Playing by the Old Rules
Merrill Lynch legend Bob Farrell famously said, “In a shift of secular or long-term significance, the markets will be adapting to a new set of rules while most market participants will still be playing by the old rules.” In HAI’s view, Farrell’s quote describes our modern moment perfectly. Indications abound that we’re in the midst of just such a major secular shift, and that a new set of rules is descending on markets—but most market participants are still playing by the old rules.
We appear to be living through the type of environment validating Vladimir Lenin’s observation that “there are decades where nothing happens; and there are weeks where decades happen.” These are the times in which to pay close attention. These are the times when a few short weeks can force turning points in long-term secular trends that catalyze the birth of new eras decades in the making. HAI doesn’t know exactly how current events in the Middle East will unfold, or if this week or next will represent one in which decades happen, but the table is set. We may well be living through a historic moment for financial markets in which the road ahead is very different from the one that brought us here.
HAI has long expected that the unsustainable policy, economic, and market dynamics of past decades would, at some point, culminate in a generational turning point. Regardless of which day, week, or month punctuates “the moment,” we appear incredibly close to a broad-based recognition that “we’re not in Kansas anymore,” and that, consequently, a new era, complete with new rules, has commenced.
Recent market moves reflect initial signs of just such a major market regime change. We’ve seen a dramatic shot higher in gold, oil prices have rallied, and volatility has surged as the VIX volatility “fear gauge” index has finally broken out over the key 20 level. On the flip side, stocks have sold off. Of significance, and counterintuitively, supposedly “safe haven” bonds have tanked as their yields have surged. Even the flight to safety into dollars has been uncharacteristically muted at a time when fear typically translates to a meaningful greenback bid. It’s a small sample size to be sure, but since October 7th, markets are displaying some notable behavioral changes. Most significantly, gold appears to be distinguishing itself as the safe haven of choice over both bonds and the dollar. Again, small sample size, but recent price action may be an important indication of where new paradigm trends are headed.
Geopolitical turmoil is usually an unsustainable stimulant for higher gold prices. They often spike on geopolitical concerns, but then drop—typically sooner rather than later. While the current set-up could certainly play out similarly, there are a number of critical reasons to suspect otherwise.
To begin with, the geopolitical flare-up in the Middle East puts oil prices at risk. Oil has already begun to move higher, but depending on exactly how events unfold, crude prices have the potential to run much higher. In the 1973 oil embargo, oil prices skyrocketed 279% in just 17 weeks. During the Iranian revolution, from January to June of 1979, oil gained 42% over 22 weeks. In response to the Gulf War in 1990, oil spiked 93% in just 10 weeks. During the subsequent 2002-2003 Iraq War, the threat posed to the oil market resulted in a 15-week 50% oil price surge.
Most recently, oil market disruption caused by the Russian invasion of Ukraine and the threat of further disruption hiked the price 38% over just three short weeks in the spring of 2022. At present, the Ukraine/Russia war remains an unresolved market headwind, and current oil supplies are worryingly tight. Any false steps from here in the Middle East could mean that the two-week 10% crude price gains we’ve already realized since October 7th are just the start of a much more significant and potentially sustained price spike. Recall that oil prices are the great inflation force-multiplier. If we have an oil price problem, inflation, by extension, will rapidly turn too hot to handle as well.
At the same time, as President Biden confirmed in his Thursday night address to the nation, more U.S. deficit spending is a natural consequence of a threat to Israel and a newly ignited flame dancing dangerously close to the Middle East powder keg.
We already have over $33.5 trillion in federal debt, deficits are heading toward $2 trillion, and interest expense alone amounts to $1 trillion. Meanwhile, the Congressional Budget Office is already forecasting that the debt and deficit blowout bonanza will accelerate as far as the eye can see, even while unrealistically assuming the existence of perfect blue-sky conditions in perpetuity. But with a new storm in the Middle East catalyzing a potential global hurricane, such a perpetual blue-sky forecast looks increasingly ridiculous.
As a result, the U.S. is now incredibly vulnerable to both a reinvigorated inflation crisis and a burgeoning sovereign debt crisis. In the face of both an elevated inflation risk and the certainty of the massive new Treasury supply needed to finance expanding deficits, the bond market is now in open rebellion. In order to take on the surging risk of supposedly “risk-free” U.S. debt, the bond market is now demanding dramatically higher yields as compensation. Gone, apparently, are the days in which the bond market willingly funds the government without requiring sufficient compensatory yields. Incentives are back, and risk/reward on U.S. debt suddenly matters again.
The crux of the problem is that if both inflation and deficits are a long-term problem, the Federal Reserve faces an untenable situation. Its governors face a problem unknown to them in the post-Bretton Woods “Fed standard” era. With debt levels so high and fiscal deficits booming, the Fed cannot increase interest rates as high for as long as might be needed to sustainably bring down inflation without causing government interest expenses—and by extension deficits and debt—to fully balloon.
In short, the Fed is backed into an incredibly tight corner. The Fed can either raise interest rates higher for longer to fight inflation—at the cost of a full debt and deficit doom loop that threatens insolvency—or try to keep interest rates lower for longer to avoid adding further stress to debt and deficits, at the risk of untethering both actual inflation and inflation expectations. In other words, monetary policy is severely compromised and may well be essentially broken. This is the new reality recent unusual market price action appears to be contending with.
The combination of inflation, debt, deficits, and broken monetary policy is the problem. The current Middle East crisis, with its clear and present threat to oil prices, higher inflation, and further increased government deficit spending is just a huge potential catalyst pressing the issue.
The wildly underappreciated risk associated with our increasingly obvious fiscal and monetary problems (currently inflamed by the Mideast crisis) has created growing potential for a critical breakdown of confidence in the efficacy of the old policy regime orthodoxy. Such a breakdown in confidence risks triggering a shift of massive long-term secular significance, and markets are starting to take notice.
Ernest Hemmingway, in The Sun Also Rises, described the process of bankruptcy as one that unfolds “gradually and then suddenly.” Market sentiment and confidence are similar. Sentiment can confidently hold fast to orthodoxy for decades, shift only gradually as underlying dynamics change, and then suddenly embrace a whole new view of reality. Currently we risk that sudden shift of sentiment and confidence.
Recent market price action and some surprising commentary in financial media both underscore the growing risk of a sudden shift in market sentiment and breakdown of confidence. Major market orthodoxies are being questioned, and markets are showing initial signs of re-equilibrating to an increasingly apparent new reality along with its new set of rules.
Last week, a Financial Times article reflected an uncharacteristic increase in mainstream awareness of the government’s fiscal and monetary problem. The article noted that the recent breathtaking plunge in U.S. Treasury prices reflects the fact that “Uncertainty around US solvency and/or political stability is higher now.” The FT went on to point out that “Extraordinary peacetime fiscal deficits require extraordinary bond issuance…[but] demand is not rising. At least, not at a pace that can offset the surge in supply.”
The problem the FT article doesn’t consider is that the higher yields necessary to incentivize increased Treasury demand would only add to the underlying debt and deficit problem. Again, what we’ve got here is an intractable debt and deficit doom loop with huge spillover consequences into deeply compromised monetary policy. Market participants, however, are increasingly waking up to this reality.
On what to make of the serious Treasury market dysfunction we are now witnessing, the FT arrived at the following remarkably casual and complacent conclusion: “The Treasury market’s global centrality makes a true breakdown unthinkable; anything approaching one would force the state to act.” Consider the implications of this statement. It is the epitome of analysis based on the old rules. Any such state action would do nothing to solve the underlying problem. The best the state could do at this point is effect another “extend-and-pretend” can-kick with attendant inflationary consequences. That would occur at the very time when Fed monetary policy—specifically its inflation-fighting interest rate brake—is broken.
To be successful, such a government can-kick requires that the market be confident that it will work, at least temporarily. But growing awareness of underlying government fiscal and monetary problems, and increased recognition of our fragile vulnerabilities to stressors such as the Middle East flare-up, severely challenge such confidence.
Those underestimating the critical importance of shifting market sentiment and an erosion of confidence in government half-measures or extend-and-pretend schemes may be making a fatal error. As John Hussman explained in his latest note, “The value that investors place on paper currencies and government debt is a function of confidence in long-term fiscal and monetary restraint.” Needless to say, broken policy, increasingly obvious for anyone to see, inspires no such confidence.
Hussman went on to cite the following crucial observations from noted economist Peter Bernholz:
“There has never occurred a hyperinflation in history which was not caused by a huge budget deficit of the state… In all cases of hyperinflation, deficits amounting to more than 20 per cent of public expenditures are present. We’ve exceeded that level in each of the past five years—even in 2019, before the pandemic—but that in itself provides no information about whether or when we might observe a break in confidence.
“The sand pile can tolerate a persistent trickle of expanding debt, loose policy, extreme overvaluation, and banking losses for quite some time. Ponzi schemes can go on for years. All we might observe for a while are a few localized ‘tumblings’ like Silicon Valley Bank, or a temporary spike in inflation, and we might imagine that everything is contained.
“Meanwhile, risk quietly extends across the whole system as a ‘skeleton of instability.’ When a confidence bubble finally breaks, it tends to break abruptly. The unwelcome consequences can further undermine confidence and amplify the crisis, as they did with inflation in the 1970s, tech stocks in 2000-2002, and the global financial system in 2007-2009.”
The prerequisite for crisis is already fully in place and mature. The table is set. The events in the Middle East risk forcing the issue, but whether the Mideast crisis calms or intensifies, the current crisis is delivering a wake-up call for markets. Fundamental assumptions are being examined. Confidence is being questioned. Market participants are increasingly recognizing that the rules of the old orthodoxy are being replaced by the new paradigm born from a new reality, complete with new rules. The ultimate bubble of our time has been a “confidence bubble,” and recent indications are that it’s popping.
In a recent Wall Street Journal op-ed, Kevin Warsh, a former member of the Federal Reserve Board of Governors and the presumed GOP front-runner for next Fed Chair, expressed deep concern over the problematic trajectory of fiscal and monetary policy. Warsh sees “a gusher of new debt” being thrust upon a demand side from which the old price-insensitive buyers “have largely exited the market.” His worry? Warsh fears that the new “purchasers of Treasury debt will demand higher yields, at least until something breaks in the economy.” While Warsh noted that he hopes the current business-as-usual policies in the U.S. can find an optimal path out of the minefield, he warned ominously that, “it would be Pollyannaish to bet the country’s future on it.”
Again, confidence in government extend-and-pretend schemes is the ultimate bubble. That confidence, however, is waning. As the old orthodoxy transitions into the new paradigm, HAI expects effective safe havens will be sought aggressively. In such an environment, gold as financial insurance, a store of value, and an asset void of counterparty risk is likely to shine bright as the best risk-adjusted bet. Indeed, a golden moment may be at hand. That said, circling back to the timeless wisdom of Bob Farrell, in HAI’s view, its best to explore allocations in gold and related assets while most market participants are still “playing by the old rules.”
Weekly performance: The S&P 500 was off 2.39%. Gold was higher by 2.72%. Silver gained 2.62%, platinum was up 2.36%, and palladium was lower by 2.97%. The HUI gold miners index gained 2.28%. The IFRA iShares US Infrastructure ETF was down 2.69%. Energy commodities were volatile and mixed on the week. WTI crude oil gained 0.44%, while natural gas tumbled by 10.41%. The CRB Commodity Index was up 0.72%. Copper slipped 0.20%. The Dow Jones US Specialty Real Estate Investment Trust Index lost 4.72. The Vanguard Utilities ETF was lower by 2.06%. The dollar index was down 0.25% to close the week at 106.16. The yield on the 10-yr U.S. Treasury surged 30 bps to end the week at 4.93%.
Investment Strategist & Co-Portfolio Manager