psychological piece is frail on two fronts. It’s frail on two fronts. One, you’ve got— With negative rates and inflation, this is how I see it coming into the first quarter next year. Negative wealth effects coming from the increase in mortgages, mortgage rates, which trims back home equity. And then secondly, the expectations of higher inflation. CNBC noted that since May the average borrower has lost about $30,000 in home equity, cumulative loss of one and a half trillion dollars. Our estimate is that household net worth takes a $10 trillion hit from rising rates over the next 12 months. In real estate, repricing has only just begun.

Kevin: Okay, so you’ve got this strange thing happening in the markets. They’re euphoric because we have 7.7% inflation and it was estimated to be 7.9. And then you’ve got consumers who are getting more and more negative. Now if you’re the Federal Reserve, which, your job is perception management, that’s what has happened over the last decade, what do you do? Do you try to cool the markets down, this schizophrenic market, or do you try to encourage the consumer, we’re sliding into a recession? Are you trying to create a recession to slow inflation down?

David: You follow through on higher rates because you know that inflation is the most damaging enemy that you have. Consumer expectations of inflation are increasing, and that is a guiding factor in the Fed’s thought in their decision-making. And here, just in the first little bit of November, we’ve got both the long-term and short-term expectations of inflation, which for consumers is on the rise. This runs in direct contrast to the financial market’s desire for policy pivot. Remember, all this enthusiasm is about the idea that lower inflation equals less pressure on rates to go higher and stay higher for longer. Meaning, we get back to that credit gravy train really quick. But even this week, you’ve got Fed Governor Waller broadcasting loudly, discouraging speculators from reading too much into the CPI number because it’s dangerous. It’s dangerous, and they will do what they have to do, which is follow through on higher interest rates regardless of the CPI number.

Kevin: Are they going to be watching the Producer Price Index this week?

David: Absolutely. So you’ve got the wholesale Producer Price Index this week, and I think there’s a possibility that that reinforces this fear of missing out. You get a good number, a really good number, again, like we had last week with CPI. Again, it’s just more fodder for the bullish speculator. This is a tricky week, though. This is a tricky week because you’ve got options expiration this week. So really anything is possible. The bullish bias can push ahead, and at this point, what if there’s a massive disappointment in PPI? If PPI disappoints, then you’re talking about the reestablishment of hedges, and all of a sudden major, major downward pressure. As much as we had manic movements up last week, we could have the same manic movements down this week. So the trader goes from buying calls to buying puts. The option writers themselves are trying to hedge, and all of a sudden the underlying assets are under pressure. It adds volatility in the other direction.

Kevin: In the past, we’ve seen some of the largest financial institutions completely destroyed by the carry trade coming apart. This last week, we’ve seen incredible volatility in the currencies. We had only seen the dollar rising. Now, what we’re seeing is we’re seeing some of these other currencies, they’re rising against the dollar. And so let’s say you’re borrowing. A carry trade is just simply borrowing in a low interest rate environment in a particular currency, and going and investing it elsewhere. But the problem is, you’ve got to pay that loan back in that currency. If it goes up versus your currency, it can just— Barings Bank, we bring it up often, but Barings Bank, one of the oldest largest institutions in London—

David: Known as the sixth great power, more powerful than other nations in the world.

Kevin: And one day it was just gone.

David: Right. Well, so we talked about interest rates and those being driven by inflation. And as interest rates move higher, it takes the wind out of the sails for the speculative community, for the investment community, and no longer can you drive valuations higher. In fact, you see the opposite, valuation compression. Well, if interest rates take the wind out of the sails, maybe you can lean on the little puttering motor—you can still drive the boat at a lower speed, grant you, but I think that’s where currencies come in. Ongoing currency volatility is a crucial aspect to the degrading of market structure. 

There’s a lot of leverage in the financial markets. A lot of that leverage is via carry trades. You borrow in a currency that has low rates, use the proceeds to speculate elsewhere. And so currency volatility makes that activity more difficult. And when you make that activity more difficult or costly, you’re basically reducing market exposure. Your buyers go away. You’re watching one form of buyer diminish their market footprint. So the US dollar dropped 4.1% last week. The South Korean won was up 7.6% last week. These are returns in a currency which you generally could see in a year, 365 days, not five days. The Swiss franc was at 5.7%, which reminded me, and the Financial Times wrote a great article on it, Polish home buyers are currently looking at how they can sue their local banks because they were encouraged to borrow in Swiss francs, and—

Kevin: Now they have to pay back in Swiss francs.

David: That’s right. And so if you look at the depreciation of the zloty versus the Swiss franc, it’s been cut in half, more than cut in a half, so your debt burden has more than doubled, more than doubled to be paid back in Swiss francs. Japanese yen. Japanese yen rallied 5.6% last week. The pound, up 4%. These are huge one-week moves, and it forces down the total amount of leverage in the system. It forces down the size of a position that someone is willing to carry using the carry trade to have a bigger position in a particular asset class. Higher cost of capital will do it. Volatility does it. You’re looking at a shrinking buyer base.

Kevin: And social intervention or bank intervention or rules and regulations intervention. Look at Country Garden. They were just about to go bankrupt with hundreds— What was their highest yield that they were paying, 120%, 140%? And all of a sudden, now it’s down to, what, 40%?

David: Well, these are crazy numbers. It doesn’t even hardly make sense because we still have Evergrande over 200% yields, but Country Garden is the largest, and so an interesting bellwether. You’re right. The state support for the real estate developers through the commercial banks and the guarantee to the commercial banks that they won’t take a loss if they just dribble out this money to the developers, Country Garden goes from an 80% yield to a 40% yield in 48 hours. If you think about that kind of a bond market rally that snapped back in price from being left for dead to being left half for dead. 40% yields are still significant. But Vanke goes from— This is the best in terms of balance sheets. Vanke goes from the teens back to 8%. Massive rallies, massive rallies. 

At the same time, we’ve got the official curtailing of COVID restrictions, which are going to come into play, a 20-point plan to reduce the severity of their lockdowns. Timing couldn’t be worse on this because you’ve got cases moving to the highest levels in months over the last three weeks. Sequentially, we’ve watched daily cases move from a thousand to 2,000, from 2,000 to 10,000, from 10,000 to 16,000. There’s an exponential curve in terms of new cases, and yet they understand they can’t keep the lockdown in place forever. Their economy is in jeopardy.

Kevin: Which makes sense. How would you like to be, and I hate to bring this up, Dave, because anytime we bring crypto up, it just brings people out of the woodwork in comments because they want to defend it or what have you, but how would you like to be one of the richest men? $26 billion a few weeks ago, then it drops to, what, 15 or 16 billion? Then you get caught at the airport, or I’m not sure exactly where they caught him, but he’s in jail right now, I believe.

David: I don’t think he’s in jail.

Kevin: He’s not in jail. Well, what happened there?

David: Well, I think it’s important to keep in mind who you choose as a messiah is of great consequence. And if his name starts with Sam or he is the son of Sam or he is the son of Soros, there’s some people that maybe you don’t want to elevate to godlike status.

Kevin: Talk about a guy with nostalgia though. Wouldn’t he love to go back to just being $26 billion rich?

David: This is utter crypto carnage. This is volatility on a scale that you only get to see really once in a lifetime or you just read about it in the history books. This is the implosion of a massive bubble like the tulip mania, like the South Seas bubble. FTX declares bankruptcy. Its founder was worth $26 billion six months ago. He was worth 16 billion two weeks ago. He resigns as CEO with billions in missing client assets. If you don’t know who this is, just go to Miami. The NBA Miami Heat, they just renamed their arena the FTX Arena. You spend a hundred million here, spend a hundred million there. Sam spent a better part of $50 million as the second largest Democratic donor in the midterms, so he’s right behind George Soros.

Kevin: Wow.

David: This is the largest blow up in crypto yet. What is this? This is a speculative asset enabled by end of cycle credit dynamics. Easy money makes for bold market bets. The more bold, probably tells you where you’re at in the credit cycle. Easy money allows for profitless companies to exist as a dream. Easy money allows for big ideas to exist and for people to hold on to hope beyond that point where it’s reasonable. Profitless companies, that’s coming home to roost as we speak because when there’s no easy money, it forces many of those dreams to bump up against reality, and that’s called extinction events. This is highly consequential. We’re in a bear market. All the darlings of the previous up-cycle are being put through a meat grinder.

Kevin: It reminds me of the sock puppet, 1999, pets.com sock puppet. Pets.com was worth more than all the airlines combined, in equity. And it was a sock puppet. That was it. It was ordering dog food online. It didn’t work. So this crypto carnage that you’re talking about, Sam Bankman-Fried. Okay, so apparently it was a rumor a few days ago that he was arrested on the tarmac at the airport, but it sure is a different way of behaving than six months ago.

David: Mood, mood shifts, and, all of a sudden, assets that were complementary to a greed environment, all of a sudden you can’t touch them. You can’t touch them with a 10-foot pole. What happens to any asset price when you don’t have a buyer? This is the nature of price discovery. The price continues to seek a bid, and it goes lower and lower until somebody steps in to buy it. That’s what we’re working out, is levels of overenthusiasm now coming up against the realities of inflation, higher interest rates, and just a sobering up. That is consequential stocks, bonds, real estate.

Kevin: Yeah, and life. You talked about living life backwards. Outcomes. Where would you like to see the outcome and how would you live today to get there?

David: In the Pecan Room at Old Parkland, we sat there sipping on some libation after the presentation of the discussion on wisdom, and I met this gentleman who’s a technologist, has worked with a number of technology companies as the CTO and CEO. And I asked him what he’s doing next, and he said, “I’m going to write a book called Shooting Where the Rabbit Was.”

Kevin: I love that.

David: What we try to do is recreate the past, and hopefully we get it again. This fear of missing out is really nothing more than, as you said earlier, some form of nostalgia. It’s just misinformed. The context has changed. You got to lead with the shot, not shoot where the rabbit was, where it’s going, where it’s going. So there is this maybe confusing but I think helpful juxtaposition between respecting the past and the things that we can learn from it. Napier, again, unpacks the events in the market by learning from the frailties and foibles of the past. And yet we work backwards from the future to the present moment to see what actions we should be taking. So maybe we’re not shooting where the rabbit was.

Kevin: You’ve been listening to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany. You can find us at mcalvany.com, M-C-A-L-V-A-N-Y dot-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 addition of the McAlvany Weekly Commentary.

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