Tactical Short 2nd Quarter 2024 Recap

Podcast: Play in new window

Bubbles Being Bubbles
MWM Q2 2024 Tactical Short Conference Call
August 8, 2024

David: I think we picked a fantastic week to be talking about volatility in the markets. There’s some pretty remarkable things happening in the last week to 10 days, even the last three or four days. And I think you’ll be pleased to gain some insight from Doug’s commentary today. What we’ll do is cover the performance aspects for Tactical Short as we get started. Then Doug’s formal remarks. We’ll open it up for Q&A thereafter.

We have a variety of questions that have already been submitted. We’ll handle those questions first. If you’re interested in adding an additional question, you certainly may. If you go to the wealth management website, you can look in the bottom right-hand corner and there is a chat box there. Feel free to submit an additional question. If there’s something that you’d like for us to expand on or clarify, happy to take a crack at it as best we can. And again, that’s on the bottom right-hand corner of our main website.

So without further ado, good afternoon. Thank you for participating in our second quarter 2024 recap conference call. As always, a special thank you to our valued clients and account holders. We greatly appreciate those client relationships.

With first-time listeners on the call today, I’ll begin with some general information for those unfamiliar with Tactical Short and you can find more detailed information available also on our website, mwealthm.com/TacticalShort. Make sure that if you are not already, on a weekly basis, Saturdays, grab a cup of coffee and avail yourself of the Credit Bubble Bulletin. It is a tremendous service that Doug has been doing for a couple decades now. And a labor of love, certainly. Labor of passion and interest. He is very intent on documenting what has happened in the credit markets that has brought us to this point, and you won’t find better insight, in my opinion, on the topic.

And a quick— While I’m at it—and Doug, this is commendation 2.0—what Doug does on a daily basis, if you’re on our website, you can look at Credit Bubble Daily and he’s organized a host of news articles for you to look at, the most prescient of the day. And if you’re interested in saving yourself an hour, two hours a day of finding the most important information points, do that. I’ve done that for years, and I owe Doug a lot of hours. It’s been fantastic.

Okay, the objective of Tactical Short is to provide a professionally managed product that reduces the overall risk in a client’s total investment portfolio, while at the same time providing downside protection in a global market backdrop with extraordinary uncertainty and extreme risk. This strategy is designed for separately managed accounts. It’s investor friendly, with full transparency, flexibility, reasonable fees, and no lockups. We have the flexibility to short stocks and ETFs, and our plan has been to, on occasion, buy liquid listed put options.

Shorting entails a unique set of risks. We are set apart both by our analytical framework as well as our uncompromising focus on identifying and managing risk. Doug will explain some of the interesting and intriguing aspects of that, both in second quarter and as we find ourselves now in the third quarter as well.

Our Tactical Short strategy began the quarter with short exposure at 80%. The target was held steady at 80% throughout the quarter, focused on the challenging backdrop for managing short exposure. A short in the S&P 500 ETF, the SPY, remains the default position for high risk environments. That’s what it has been, and that’s what it continues to be. I’ll update you on performance and then pass the mic.

Tactical Short accounts after fees returned negative 3.06% during the second quarter. Negative 3.06. The S&P 500 returned 4.28. So for the quarter, Tactical Short accounts returned negative 71% of the S&P 500’s positive return. As for one year performance, Tactical Short, after fees, returned a negative 14.68 versus the 24.54% for the S&P. So the Tactical Short loss was 59% of the S&P’s positive return. Again, as I mentioned earlier, target is 80 and Doug will explain some of this, but I’m always fascinated by his expansion of the band and his ability to manage this aspect of a short portfolio.

We regularly track Tactical Short performance versus three actively managed short fund competitors. First, the Grizzly Short Fund, which returned 1.75% during Q2. Over the past year, a negative 2.23%. Ranger Equity Bear returned 5.15 for the quarter, with a zero one year return. Federated Prudent Bear, a negative 1.85 in Q2, and a negative 13.05 for the one-year.

Tactical Short underperformed. This is not a common thing when we’re looking at our competitors here. So underperformed the actively managed bear funds for the quarter. On average, Tactical Short underperformed by 474 basis points during the quarter. Tactical Short underperformed over the past year by an average of 958 basis points. It has, however, significantly outperformed each of the bear funds since inception. April 7th, 2017 through the end of the second quarter, Tactical Short outperformed the three competitors by 1,868 basis points, or 18.68%.

There are also popular passive short index products. The ProShares Short S&P 500 ETF returned a negative 2.12% for the quarter and negative 12.84 for the past year. And the Rydex Inverse S&P 500 Fund returned a negative 1.98 during Q1 and a negative 12.27 for the full year. PIMCO, the last I’ll mention, PIMCO StocksPLUS Short Fund Q2’s return was negative 1.82 and one year return of negative 10.56.

Again, I’ll come back around for the Q&A. I’ll just remind you of the chat function at the bottom of our website where you can add any questions that you have. Doug, take it away.

Doug: Thanks, David. Hello everyone. Thank you for being with us. This is the second straight quarter where our call was delayed a couple of weeks, and again, there are recent developments that somewhat diminished the value of focusing too much on the previous quarter. Like April, July was quite eventful for the markets and geopolitics, and August has begun even more dramatically.

But let’s start with comments on performance. Tactical Short lost 71% of the S&P 500’s positive return for the quarter, reasonable considering short exposure was targeted at 80%. Because of my expectations for heightened volatility, I placed a wider than typical band around short exposure. Recall in previous discussions how, in a rising market environment, short exposure increases as stock prices rise, while account equity will decline due to market losses, resulting in an increase in the ratio of short market value to account value. This can get a little complicated. Basically, short exposure increases when markets are rising, and is automatically reduced when markets are declining.

Back in my mutual fund days, we would do trades near the end of most sessions to return exposure back to target. With Tactical Short, with our separately managed accounts, we would prefer not to have daily individual transactions. Also, the repetitive buy high, sell low nature of rebalancing tends over time to negatively impact performance, especially in volatile environments.

I did rebalance by adding short exposure in April when market weakness pushed our short exposure below 80%. Seeing major market downside risk, I prefer short exposure not to drop below our target level. Just as we regularly reduced short exposure to rebalance during the long market ascent, I expect to rebalance by adding short exposure throughout the bear market, allowing Tactical Short returns to compound over time.

Anticipating volatility, I was slow to rebalance when the market reversed course in May and stayed strong through June. For the quarter, our rebalancing strategy, the wider trading band in particular, somewhat negatively impacted performance. This impact has been reversed to start Q3.

Tactical Short performance lagged its closest competitors during the quarter. I can point to a couple of reasons. First, Q2 provided favorable relative performance opportunities for those shorting stocks. Powered by big tech, the S&P 500 significantly outperformed most indices. The small cap Russell 2000 declined to 3.3% during the quarter, with the mid-caps down 3.5%. The average stock Value Line Arithmetic Index returned negative 3.7%. Our competitors captured gains from weaker individual stocks.

Our competitors also benefited from the performance advantage of generating cash returns from short account balances. I addressed this in some detail during the Q1 call. A quick summary here. When a fund shorts stocks, proceeds from the short sales are held in a restricted account at the brokerage, where they generate a cash return just below the overnight funding rate. While Tactical Short’s separately managed accounts have important advantages including transparency and flexibility, we are not compensated for our short balances. We do earn returns on cash balances, just not on the proceeds from short sales.

With short-term interest rates currently elevated, our competitors have a performance advantage likely around 120 basis points a quarter. Prudent Bear, for example, outperformed us by 121 basis points during the quarter, of which much can be explained by the fund’s return on short balances. The return dynamics of the three passive short index products are similar to Prudent Bear.

The Grizzly and Ranger funds’ focus on individual company shorts was behind their meaningful outperformance versus the more index-related short products, including Tactical Short’s current positioning. For me, it was an especially frustrating quarter. The meltup in big tech fueled exceptional S&P 500 outperformance versus the broader market. It drives me a little crazy when a strategy adopted to cautiously manage risk in a high risk environment underperforms products that take more risk. This type of performance dynamic usually happens in a down market, but the dispersion of performance during the quarter was atypical.

The obvious question would be, “Doug, why don’t you just shift short exposure to have broader market short exposure.” A couple of quarters back, I was asked, “If the small caps are underperforming the S&P 500, why not short the Russell 2000?” I’ve not been comfortable shorting the small caps because of the index’s volatility, its higher beta. And this index is prone to large, unpredictable moves.

This is an extraordinary environment. Markets are on a speculative meltup, at least they were during the second quarter. Intense short squeezes have been routine. Financial conditions have remained loose, with strong system credit growth, near record corporate debt issuance, and abundant liquidity. We have positioned for late cycle craziness, wild instability where anything can happen. Expecting the unexpected, I have specifically avoided guessing this market.

My discipline has been to remain hunkered down in the default short of the S&P 500 . This is key to avoiding outsized losses and big negative surprises. In extremely uncertain and unstable environments, it’s imperative to mitigate the risk of being caught with short exposure that is high beta or susceptible to short squeezes. Risky short exposure is a game of Russian roulette. This strategy can generate decent outperformance until you get run over by a short squeeze or abrupt rotation.

Last month was particularly rough for high-beta short strategies. The Goldman Sachs Most Short Index rose 10.5% in July, with the index surging 12.5% in a brutal five session squeeze ending on July 16th. The Small Cap Russell 2000 returned 10.2% in July versus the S&P 500’s 1.2% gain. Tactical Short posted a small loss for the month. Ranger Equity Bear Fund, abruptly on the wrong side of the market, lost 9.6% during July, quickly reversing recent outperformance.

The Tactical Short strategy strives to be an effective hedge against equity market risk. It would be unacceptable to lose more than 9% during a month where the S&P 500 gained about 1%. That’s an outsized loss, big negative surprise we strive to avoid. Yet this is exactly the type of volatility and crazy moves that should be expected in such a speculative environment. You don’t know when or where, but if you put your risk management guard down in this environment, you’re asking for trouble. Many investors in high risk short strategies likely panicked out of their positions in July right before the market reversal.

This is a good segue to macro analysis. I will briefly discuss Q2 developments and then focus on what has been a quite eventful start to Q3.

Markets were unsettled to begin Q2. With the economy and inflation proving more resilient expected, 10-year Treasury yields surged 50 basis points to an April 25th high of 4.7%. The global yield spike triggered a bout of de-risking/de-leveraging, with emerging market currencies and bonds under notable pressure. The Nasdaq 100 sank 7% in the six sessions ending April 19th, as the S&P 500 dropped 4.5%. Global currencies turned unstable, and with trading turning disorderly, the yen sank to the weakest level versus the dollar back to 1990.

Right on cue, Chair Powell struck a less hawkish tone at his May 1st press conference. Downplaying inflation risk, he discussed potential paths to rate cuts, including softening labor markets. Stocks and bonds rallied sharply, with global risk on regaining momentum. Fed assertions of restrictive policy notwithstanding, financial conditions loosened further. Corporate risk premiums, CD prices, and other indicators moved back to near multi-year lows.

Importantly, easy conditions stoked a historic AI arms race mania and bubble. At its June 20th peak, NVIDIA enjoyed a year-to-date gain of 180%, and market capitalization of 3.3 trillion. The semiconductor index was up 38% year-to-date with an 80% eight month advance. It was a classic speculative blow off, the kind of crazy mania that would be a fitting finale to history’s greatest bubble.

Bubbles being bubbles. Even for me, that’s a quirky title. The point I want to stress is that as extraordinary, incredible, and crazy as things have been, the backdrop is consistent with how powerfully mature bubbles will behave if left to their own devices. And as things unfold, there will be a lot of confusion. I expect most economists, Wall Street strategists, and policymakers to be confounded by developments. Confusion has been apparent over the past week. Our hope is to offer an analytical framework that helps make sense of what will continue to be an extraordinary environment.

Lately, I find my thoughts returning to the mid ’90s. I was deep into macroanalysis, and by the end of 1994 was convinced that finance had fundamentally and momentously changed. It was out with traditional banking and in with market-based finance—the repo market, asset and mortgage-backed securities, hedge funds, money market funds, Wall Street structured finance, and the government-sponsored enterprises. I remember watching in awe as Fannie and Freddie operated as quasi-central banks as they bailed out the hedge funds during the 1994 bond market dislocation. This had followed the Greenspan Fed’s early ’90s rate collapse and yield curve manipulation that surreptitiously bailed out the banking system following the bursting of the ’80s decade-of-greed bubble.

I became convinced that the inflating bubble was the most monumental since the Roaring ’20s. I began diligently researching that period, seeking better understanding of the nature of bubbles, inflationary dynamics, and speculation. And the deeper I dug, the more complex and fascinating it all became. I often found myself thinking, “How could everyone have come to believe all the hype and nonsense? How could they have put blinders on and ignored so much? And how on earth could things have turned so crazy, especially during the climactic 1927 to ’29 manic speculative blow-off?” Those questions, they no longer puzzle me, not after witnessing markets over the years and especially over recent months.

Back in the year 2000, I titled a presentation, How Could Irving Fisher have been so wrong? He was, after all, the preeminent economist of that era that went on to write authoritative work on debt deflations and the Great Depression. His keen interest is understandable. Fisher made his infamous “stock prices have reached what looks like a permanently high plateau” just days before his fortune was wiped out in the 1929 stock market crash.

Virtually all were completely blindsided. Yeah, there were a few skeptics and a group of naysayers that recognized the peril of bubble excess, but by 1929, they had largely turned silent. To the naked eye, that period’s incredible prosperity appeared sound and sustainable.

Importantly, and most pertinent to today’s backdrop, things must appear extraordinary for bubbles to inflate to ever greater excess year after year, the type of long-term bubble inflation that ensures deep structural maladjustment.

Things look extraordinary today. Accelerating technological advancement, AI, quantum computing, robotics, biotechnology, advanced telecommunications, and the like. The Roaring ’20s period is analogous with respect to monumental technological advancement, the widespread availability of electricity, the growing use of production line manufacturing, affordable automobiles for the masses, radio broadcasting, widespread use of the telephone, expansion of aviation, the liquid-fueled rocket, to name just a few. Along with wonderful breakthroughs in science and medicine.

There are loads of research studies and theorizing over what went so horribly wrong to cause the Great Depression. Adherents to more of an Austrian economics perspective believe credit excess and breakdowns in market function led to epic resource misallocation. There are insightful contemporaneous accounts and analyses that collect dust on library bookshelves. I’m intrigued by a debate of whether the key issue was overinvestment or malinvestment, though it seems years of easy money and market euphoria ensured plenty of both.

I remember reading analysis that particularly resonated. It discussed how technological advancement tends to evolve in clusters. Key breakthroughs inspire scientists, inventors, creators, entrepreneurs, and financiers alike. For example, electrification spawned exciting new inventions including refrigerators, washing machines, irons, toasters, electric razors, vacuums, and such, along with massive infrastructure investment.

The mass-produced affordable Model T spurred advancements in road and highway construction, traffic signals, gas stations, leisure activities, and tourist destinations. Radio broadcasting promoted the development of home radio units, phonographs, the jukebox, instant cameras, silent movies, and cinemas. Waves of exciting new technologies changed the way people lived and how they thought about the future.

A deep sense of optimism took hold, with borrowers more willing to take on debt to purchase homes, cars, and myriad new products. With the future so bright, businesses and entrepreneurs borrowed lavishly for investment across the economy. And of course, booming markets enticed an historic expansion of speculative credit, including margin debt, broker call loans, and the highly levered investment trust sector.

Ben Bernanke is considered the foremost contemporary expert on the Great Depression. He comes from the revisionist Milton Friedman school of thinking that views the 1920s as the golden age of capitalism tragically brought to an end by inept Federal Reserve policymaking. Bernanke argues that the Fed grossly erred by tightening policy into 1929 in the face of weak commodity prices and mounting signals of economic vulnerability.

Bernanke is fond of deriding what he refers to as the bubble poppers, fixated on the speculative market and Wall Street exits. Moreover, Bernanke professes the view that the Fed’s gravest error was its failure to print sufficient money to recapitalize the post-crash impaired banking sector, a policy blunder he holds directly responsible for The Great Depression.

I’ve long been fascinated by this analytical debate, and I’ve argued against inflationism for years now. History teaches us that monetary inflation is such a slippery slope. Once commenced, it becomes difficult, if not impossible, to rein in. The Fed doubled its balance sheet to 2 trillion in 2008, doubled it again between 2011 and 2014, and then doubled it once more to about 9 trillion during the pandemic inflation. I fully expect the next serious crisis will compel the Fed to begin doubling its holdings yet again. After all, each QE-fueled inflation ensures a much larger and perilous bubble.

Bubbles being bubbles, there are alarming parallels between current bubbles and those from the Roaring ’20s. Today’s global government finance bubble inflation emerged out of the crisis response to the bursting mortgage finance bubble. Late ’20s bubbles were the culmination of a great inflation spawned by the First World War. Just as Bernanke argues that policy was perilously tight in 1929, many on Wall Street today contend that excessive Fed tightening risks a hard landing for markets and the economy.

But it’s no coincidence that a 5% policy rate both in 1929 and over the past year neither tightened financial conditions nor restrained asset inflation and speculative bubbles. Bubbles being bubbles.

Over time bubbles attain great power and become increasingly immune to policy tightening measures. The bubbles of 1929 and today are both phenomenally long duration, late stage, and extraordinarily powerful. During protracted boom cycles, the aggressive risk-takers rise to the top, whether it be corporate executives, technology innovators and CEOs, entrepreneurs, bankers, financiers or speculators. The more cautious and risk-focused get pushed to the side. Businesses large and small that take every ebb in economic activity to aggressively expand for the future are handsomely rewarded. Investors and speculators that take greater risk and buy every market dip enjoy the strongest returns and accumulate the most assets.

By 1929, it was believed that the creation of the Federal Reserve some 15 years earlier had fundamentally reduced the risk of financial and economic crises. The easing of monetary policy in 1927—the infamous coup de whiskey—solidified confidence that the Federal Reserve was fully equipped to safeguard prosperity. The Fed’s 5 trillion pandemic stimulus and also the March 23 banking crisis response crystallized the view that took hold after years of Fed interventions, bailouts and reflations. Market players and the business community operate today with full confidence that the Fed will do whatever it takes to ensure ongoing robust financial markets and an expanding economy.

Things get crazy near the end of protracted bubbles. The interplay of powerful bubbles in credit and asset markets and in the economy takes on a precarious life of its own. Excess begets excess. Late cycle credit bubbles thrive on years of strong self-reinforcing credit growth. Boom time lending profitability incentivizes financial innovation with a proliferation of new age lenders and financial products. With Fed QE ready to backstop the Treasury market, Washington takes full advantage of its blank checkbook.

In business, the most successful have, over the cycle, accumulated huge war chests of financial resources to be aggressively deployed to secure market power. Nowhere is this more apparent than within the powerful tech oligarchy. I think of the clusters of innovation phenomenon and the hundreds of billions of cash resources accumulated over this long cycle by the dominant technology companies, the PC, internet, advanced telecommunications, the smartphone, enterprise software, the cloud and such, and now artificial intelligence.

The purview of AI is just so far-reaching, and the big technology companies today have their massive war chests to engage in a truly historic late cycle investment arms race. Meanwhile, the long boom cemented loose credit conditions, from aggressive bankers and non-bank lenders to over-liquified corporate credit markets, all eager to fund massive spending on data centers, hardware, semiconductor manufacturing, energy infrastructure, and the like. Meanwhile, a manic equities market bids up prices for anything related to AI, similar to how stocks in any way tied to radio broadcasting skyrocketed during 1929’s blow-off. In short, the powerful forces of late cycle bubble excess have coalesced in historic fashion.

But there’s a reality that should not be ignored. By their nature, manias and speculative melt-ups are relatively short-lived. Meanwhile, credit bubble excess sows the seeds of its own destruction. There are credit cycle realities, risky lending fosters over-indebtedness, and eventually impaired lenders. Bubbles being bubbles, late cycle optimism and manic excess coincide with deepening underlying financial fragility and economic vulnerability.

When I initially warned in 2009 of the risk of an unfolding global government finance bubble, I never could have imagined the degree of excess or its breadth and duration. And just as big tech built their arms race war chests, China and EM countries over the cycle accumulated huge international reserve positions. These reserves, China in particular with its massive 3.2 trillion, have been instrumental in extending the cycle.

The Chinese credit boom inflated a historic apartment bubble, yet its bursting has yet to ignite the usual financial crisis and run on its currency. This is specifically because the Chinese currency, as vulnerable as it has become, is underpinned by confidence that Beijing will deploy reserves to support the renminbi as necessary. And with its currency well defended, Beijing maintains the rare capacity to direct its banking system to land aggressively, last year to the tune of a record 5 trillion of asset growth. And with its ongoing state-directed credit expansion, China will likely meet its 5% GDP mandate.

It’s tempting to believe that Xi Jinping’s China has subverted credit and business cycles. In reality, the Chinese have only extended cycles and accommodated history’s greatest credit bubble, and with it, unprecedented overinvestment, malinvestment and financial vulnerability. Despite ongoing massive credit growth and government stimulus, Beijing today is pushing on the proverbial string.

Meanwhile, Japan embarked on its own perilous government finance bubble, subversion of market forces, and promotion of late cycle excess. Years of massive monetization, zero rates, and even the pegging of government bond yields.

Most importantly, the interplay of ultra-loose Bank of Japan policies and global leveraged speculation certainly extended late cycle financial exit. I suspect the yen carry trade, borrowing cheap in Japan and using proceeds to lever in higher-yielding securities globally, inflated into one of history’s great speculations. Now, the Bank of Japan timidly raises rates to 25 basis points and global markets start to unravel.

A strong case can be made that government finance bubble excess across the entire globe has reached a critical phase. This is a good segue to recent market developments.

I believe the odds are reasonably high that markets have reached a critical juncture. Bubbles being bubbles, end-of-cycle craziness typically has markets succumbing to manic speculative blow-offs. We’ve witnessed this dynamic. History provides us a critically important warning. These upside dislocations set the stage for acute instability, volatility, destabilizing reversals, downside dislocations, and even panic. We’re now witnessing key speculative bubbles falter, most notably yen carry trades and the AI big tech mania.

After trading to almost 162 on July 11th, the yen rallied 14% to 142 to the dollar at Monday’s high. Since the 11th, the Mexican peso sank as much as 19% versus the yen. The Brazilian real 16%, the Chilean and Colombian peso 15%, and the Argentine peso 13%. The global leveraged speculating community, which had aggressively shorted the yen to take levered positions around the world, has suffered major losses and been forced to begin unwinding leverage. The global liquidity created in great abundance as these levered trades expanded has now begun to contract.

Liquidity is also being destroyed with the reversal of leverage throughout the crowded AI big tech trade, the unwind of margin debt, and enormous derivatives-related leverage. Speculating and call options on the major tech stocks and indices became a phenomenally popular strategy, and certainly helped fuel the manic melt-up as derivative dealers aggressively purchased stocks to hedge in the money call options they’d written.

Now, with the tech stocks and major indices having reversed course, those aggressive buyers abruptly shifted to frantic sellers. Moreover, market players are now rushing to hedge their exposures with the buying and hedging of put options creating significant downside market pressure. The VIX indexes Monday spiked to 66, eliciting the headline, “The VIX just did something it hasn’t done since 2008.”

When analyzing market liquidity and crisis dynamics, I lean heavily on the periphery and core analytical framework. Risk aversion typically emerges first at the periphery—the domain of the most indebted and vulnerable asset classes, regions, countries, sectors, and companies. Often, nascent instability at the periphery initially bolsters the perceived safer core, a dynamic that had benefited the core US credit market over recent weeks.

But trouble at the periphery unleashes contagion effect that, left unchecked, gravitates toward the core. The impact of deleveraging and waning liquidity mounts as risk-off gathers momentum. Effects tend to be non-linear, with crisis dynamics accelerating significantly as risk aversion strikes nearer the core.

Believing de-risking/de-leveraging had made the consequential jump to core US markets, I titled last Friday’s Credit Bubble Bulletin, “The Critical Leap.” I highlighted a Bloomberg article— in quotes here, “Wall Street banks are calling for aggressive interest rate cuts by the Federal Reserve. Economists at Bank of America, Barclays, Citigroup, Goldman Sachs, and JP Morgan revamped their forecast for US monetary policy Friday after data showed the US unemployment rate rose again in July.”

Citigroup expected 250 and 125 basis point cuts by year-end, with JP Morgan calling for the same 125 basis points of cuts, but also beckoning for the Fed to take the unusual step of slashing rates prior to next month’s FOMC meeting. Calls for an emergency inter-meeting cut got louder following Monday’s turbulence.

In early Monday trading, the market was pricing as much as 148 basis points of Fed rate reduction by year-end. Let’s be clear, there’s nothing in the economic data that would justify aggressive 50 basis point cuts, let alone an emergency move. But these banks are monitoring de-risking/de-leveraging from high in their catbird seats. They clearly see market developments that have them quite alarmed.

As I highlighted in Friday’s CBB in some detail, last week saw some of the most dramatic moves in various risk indicators since the March ’23 banking crisis. A key short-term rate, the one-year overnight swaps rate, sank 49 basis points in pre-sessions, the largest drop since March ’23. Same for two-year Treasury and MBS yields that dropped 50 basis points.

I closely monitor various corporate yield spreads to Treasurys, along with credit default swap prices, or the cost to purchase insurance against bond default. A mosaic of risk premiums throughout the markets provides an invaluable tool for monitoring risk perceptions in the marketplace, and more specifically the progression of risk-off from the periphery to the core.

I’ll briefly underscore quite important recent developments in corporate credit. High-yield CDS last week posted the largest one-day and weekly gains since the banking crisis. At Monday’s close, high-yield spreads to Treasurys had surged an extraordinary 67 basis points in three sessions. As high-yield CDS surged 74 basis points, investment-grade CDS jumped 14 basis points.

This was the most dramatic spike in corporate risk premiums back to March 2023. A few Tuesday headlines corroborated the tightening financial conditions thesis. “Risky borrowers discover doors are closing in bond loan markets.” “U.S. corporate bond market issuance set to slow amid market volatility.” And, “Leveraged loan outflows poised to be the most since 2023 bank crisis.” Also indicative of core instability, bank and broker stocks have been under heavy selling pressure at home and abroad.

In just three sessions, the KBW Bank Index lost almost 10%, with the broker dealers down 9%. European bank stocks sank 10%, while Japanese banks collapsed 26%. The yen jumped almost 5% versus the dollar last week, and was up another 3% in early Monday trading. Gains were more extreme versus key carry trade currencies.

Meanwhile, the semiconductors over three sessions were clobbered almost 14%. It is a major development when two highly levered and momentous speculative bubbles are concurrently under significant stress. Moreover, the panic buying of Treasurys has been indicative of fear of more systemic de-risking/de-leveraging.

There is evidence to suggest unprecedented speculative leverage has accumulated throughout the U.S. credit market comprising the core in my periphery and core framework. There’s the so-called basis trade, where a few dominant hedge funds borrow in the repo market to take the most extreme levered positions in Treasurys, playing the tiny spread between Treasury Bonds and futures. This trade is reported to be in the trillion dollar range.

I suspect leverage has also ballooned in MBS and agency debt markets, and carry trades became a popular and lucrative speculation throughout corporate credit, where speculators can use the proceeds from shorting Treasurys to lever in higher yielding corporate bonds, leveraged loans, private credit, and structured products such as collateralized debt obligations. Speculative leverage even stormed the muni market. Panic buying of Treasurys widened yield spreads, placing pressure on myriad levered bets.

If I’m correct that a major de-risking/de-leveraging in the U.S. credit market is likely now unfolding, this tightening of financial conditions will hit egregiously speculative asset market bubbles and a grossly unbalanced, maladjusted economy. It’s worth noting gold’s $52 jump last week as financial assets were in the throes of instability.

As we saw Monday, the precious metals can get caught up in de-leveraging with the levered players forced to liquidate some holdings as they scramble to de-risk. But I do see this year’s solid metals performance supporting the thesis that the Fed and global central banks will have no alternative than to aggressively expand their balance sheets to accommodate de-leveraging and thwart collapse.

Bubbles being bubbles, I know as well as anyone there’s a Chicken Little element to the analysis. Bubbles have a proclivity for approaching the precipice only to recoil and then proceed to gain additional strength. Once having attained momentum, bubbles are very difficult to contain, so it’s incumbent upon central bankers to recognize and quell bubble dynamics early.

But inflationists—the inflationist contemporary central bankers—they’re in the business of inflating bubbles, not reining them in. Current bubbles have become so powerful that even a Fed policy rate above 5% imposed little restraint. Most important and pertinent, bubbles do eventually burst, and the longer this inevitability is postponed, the more destabilizing the consequences for markets, economies, societies, and the world order.

I believe this period will be debated for decades, if not longer. Conventional analysis will surely blame overzealous Fed tightening for needlessly harming what were robust markets and a sound economy, just as the revisionists have done with a 1929 crash and Great Depression.

But let there be no doubt, the excesses of the preceding boom are responsible for devastating busts, and of course, the inflationist policies that nurtured, promoted, and sustained boom time excess. I hope history will scrutinize the FOMC meeting from last December. Powell pivoted dovish despite ongoing loose financial conditions, a highly speculative market environment, and virulent asset inflation.

Between that fateful Fed meeting and July 10th peak highs, the semiconductors inflated 50%. NVIDIA ballooned 180% to surpass three trillion in market cap. The Nasdaq 100 returned 27%, the S&P 500 22%. Moreover, the speculative mania ensured markets disregarded troubling economic, political, and geopolitical developments.

The US bubble economy has become increasingly plagued by wealth disparities and balances, deep maladjustment, and a fateful addiction to loose credit. Our country remains deeply divided heading into what will be a close, hotly contested, and likely unsettling presidential election. And the geopolitical environment seemingly could not be more fraught with risk. The Ukraine-Russia war, tensions in the Taiwan Strait and South China Sea, North Korea, and the Middle East that appears at the brink of exploding into a regional, full-fledged war or worse.

It was a wildly unstable first half of 2024. Believing the deflation of history’s greatest bubble has likely commenced, there’s every reason to expect an historic second half. David, back to you.

David: Thank you, Doug. The first question is about the BRICS. Lots of talk about BRICS these days to the extent the share of payments and transactions and participating countries increases in BRICS and decreases in SWIFT. What material impact would an ordinary person see, and I’ll take a crack at that.

You’ve got the gradual erosion of monopoly, and I think that’s more impactful to those with a direct tie to the monopoly. The two parties involved would be the U.S. commercial banks and the U.S. Treasury, with access to the data. There’s not an immediate impact to the ordinary person, but if you play it out on a go-forward basis, theoretically you can make the case that as capital flows circumvent the US dollar system and trade invoicing drops, the dollar will be impacted. And again, this is the dollar dropping from the normal payment settlement processes. The net effect is US dollar demand decreases alongside the requirement for foreign financial institutions to hold the same degree of US dollar balances. And those two factors arguably put downside pressure on the dollar. It’s a basic reduction in demand for the currency.

So eventually the implication is, and I don’t know if this is a problem out there on a five-year or ten-year horizon, but that is that you and I experience a loss in purchasing power. If you say that differently, the dollar declines in value, goods and services cost more, with the consumer experiencing a drop in a living standard. I think that’s the net effect for the ordinary person, but it’s something that I think will take a good bit of time to play out.

Doug, this next one for you. “I believe the bond market is broken, and everything else emanates from that. Is the US going to get another credit downgrade, and would the first one probably be from a foreign rating agency?

Doug: I don’t disagree, Dave. From my framework, I would suggest that the unprecedented increase in government finance, and that’s Treasury, Federal Reserve, GSE, all of that broke market function generally. You can’t have a Fed repeatedly purchasing trillions of dollars of Treasury debt and MBS also, and expect sound market function.

So we can argue that the bond market, it has been broken for a long time now. Where was market discipline as the Treasury ramped up issuance and accumulated $35 trillion of debt? And it’s worth remembering that the 10-year Treasury yield was only 1.3% just three years ago. That just invited deficit spending and bolstered the perception that the amount of outstanding debt was irrelevant, and it was directly responsible for the jump in inflation. It also promoted this increase in the basis trade.

So far markets haven’t paid much attention to debt ratios or debt ratings, so I’m not holding my breath that the rating agencies will have much impact—and that’s the US agencies or the foreign agencies. Remembering back to the mortgage finance bubble, nobody had any concern about the rating agencies, at least their AAA ratings, until after the bust, and then they blamed it on the rating agencies instead of doing their own credit analysis. But anyway—

I thought yesterday was interesting. Despite these crisis dynamics we’ve seen of the late, and recent panic buying of Treasurys, the 10-year auction actually met disappointing demand. And we’ve witnessed over recent months, the marketplace has become more focused on these auctions. There’s understandable concern for the massive issuance that—it’s as far as the eye can see. They’re just issuing more and more, and it doesn’t take a wild imagination to envisage a scenario of deep recession, steep market losses, sinking tax revenues, and frightening deficit numbers, if today’s aren’t frightening enough.

Treasurys over recent years have benefited greatly from the strong dollar. When international demand for our debt wanes, that will put further pressure on yields. With this amount of debt outstanding, a spike in borrowing costs, that is extremely problematic.

But let’s not get too far ahead of ourselves. 10-year yields are down 75 basis points, a little less than that counting today, from where they were at the start of May. If we’re heading into a crisis environment, Treasurys would likely enjoy robust demand. At least we’ve seen that repeatedly. They’re safe haven demand in a crisis environment.

And if marketplace liquidity becomes an issue, the Fed will use the Treasury market as its prevailing mechanism for system liquidity injection. So the market assumes big Treasury buying is coming if a crisis starts to unfold.

In the short term, I could see Treasurys winning by default. There’s been enormous growth in credit, throughout corporate credit, corporate bonds, leverage loans, private credit structured finance. I see greater short-term vulnerability in non-Treasury debt. We’ll have to monitor market conditions diligently, and certainly this huge trillion-dollar basis trade. That’s an issue that creates great uncertainty there. But thank you for your question, Dave.

David: Art asks, “Bitcoin your current thoughts, any level of investment?”

I’ve read a handful of books on Bitcoin, blockchain technology, and cryptocurrencies, and that certainly doesn’t make me an expert. But my opinion after wading through a good bit of material is that it remains a viable speculation as long as a speculative environment persists. So we’ve got Wall Street in the last six to 12 months introducing a host of ETF products, and that’s added further runway for investor demand. That demand can be more easily accommodated, and with supply remaining relatively limited, there’s a case to be made for further upside. That’s the basic bet that speculator demand outpaces supply and the price moves exponentially. So the demand vehicles exist. What I think will drive the outcomes is the appetite for risk and speculation, which remain subject to the market environments risk-on or risk-off proclivity.

There are not enough use cases for the cryptocurrencies to have actually revolutionized the financial system. You do recall that the blockchain in its most basic understanding is really just an old school database. With multiple nodes, but still it’s just a database. Nothing profound in that. But if you have buyers outnumber sellers, then prices rise.

The level of investment in a broad-based cryptocurrency, if that’s something that someone’s interested in, I see that as a 1% range of net worth as a max. That’s not a choice that I’ve made, but in terms of highly speculative positions that you might have in a portfolio, you can easily replace your losses from a healthy T-bill account, and if you get lucky, you can add significantly to your T-bill account down the line.

Again, I think it comes back to this key point that cryptocurrencies have taken hold and become most popular, most successful, and have been adopted by the public in an environment of incredibly loose financial conditions. And the environment is one that from an emotional or a sentiment standpoint is highly supportive. Change the environment, change the sentiment, and I think the “bona fides” of the cryptocurrencies all of a sudden are in question like any other legitimate technology which is even more revolutionary.

Next question from Adam. Thanks for the question, Art. Adam asks, “during the unwinding yen carry trade over the last several days, US Treasurys have rallied, yields have fallen quite dramatically. I understand the flight to quality during chaotic markets, but didn’t much of the multi-trillion dollar carry trade involve shorting yen and buying US Treasurys? Therefore, shouldn’t an unwind involve selling of Treasurys and a rise in yields?”

Doug: Well, that’s an excellent question, Adam. Thank you for that. The world of leveraged speculation has become quite complex. It’s always complex. It’s gotten more complex. There’s a lack of transparency. So we don’t know all the various lever trades and derivative trades that have proliferated over recent years and recent months. But I feel comfortable that the focus of much of the yen carry trade was on higher yielding instruments in perceived weaker or vulnerable currencies. I mentioned in my earlier presentation the huge declines in the Mexican peso and the Brazilian real versus the yen, for example. I assume the yen borrowings for US securities would largely be in higher yielding junk bonds, leveraged loans, and such.

And I touched on this earlier, but when the global levered players get hit with significant unexpected losses, they move to de-risk across their portfolios, across various asset classes. When they are hit simultaneously with big losses in yen carry and technology, all the crowded trades become vulnerable to unwind. And I interpret the panic buying of Treasurys we were seeing Friday and Monday in particular on fears of systemic deleveraging, and I believe there are huge domestic carry trades where speculators have shorted Treasury and agency debt and used the proceeds to lever in higher yield in corporate credit. So an unwind of these types of trades would entail significant Treasury purchases, and that’s how you can see the spreads blow out because you can get the Treasury yields to climb rapidly relative to the other yields. And when markets begin to dislocate—the panic Treasury buying, widening spreads, and waning liquidity—your concerns grow for the stability of this massive basis trade that I keep mentioning, these highly levered long cash Treasury bonds against short Treasury futures.

My sense is there is enormous leverage in various perceived stable basis trades where you have two sides of the trade that have a very stable relationship. They move tick for tick, such as Treasury bonds and Treasury futures contracts. Playing this spread is basically free money unless something really goes haywire. Well, things went haywire in March of 2020, and the Fed was forced into massive QE to bail out the basis trade players in the general market. I think these highly levered basis trades have become problematic because when things start to go haywire, the concern is that things could go really haywire—crash-type haywire—if these basis trade players get in trouble. And such concerns provoke a mad dash to the safety of Treasury bonds, which causes a lot of stress and dislocation in trades that are short Treasurys.

The unwind of such trades then really weighs on marketplace liquidity that places a lot of other trades, including basis trades, in jeopardy. And that these basis trade players borrow huge in the money market creates vulnerability to a Lehman brothers-type scenario. So I expect intense Treasury buying in a de-risking/de-leveraging scenario at least initially. And thank you for the question my friend.

David: Doug, an add-on to that. Bill asks about money market funds. “Can you comment on the safety of money market funds, especially regarding repos and the enormity of basis trades?”

Doug: This is always a sensitive issue when you start talking about the money funds. I’m never the type that wants to yell fire in a crowded theater, but I think, to me, in this environment, you certainly want to choose money market funds that hold Treasurys versus repos. A lot of so-called government funds own repos, collateralized by Treasurys, agency bonds, MBS, and such. I think you’re just not paid much extra yield in the money market complex to assume such risk in this environment. So I just say, stick with Treasury mutual funds or you can always have someone manage your Treasury positions or purchase them yourself, but time to be cautious, I think.

David: That is—just to note—that’s something we’ve had strong demand for over the last six to 12 months. You can go to treasurydirect.com and roll a Treasury position yourself, but for a very small fee we are willing to do that as well and own a direct issue in 90-day paper and just continually roll that. So if that’s of interest, again, feel free to do that on a do-it-yourself basis, or let us know if you’d like for us to help you with that.

Tom Kennedy asks, “what’s the collateral behind the US Treasury Bonds that are given to the Federal Reserve in exchange for their creating money for us? The real hard physical assets of this country. So now the Fed owns more than enough bonds to own the whole country, probably the world by the central banks of the whole world. How should that knowledge influence our short and long-term financial strategies? Even our precious metals only have value as long as they concede to let us own and trade with it. Just as De Beers controls the price of diamonds by withholding a huge inventory of them, the Fed controls the price of precious metals by virtue of their control of the world’s currencies.”

I think I would frame that a bit differently. Any creditor of the US Treasury Department—and you can include the Federal Reserve, if you like—depends on the ability of the Treasury to make payments on the debt, and there’s no contract that’s been signed. There’s no formal obligation for the US government to hand over American land or other assets to its creditors. The creditor’s confidence comes from the ability to pay on the loans outstanding. And this ties back to taxation and the latitude the Treasury department has to extract really any amount they’re able from individuals, etc. Since the Treasury is a branch of the US government and the US government maintains an ability to coerce any amount of taxation they choose, creditor confidence is really tied to the government’s power to coerce and force the taxation.

So they do not maintain direct claims to any assets. In the sense when you own Treasurys. Every creditor of the US is unsecured, but you’re looking at the ability to extract. And relative to other countries, other governments, our tax rates are relatively low. So there is this notion that they have the latitude to increase taxation relative to the rest of the world and still be in a position where you’re not in a revolutionary state. The Fed and every other creditor of US Treasury buys and sells us debt based on the ability and the willingness of the government to tax, and it’s based on the confidence or the lack thereof in the government’s ability to manage its fiscal position well.

Speaking of metals, I disagree that our ability to own metals or any other asset is on a permission granted basis, and this may be a little bit philosophical, but our individual agency determines what and how we operate. It’s true that rules can change. It’s still at our discretion as to whether we follow them. Agency is a very powerful thing, and migrations often coincide with individuals who determine that their agency is best expressed elsewhere. The laws of any land are simple. They’re arbitrary constructs. They could have been otherwise, and it’s always up to us as to either determine the governments that create the laws. We’re involved in and will be in November in this whole process. Or when we choose to defy the laws, we must be willing to pay the consequences, or you can change your direct relationship with the country designing those laws. And again, that’s a migratory process.

But I think if you look at 1776 and our founding, that has something to do with this concept where you don’t like what you have and you consider other options. Again, I think I disagree that the Fed controls the price of everything. The Fed may determine the value of our currency unit and thereby, indirectly impact the price of everything, but they do not control prices. Now granted, if you’re talking about short-term influences, the plunge protection team—it’s more formally known as the President’s Working Group on Financial Markets, of which the Fed is a part—yes, prices can be influenced in very short timeframes.

In fact, I was reminded of that last week. I sat at dinner with Charles Goodhart from the Bank of England. His PhD thesis was on trade cycles and the time to recovery following a financial collapse. His focus was on 1907. I was operating with one set of facts. He provided a few fresh ones, which was interesting. JPMorgan intervened in the market following the collapse of the Knickerbocker Trust. What I didn’t previously know, which Goodhart shared with me, was that JPMorgan was given Treasury money to intervene. The Treasury Department determined that he had better knowledge of which commercial banks were under acute stress, and therefore delegated both the right, the responsibility, and the resources to bail out the banking system. This influenced confidence ,which influenced price, but even with access to Treasury cash, he did not control anything, the market did. What he was attempting to do was calm the concerns in the marketplace, and again, influence not directly control.

We do not—and again, this is thinking of the world’s central banks, not just the Fed—we don’t control the world’s currencies. Maybe under the Bretton Woods system we came closer to that. But what we do have in terms of the US dollar position is a privilege, an exorbitant privilege. The history unfolding over recent decades—and if you want to project ahead a few more decades, I think it’s safe to say—concerns the loss of those privileges and advantages in favor of a less dollar-centric system. So just as confidence in Treasury’s ability to pay ties to the government’s ability to coerce, so does dollar hegemony. It depends on a military advantage. It depends on the ability, the willingness to maintain the most powerful military in the world.

I think what I like about gold, and again, I would just say that this is not something that’s determined. What I like about gold is that it conveys on a universal basis the degree to which various monetary authorities have done their job. The job of maintaining price stability. Gold is measuring and it measures the central bank’s credibility. The price is not controlled by them. I think that’s one of the things that’s annoying about gold, too many central banks. It measures their competency and credibility in real time.

To illustrate, what does the market say about that right now? In Swiss Franc terms, gold’s priced at 2100. In US dollar terms, 2,400 roughly. In Canadian dollar terms, 3,300. In Mexican peso terms, 46,000. In Indian rupee terms, 203,000. In yen terms, 357,000. Again, gold is communicating to you something about competency and credibility in real time.

Again, I would just look at things a little bit differently. Not so much that everything’s controlled, but that the market actually does have a clear voice. Yes, there’s carve-outs for very short periods of time, but I think that’s one of the things that I love about gold is that it is really a barometer and a signal of competency and credibility.

Penny asks, “how bad are the banks? Explain a bit about interest rate derivatives.”

Doug: Okay. Well, thank you very much for your question, Penny. I have to admit to not spending a ton of time reading bank NK and NQ filings, not like I used to, but I’ll venture a few comments. The major money center banks are better capitalized today than they were heading into the 2008 crisis. And I’ll even give them the benefit of the doubt that they’ve improved the risk management function, but I also have serious doubts they appreciate the scope of current speculative leverage and bubble distortions. We saw in March 2023 that bank capital levels didn’t stop bank runs. It seems clear that there will be more bank failures as bubble deflation and economic weakness gain momentum.

But I probably, and I shouldn’t say probably, I worry more about the non-banks. When the banking system falls under stress, the Fed, they’ll just open whatever liquidity facilities the industry demands. I’m just not sure how things will play out when, for example, one of the major hedge funds, one of those operators loses access to market liquidity, the repo market for example. And there are huge numbers of large leverage speculators that operate out of these various offshore tax havens. I don’t think there’s a plan or a mechanism to provide a liquidity backstop to these types of operators in the event of a global systemic liquidity crisis.

In 2020, the Fed and other central banks, they just resorted to massive trillions of liquidity injections, just massive liquidity. I doubt the Fed and central bank community are excited to repeat this approach, although they could find they have no alternative.

For interest rate derivatives— Okay. So got a little factoid here. According to the Bank of International Settlement, and that’s the central banker’s central bank, interest rate derivatives increased 83 trillion, or 17%, to 574 trillion in the six months ending June 30th, 2023—the most recent available data. I remember being shocked when interest rate derivatives surpassed 100 trillion. These numbers, they’re unfathomable. There are all kinds of interest rate derivatives, or— These are just financial contracts tied to various market interest rates.

So-called interest rate swaps are the most common derivatives contract. Swaps vary between the relatively straightforward to the exceedingly complex. So let’s just think of a basic interest rate swap contract. We might agree for the next five years that you promise to pay me an interest rate tied to a short-term rate, say the overnight bank funding rate. You’re going to pay me the overnight bank funding rate while I promise to pay you a fixed rate, say the current five-year Treasury bond yield. And then every six months we’re going to net that out and somebody’s going to send somebody else money and we’re just going to have this agreement between the two of us. With this interest rate swap derivative, you can lock in your borrowing costs, and as long as your counterparty remains solvent, hedge your exposure to rising rates.

In this example, you might borrow short-term in the money markets to finance longer-term assets. And what you want to do is you want to hedge that. So you want to reverse your interest rate exposure on that. Even the most straightforward derivative is confusing, and I did not do a very good job of explaining the basic one. But often they involve foreign currencies where parties are swapping, say short-term interest rates in Japan for long-term market yields in say, Mexico, Brazil, or even the US. These derivatives can be quite effective and efficient in hedging various market risks. The problem is, they have become the epicenter of global leveraged speculation, and I can confidently assert that interest rate derivatives are integral to yen carry trades and have played a major role in recent market instability.

The derivatives universe, it’s vulnerable. It’s vulnerable to market dislocation and illiquidity, and if a major derivative player gets in trouble, you immediately have a systemic issue. These derivative markets are so massive and opaque, and that doesn’t matter when things are normal, but it becomes a major issue during periods of deleveraging and market upheaval. So, anyway, Penny, thank you for your question.

David: Just a small anecdote, I mentioned the Panic of 1907, and Doug, you talked about non-banks being problematic. It’s interesting because it was the Knickerbocker Trust which was serving as that era’s shadow bank. The trust company system in that era was the shadow banking system that we have today. Benjamin Strong was invited to look at Knickerbocker Trust’s books. He was at that time head of the Banker’s Trust, and later he became head of the New York Fed. But he looked at the books, he couldn’t decide if they were solvent, and they passed on the bailout. So there was a suspension of the trust, and—

The dynamics involved today, I think you’re right, there’s the banks and then there’s the shadow banks. And our shadow banks today include a lot of private equity and private credit and stuff that there’s just a lot of opacity. In the midst of crisis, you need to be able to know what the assets are worth. You need to be able to read the books, determine solvency. And that is no small task. That is no small task.

Leslie, thank you for your question. “Any special counsel for an 80-year-old widow with no family, CDs, fixed annuities, money markets, gold coins. My goal is to leave this to Christian Charities.” Leslie, I really don’t have any special counsel. If your income is sufficient, continue to take as little risk as possible. And if there’s some comfort in getting the safety rating of the insurance companies that you’re working with, we’re happy to provide that for you for free. We have some resources that look at those institutions in detail, both banks and insurance companies. And so if that is of interest to you, please reach out to our office and on the fixed annuity side just to double check how well those institutions are run. We’re happy to do that for you.

Chris asks, “how much is the investment risk rising for holding large amounts of money markets and short-term Treasurys? With my gold and silver allocation max reached, where’s the best place to move some of this exposure now through the next 12 months?”

Doug: I had mentioned earlier, I’ll say the rising concern for money market funds— And the growth in money market funds over recent years has just been phenomenal, and this growth in money market funds has— It just followed the enormous growth in the repo market, which has followed the growth of the basis trade and leveraged speculation. So in this environment in particular, I’m just uncomfortable, but also I don’t dive into those filings like I used to either. But in this environment, why dive into filings? Just own the best. If you have to own a money market fund, just own the best Treasury funds and then we don’t have to worry about it. And I mentioned earlier before, there’s a big difference between the Treasury fund and the so-called government fund, and that difference is in the repo market. So that’s a very important difference. And David, I’ll lean on you here for where best to move some of the gold and silver exposure.

David: It sounds to me that— The sense that I get from the question is that there’s sort of sufficient allocation to the metals and the concern is over that liquidity piece and managing that liquidity as intelligently as possible, and to consider other assets. I mean I really do like Treasurys, and I do like gold. Those are positions I wouldn’t necessarily change. But when you look at your other options, of course all assets have risks, all assets have trade-offs. Balancing those trade-offs and risks is key. I think the benefit of having short-term Treasurys, money markets in that Treasury category that you mentioned, Doug, the benefit there is the ease of deployment, super liquid, and you’re sort of at the— That is the lowest risk, the financial asset, the short-term duration government obligations. Moving it around, I think it depends on the balance of everything else in sort of not just liquid assets, but a total net worth picture.

Do you have, on the horizon, short-term or intermediate term liquidity needs? That’s going to impact as you’re weighing trade-offs where you would allocate capital? Happy to review all of that if you want to do sort of a full mock-up of assets, liquid and illiquid. I think some of those kinds of decisions need more full context, but I wouldn’t hesitate to own gold. I wouldn’t hesitate to own Treasurys.

I see Chris put up another question. Let’s look at that while we’re addressing Chris’s first question. “In the recent market downturns, gold and silver appear to drop at similar magnitudes. Does this indicate that the inverse correlation between equities and bullion is disappearing? Relatedly, are GLD and SOV becoming more risky in this deteriorating economic environment?” If you want to take a stab at that, I’ll sweep up and deal with the remainder.

Doug: I’m sorry, David. I was distracted there for a second. I thought that was your question. What part of that would you— I know—

David: Well, I’ll start—

Doug: —You mentioned before, gold and silver, they get caught up in this de-risking/de-leveraging, but it seemed a little random to me at the time.

David: Yeah. Yeah. Well, I’ll start, and maybe you can clean up then. Yes. Gold and silver, they can get caught up in de-leveraging, and a part of that is a question of who owns them and how they’re owned. And we watch the COT reports on a weekly basis, and so we can see where hedge funds and leveraged speculators are taking positions in metals, and they’re doing it, in that form, on a leveraged basis. They like the asset. Instead of the 16% returns we’ve had year to date at gold, I guess a little bit more after today, they’d like to multiply that. The beauty of leverage.

When speculation is put under pressure, the yen carry trade unwinding, as we’ve had in recent days, now all of a sudden you sell what you can, and typically de-grossing means you’re selling a little bit of everything. You’re selling everything across the board, bringing down your positions. And that would include the assets that you think have legitimacy in a portfolio going forward. You’re just having to de-leverage across the board, whether that’s to meet margin calls or just to avoid them, or what have you.

So I think there are periods of time where gold and silver move up with equities. What we’ve seen is that over longer periods of time, not necessarily on an individual day or over the shorter period of time, like a week, where they can move and lock equities down, gold down, on a longer basis, they do quite well. 2008, 2009 come to mind. That last quarter of 2008, gold did two things, very— This is, I think, very apropos. First, it sold off right alongside equities. Equities remain down, and you had your US equity market finishing the year down 30, 35%. You had emerging markets down anywhere from 60 to 80%. But by the end of the year, after that initial sort of knee-jerk sell-off, gold did recover and finished the year positive by 6%.

So there was this forced de-leveraging which did hit the metals. And then when people began to ask the question of will I get my money back, this is the question of counterparty risk, that— The first question is, which bets do I keep? Which bets can I maintain? How do I maintain them? Then the secondary question, once the dust sort of settles, managing the P&L, is to say, is my money still across the street at Morgan Stanley? Is my money still available at MF Global? Will I get any of it back? And that counterparty risk, I think, drives massive demand for gold. That is what happened late in 2008. And I think as I’ve talked to industry experts, in fact on the weekly commentary a few weeks back, I talked to Jeff Christian, who runs CPM group, he’s shared with us that the amount of buying right now by family offices and wealthy individuals has been very intense. And the first thing out of their mouths, and this goes back ,again, before the yen carry trade was even on people’s minds, the one word on their mind was counterparty risk, counterparty risk, counterparty risk.

So it’s there even prior to crisis, and I think that ultimately is something that maintains that inverse correlation. As it relates to GLD and SLV, I don’t think there’s concerns with GLD and SLV. There is sort of a preference being expressed in the bullion markets for physically deliverable metals as opposed to the ETF. And that, I think, is an expression of wanting greater control. I don’t think it suggests a weakness with the products as much as it does a preference for having something that is out of the system, out of the financial system. So anything you want to add?

Doug: Yeah, David, that was excellent. I was just going to add an example. There’s risk parity strategies. What risk parity does is it’s going to take stocks, bonds, commodities, precious metals. And since these assets are not generally that correlated, it’s going to leverage that strategy. Well, the problem is, when you get de-risking/de-leveraging, all of a sudden the asset classes become very highly correlated, and the losses mount, and even like a risk parity strategy has to rein in your risk. So gold gets caught up in just a general de-risking/de-leveraging where they’re going to sell gold not based on any preference, any view of the future gold price, but just because that strategy all of a sudden, the correlations are breaking down and they have to rein in risk.

We also know, the sophisticated players out in the world, they want to own a lot of precious metals, but they’re going to get caught in some of these trades and there’ll be hiccups along the way. And they’ll at times liquidate some of their holdings, and other times they’ll buy some holdings. So it’s not going to be a smooth line, but we certainly see it as a long-term store value.

David: Joe and Virginia ask, “the BRICs appear to grow larger each month. Is there a threshold of change where BRICs become the global economic driver? Could that happen in 2024? Is there a point where you sell off mining stocks and invest capital somewhere else? Why does silver keep losing traction?”

So there’s a couple of questions embedded there. I’ll start with the BRICs, and then circle back around to the other questions in a moment. You can expand the acronym from the BRICs to all emerging market economies. And when you do, whether it’s the MSCI index or the way the IMF and World Bank count them, it’s between 20 and 24 countries. That includes India and China. And that group is responsible for about 42% of global GDP, call it 45 trillion, roughly, out of 105 trillion. Again, these are rough figures, but 45 trillion out of 105 trillion, that’s coming from the emerging markets.

I’m going to use those numbers. You can find different numbers out there. The World Bank likes to use purchasing power parity, in which case the 42% of global GDP gets bumped up to 59%, but I’m going to use the unadjusted numbers, not purchasing power parity.

Emerging markets have for some time dominated GDP growth, and that’s a part of the argument that they’re making for a shift in the global currency regime. In the US, we’re 25 to $28 trillion economy. They are 45 trillion in aggregate. Then you count the other non-US developed markets, 77 trillion. And the issue on the table is kind of a fairness question. Is it fair that we only have 28 trillion, and yet the world’s currency regime is related to us? So if fairness or equality were the issue, then this is arguably an unfair system. I think the reason why it remains is because it’s a simple system. It’s efficient, and the dollar is an easier choice. It’s one number versus dozens, or hundreds even.

And so I think from a trade standpoint, the dollar has maintained its position as the key currency that you invoice in. Now, a little bit of a shift, the year 2022. That is a key year because it underscored the fact that there might be other motivations for diversifying away from the dollar. I think convenience is still a factor when you’re talking about international trade. But when the Treasury seizure of foreign-owned assets, that’s the Russian assets, when that occurred, it gave our trade partners pause. And again, there’s two different things going on here. The reserve assets, which have been coming down. We were 71% 20 years ago, we’re roughly 58% of all reserve assets today. So that number has dropped, but trade invoicing is still predominantly in US dollars. And I think it comes back to this efficiency and simplicity issue. The Federal Reserve tracks this. And between the US and Asia Pacific, 74% of export invoicing is in US dollars.

In the Americas it’s 79%. In Europe, it’s about 23%, which makes sense because as Europeans are trading amongst themselves, they can do it in euros. That’s pretty easy. But we’re still the dominant player in terms of trade invoicing. And I think it comes back to simplicity, crushed costs of capital flows in US dollar terms, and I think that’s still compelling. It does seem like our foreign policy decisions, our Treasury policies could really play with that. But for the time being, I would say that that tipping point is very far off. So the question about, could that happen in 2024, no. Now these are things that erode over time. I mentioned the reserve assets of central banks coming down from 71% to 58%. That’s been a 20-year process. So these things happen very incrementally.

The other parts of the question that we’re asked, at some point, would you sell off mining shares and invest capital elsewhere?

I think the answer to that is clearly yes. To the degree that precious metals are in a bull market, there is an argument to be made for owning the best shares in that space, the best balance sheets. They are far more volatile, they have far more vulnerability than the physical metal themselves. But as a growth play in that space, I think they do make sense, but not forever. And so, yes, there are other places, whether it’s geographies or asset classes, that make sense, and that’s something that is certainly on our watch list and on the list of things to do and bear in mind as we allocate assets.

“Why does silver keep losing traction?” is the last part of the question. And I would just sort of remind you both that, year to date, silver’s still north of 12% in terms of returns. Yes, it was up closer to 30% at its peak, and so yes, it’s given up some ground. It just tends to be the more volatile of those precious metals. It has an industrial component, so if there’s concerns about an economic slowdown, it does have some added vulnerability.

It is not owned by central banks. So being dependent on investor demand and demand, if investors get finicky or fickle about that, then yes, it can have some short-term vulnerability. Ultimately, the direction of gold, I think of it a little bit like the power of a train engine. Gold leads and silver follows. If you reestablish an upward trend in gold, silver gets in line. It may come around the corner later. There may be a lag time in terms of performance, but it has traditionally followed gold eventually.

The next question, Jonathan asks, “I think it is the case that Japan just recently injected more liquidity into its currency to stop a possible bond market meltdown. Is that correct? Is there anything Doug Noland sees on the horizon to indicate that it’s different this time with this time-honored and so far successful practice of central bank’s arresting asset depreciating events?”

Doug: Yeah, that’s another excellent question. Not surprisingly, the Bank of Japan has been really struggling, really struggling to get so-called policy normalization started after way too many years of hyper-stimulus. The disorderly yen forced the Ministry of Finance to repeatedly intervene in the currency market, selling dollars to support the yen. They purchased $41 billion in a single day back on April 29th. These are huge numbers. At the same time, they continue with their bond buying program. They’ve had yield curve control for so many years that they’re afraid that their bond yields could spike. So they continue with their bond buying program, which adds system liquidity. And this system liquidity just puts downward pressure on the yen. So this mix of policy, timid policymaking was just unsustainable. These huge yen purchases, which forced the sale of their international reserve holdings, were not halting the yen’s free fall.

So it became apparent that the Bank of Japan, that they needed to move more quickly with normalization. They needed to raise rates and reduce bond purchases. But the markets reacted so strongly to this change in policy, and this policy change came because they waited so long, along with weaker US data and the likelihood of a more aggressive Fed for rate cuts. And this all led to a big unwind of these yen carry trades that we’ve been discussing.

I do think it could be different this time. Actually, I do think it is. I’m just cautious because generally, it’s not. I do think it is. For starters, speculative meltups and leverage, they just went to such egregious extremes that they became unsustainable. We’ve now witnessed big reversals in the yen carry trade and tech bubbles. And the leverage speculating community, they’ve been hit with losses and I expect they’ll be managing risk more carefully now.

Some, I think, important risks that have been building under the market surface over recent months in particular, they have been revealed here the last week or two. So the odds should favor that we have passed peak speculative leverage, and I’ll come back next quarter and tell you if that’s the case or not.

That doesn’t mean there won’t be big rallies. Of course, these are unstable markets. There’ll be big rallies. But I expect, on the margin, the global market, that liquidity will be less abundant, and that will translate to less risk taking and leveraged speculation. And it’s this risk taking and leveraged speculation that is the key source of liquidity in global markets. And I also think that higher inflation, and that’s here in the US and in Japan and globally, that should impact central bankers willingness to adopt aggressive measures, rates and QE, at least initially.

I think they’ll be slower to react than markets want or are used to. And one of these days, I think we’re getting closer, we’ll see, bonds might even sell off on central bank liquidity operations, fearing potential inflationary effects. I would say there is much more uncertainty today, and that’s market economic policy, geopolitical uncertainty that the levered players, they’ll adopt a more cautious approach.

Furthermore, it should be clear to the central bankers that their liquidity injections and market interventions come with consequences. So they should be a little bit more cautious with these things, but only time will tell. Thank you for your question.

David: Another question. David asks, this is a tough question, “In which quarter do you think the gold-silver ratio will fall below 60?” It has been a few years since we’ve seen it at those levels, and I would want to say in which year. If we tried to answer that within the last 10 years, we might’ve even said, in which decade? The first target is 75, and that is, again, silver closing the gap and beginning to, like the caboose following the engine, get in line 65 thereafter. I wouldn’t want to combine timing and target both together. I think those are impossible things to predict. But in the 90 range now, you’re at the top end of the range, and 75 has been the most recent sort of low edge. That’s what I would be looking at. A break below 75 is really silver beginning to get into high gear, as we saw back in the 2009, ’10, and ’11 timeframe.

I’m going to wrap up just by commenting on something very quickly, and it is this. Doug, what you’ve been doing with the Credit Bubble Bulletin for many decades is documenting bubble dynamics, and I just want to note this for everyone listening today. There will be not one book, but there will be many books written about this period of time where many signs and signals were ignored and excess accumulated, and ultimately we saw an unwind of those excesses. And it was just last year, as I read through Edward Chancellor’s book on credit, that over and over again, I found Doug Noland in the footnotes. And I think that it’s not going to be one book, but it’ll be many books in which they will go for the resources to figure out what was happening, how it happened, and there you will be, footnote after footnote.

So for those of you listening, for you on the call, I want you to know that your participation in these calls, you’re going to reflect back on this, and you’re going to say, “I was there. I was there, I heard it, I knew it was happening, and I had the opportunity to do something about it.”

If you’re reading the Credit Bubble Bulletin on a regular basis, again, years from now, you’ll look back and you’ll say, “I read it routinely. I knew it was happening. I knew what I had to do.” And this is a very historic period of time. These excesses we’ve seen accumulate in the past, in 1907, 1929, many others if you’re talking about foreign markets as well. Of course, 2000, 2008 if you’re talking about here in the US in a more recent timeframe. You were there. You heard it. You heard it from the horse’s mouth.

Doug, I want to thank you for your intense scrutiny of details and the discipline that it takes to engage a tremendous amount of data over a long period of time.

You’ve done us a tremendous service, and again, I think it’ll be footnoted just how crucial the documentation was as it happened in real time.

So appreciate your time joining us on the call today. And Doug, thank you.

Doug: Thank you very much, David. And I will say I think I ended last year, or last quarter’s call, I sincerely hope that I’m wrong, and I sincerely hope that you think back on my work and chuckle. That is my hope. Thanks so much for being on the call everyone, and good luck out there.