Trapped! Are You In An Illiquid Fund Full Of “Ghetto Bonds”?

Weekly Commentary • Jul 02 2019
Trapped! Are You In An Illiquid Fund Full Of “Ghetto Bonds”?
David McAlvany Posted on July 2, 2019
  • Trump’s best cheerleaders & supporters – The angry, crowded democrat candidates
  • DOW has best June in 81 years (on low volume) Safe haven investors flee into cover
  • Will SWIFT be swiftly replaced?


The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Trapped! Are You In An Illiquid Fund Full Of “Ghetto Bonds”?
July 2, 2019

“They’re looking for things that do continue to make sense because they are real and basic in the context of things just getting crazy. Please, don’t ignore some of the ‘masters of the universe’ and the fact that the world is getting topsy-turvy, but there are still some very clear-headed things that can be done.”

– David McAlvany

Kevin:David, honestly, I get so bored with politics. I hope that this program never becomes like a lot of the political programs that are on the radio. Not that there is anything wrong, but if you need three hours of your side cheering for your side, that’s where you go. If we’re here, we can make political comments, and I’ll tell you, I watched the debates the other night, and I realized at this point Trump may not need Powell to lower rates after all to get re-elected. I think the Democrats, the way they bicker with each other right now, are going to do it for him.

David:I know. You have Trump, who is wanting in the U.S. to have the equivalent of a Mario Draghi, the head of the European Central Bank, that type of person, at the helm of the Federal Reserve so he can lock in his re-election bid. And I understand that, but Powell is not a guarantor of either Trump’s victory or defeat. You’re right, when you judge the Democratic debates this last week, you have the myriad of candidates all competing for the oval office, they’re competing with each other for various versions of shake-down socialism.

Kevin:“How can we give everything away for free and still get elected?”

David:They may do more for Trump’s campaign than easy money policies can. One headline read, “Democrats Split on How Far Left to Nudge the Nation.” This was a comment from our friend, Bill King. He pointed out that, “A vote for Trump is really a vote for a firewall against extreme socialism.” Back to our conversation with Pippa Malmgren when she drew the distinction between fresh water and saltwater types, and the fresh water Americans are the non-coastal states. I think those in those areas who voted for Trump and may vote for Trump in the next election, it’s not that they’re voting for Trump as much as they are voting against the perpetuation of a nanny state bent on redistributing assets. And that is what you had on display with all the 20-odd people arguing for whose assets they can take and give to whom.

Kevin:Did you see Bernie Sanders? He said, “We’re going to tax the middle class.” Oh, now, that’s wise.


Kevin:They asked Biden what his first agenda item would be when elected president and he said, “Defeat Trump.”

David:Yeah, there’s a guy who is really connected.


David:So it’s not a surprise that you have Trump’s odds of re-election went from 45% on Friday prior to the debates to 52% on Saturday morning the day after. His odds are increasing and all that is improving his odds of winning the White House, again, is the Democrats blathering back and forth against each other.

Kevin:If Trump was wise he would actually sponsor some of these and get these on. The more Democratic debates, the better.


Kevin:Going back, we were talking about Federal Reserve presidents. Mario Draghi in 2011, we’ve talked about before, he came out and said, “We’ll do whatever it takes.” Obviously that meant, “We will buy everything out there – bad, good, whatever.” But here in America, Dallas Fed President, Robert Kaplan, this sounds under-stated when you listen to this program and you hear what he has to say, but he actually was making sense. He said, “We may be contributing to a build-up of excesses and imbalances in the economy at this point if we cut rates.

David:Occasionally you see some reasoned thinking come into the conversation with the various Fed presidents, and this one I thought was very good, a paper that Kaplan wrote. The paper he published was asking the question, “Stimulus at this juncture – isn’t it going to contribute to a build-up of excesses and imbalances in the economy?” And the answer is yes. He suggests that if we continue to build those excesses and imbalances, they will become difficult and painful to manage. Just a moment of sobriety, what some would interpret as a hawkish statement, but it is just asking the question, “Can you do this forever?” Whereas the doves would say, “No, you have to be loose, you have to be accommodative, you have to make sure we never get in a tough spot.”

Kevin:Okay, but let’s look at excess. Just a month ago we said the old saying on the stock market is sell in May and go away. I guess those excesses actually changed that statement.

David:Fox business pointed out that the Dow had its best June in 81 years and the S&P 500 had its best June in 64 years. So yes, the idea of sell in May and go away, while there is wisdom attached to it, and it is generally helpful – not this year. Instead, we have a low-volume rally in price, which can be pretty dangerous if you are talking about coming into the summer months and a pretty radical increase in price, but not on strong volume. Low-volume rally in price is aided by your super-low interest rate structure. Ours are reasonably accommodative, and if you are looking globally, it is accelerating things like the issuance of junk bonds.

Kevin:The other bond market is singing a different tune.

David:Yes, and it is also feeding the appetite for investment-grade bonds, which are obviously a bigger income stream relative to your sovereign debt markets. But again, if you’re talking about a lower structure of interest rates globally, it is feeding imbalances. It’s feeding a misdirection of capital. Sovereign debt from across Europe and the move into sovereign debt by your central bank community is reshaping the fixed income landscape.

Kevin:Well, sure, because 13 trillion dollars now is yielding negative returns. When you have a central banking community that buys all the bonds, the bonds don’t have to offer interest.

David:I was on a portfolio management meeting call this last week, and I mentioned 11.6 trillion in negative yielding bonds, and Doug Noland was kind, but had a little bit a scolding tone in his voice, and said, “Dave, that was several weeks ago. It’s at 13 presently.”

Kevin:Wow! Wow!

David:I said, “Okay, 13. I’m wrong. It wasn’t 11.6 trillion.” But yes, when you have sovereign debt from across Europe reshaping the fixed income landscape, it makes things here in the U.S. look downright generous by comparison. So not only do we have positive nominal yields, but our ten years is still above 2%. We’ll get into this a little bit later, but relative to the rest of the world, we’ve got pretty juicy yields.

But again, in a low rate environment, we mention access for junk borrowers. You have a lot of new issuance from junk borrowers, folks that need to raise capital and do it at a higher interest rate. But it is also worth reflecting on what this low interest rate structure has done to accelerate and enhance and underscore the IPO environment in the last five years.

Kevin:Do you remember the late 1990s when you could pull anything up and do an IPO, and whoever was on the IPO, whoever could invest in it beforehand, would get rich as long as they sold within a couple of hours. IPOs are an amazing way to just hand your friends your money, initially. And what we are seeing now is the same type of environment. Just bring something out for initial public offering.

David:Yes, year-to-date, you have the best IPO environment that you’ve had in the last five years. Baker-McKenzie, who have showed a total of 62 IPOs so far this year, raising 25 billion. And actually, that is just in the second quarter, that is not year-to-date. That’s 62 IPOs in the second quarter raising 25 billion, which is a pretty good pace.

Kevin:So, those are some of the imbalances that maybe Kaplan was talking about. But what bothers me, Dave, we have talked before about this passive investing environment where a person doesn’t actually go buy the investment anymore, they just put it into an ETF, or they put it into something where they can say, “I’m not going to go buy bonds, themselves, I’ll just buy an ETF that buys bonds.” The problem is, they are assuming liquidity when they want to get out.

David:Mark Carney has been particularly critical of this, at the head of the Bank of England, looking at the structural problem where funds are flowing into products that don’t have the implied liquidity. They don’t actually have the liquidity that the structure implies. So your modern-day conservative investor is seeking the comfort, today, of a larger bond allocation, a lot of that via ETFs, and the structure of those products is mismatched with the nature of how bonds trade.

Again, what you have is the implied liquidity in a basket of assets. That is not consistent with the relatively illiquid nature of bonds. There is a fresh record high here in the last week that ETF bond funds have seen continued inflows, year-to-date 72 billion dollars, new all-time high, 741 billion, into those products, in total. And those products have only ever been tested in an environment of long-term secular downtrend in rates.

Kevin:Yes, 35 years of downtrend in rates. You don’t have mass bond exodus when people are continually seeing the rates go down because they are holding those bonds at higher and higher rates. What happens when interest rates reverse? There are going to be people who actually want to get out of those bonds. What if they all want out at the same time?

David:Yes, and this is where selling by appointment is not a concept that an ETF investor is used to, but sometimes it is not the click of a mouse. You have to schedule it in order to liquidate, and you may not get the best bid. So there are dynamics that are…

Kevin:Well, mutual funds are also like that, are they not?

David:Right. Well, Bloomberg points to mutual funds, and this is a staggering figure, but what has evolved, and maybe arguably devolved, over the last 10, 11, 12 years, is that mutual funds are holding more and more corporate bonds on their balance sheets. So it used to be that dealers would keep an inventory, and we’ve talked about how that has changed dramatically, to go back to our conversation with Richard Bookstaber. He would say, “We changed the incentive structure for the folks who would have inventoried stocks and bonds, and there is not as much incentive to be a market-maker today.

Kevin:You penalize the middleman.

David:The market maker in the bond market is called a dealer, and dealers today hold a lot less in corporate bond inventory. In fact, mutual funds now have 43 times more corporate bonds on their balance sheets than dealers do, compared to just two times back in 2007. Part of it is the dealer is holding less, and part of it is the mutual funds holding more. But we’re back to that same issue of a mismatch of the structure and the items that are going into the structure. The structure implies liquidity but the items going in don’t have inherent liquidity, and this was fascinating.

Kevin:And so, what you’re saying is, Mark Carney, President of the Bank of England, is basically at this point saying, “Hey, there might be a problem here, guys. We’re seeing these markets buy up an awful lot of illiquid assets at times – at times, illiquid. What if somebody wants to sell this in large order?

David:And frankly, it’s not just a hypothetical for him because in recent weeks the flag has been raised over a particular fund and this is, in my mind, the supreme irony of the second quarter. If you close out the second quarter and go into the second half of the year, Mark Carney from the Bank of England is chastising this fund for holding illiquid assets, but allowing for unlimited withdrawals, so the assets inside can’t be sold at a moment’s notice, and yet the structure of the fund says that you can sell as much as you want and get as much liquidity as you need in an instant, and it’s just not reasonable.

So he says that this fund, in particular, is problematic, but that the risks like it are, in fact, systemic. So you have 30 trillion dollars, he points out, now tied up in difficult-to-trade instruments – 30 trillion with a “T” – not million, not billion, that was trillion with a T. And yes, if you, the listener, can’t wrap your mind around 1 trillion, neither can I – 5 trillion, 30 trillion – it’s just a big number.

Kevin:Well, each time you multiply it by 1,000. So a million times 1,000 is a billion, times 1,000 is a trillion.

David:And this is 30 of those. So Mark says that there is a lot of that money in mutual funds and exchange-traded products owned by mom and pop investors. It is raising questions of who is responsible for keeping investors safe from having liquidity dry up at just the wrong time. Again, this is why I call it the supreme irony of the 2ndquarter. Guess what the name of the fund was investing in high-yield bonds that are at present illiquid?

Kevin:I don’t know.

David:H2O Asset Management.

Kevin:(laughs) H2O Asset Management – oh my gosh.

David:Having liquidity problems, are we?

Kevin:You know, part of art is irony, but this is beyond irony. It’s ridiculous.

David:I know, it was funny. So you have the attractiveness of lower quality credit, and the attractiveness of that credit is being defined by the relative relationship to government bonds, government-issued paper. This is where the ECB is very significant, the ECB and other central banks, as well. Buying government paper, you have individual investors squeezed out of safer income streams, they are forced to look at less safe income streams, and to get their income needs met elsewhere.

It’s a crowding out effect, or if you want to think of it as a knock-on effect, I think it’s a very profound one. It’s a central bank making a policy choice which alters investment behavior, and the net result of central banks stepping in as the artificial source of demand in the bond market is a much riskier environment altogether, with an under-appreciation for the risks being taken by, as Mark Carney called them, the mom and pop investors. And I think he rightfully points out, “Who is responsible for keeping them safe?”

Well, ultimately, I think we know where this ends – massive bailouts, even more money-printing, as Doug Noland suggested, having our central bank go from a 4 trillion dollar balance sheet to a 10 trillion dollar balance sheet. There will be no surprise when that happens. And by the way, there will be some sort of mirrored response by the ECB, the BOJ, etc., etc., savior of all, knight on a white horse for anyone in distress – today’s modern central banks.

Kevin:Using the metaphor of the last ten years, especially the last eight years when interest rates continued to drop, and then by 2015 they went to negative rates. It’s a little bit like being in a market. Let’s say that you are retired and you have savings. You need someone to loan to who will pay you interest so that you can get some income. And then, the giant steps in – the European Central Bank, or the Federal Reserve, or you name it, the Bank of Japan, the People’s Bank of China. They step up to the same market device and they say, you don’t have to pay interest, we’re just going to buy them anyway. We’re going to buy those bonds.

Well, here you are, you are a retired person, you need interest. You need to be able to loan it to somebody. What happens is, you end up having to go to the ghetto bonds, the guys who you absolutely know in the end are not good for it. You have to loan them the money so that you can eek out just a little bit of an interest rate. This is a crime, Dave. What it is doing – you said it yourself – these people are being squeezed out of the income that they could have from a relatively save investment by investors like these central banks that can just print money and do it as long as they would like because they can make more.

David:Repression is redistribution. That’s what it is. Repression of interest rates, repression within the financial markets is redistribution. The savers, the person in the middle class living on a fixed income, that is having a revenue stream that would have been theirs go to subsidizing a larger stock of debtors.

Kevin:And they are going to have a hard time selling even the ghetto bonds when the time comes.

David:I like the way that you have described that, because high-yield is a euphemism for junk bonds, and junk speaks to kind of the quality of it, and you could say one man’s trash is another man’s treasure. But calling them ghetto bonds (laughs) kind of creates a visual. You say, “Yes, it’s a little rough. It’s a little rough.” And the fact that ETFs and mutual funds are the vehicles seeing massive inflows is extra disturbing because it reinforces a financial market design flaw.

This is really the point here. You have well-functioning robust financial markets in one environment, and they become extra dysfunctional when the flows of capital move in reverse. Again, as long as you have a buyer’s appetite, these vehicles work well. But when sellers become dominant in the marketplace, this is where the dysfunction and the capital in reverse reveal the weaknesses in the structures.

Kevin:So this is what Carney is addressing.

David:That’s his point – 30 trillion dollars in capital which works functionally under the best of circumstances, doesn’t behave as well under the less than ideal circumstances. This is what we have in the making. We continue to add to misallocation of capital and pretend as if capital only flows one direction. Well, anyone who has been around more than a day on Wall Street knows that is not the case.

Kevin:So we’re hitting 81-year records for June in the stock market, so equity is melting up, basically, at the same time that there is a lot of money going into the bond market right now. So you have these two things going on at once. We’ve seen this before.

David:Yes, and as we have talked about last week, there are multiple people, multiple audiences if you will, or buyers, coming into the bond market. The segment that is the most interesting to us is the segment that is seeking the safe haven aspects of particular bonds – not all bonds, but particular bonds.

Kevin:Does this smack of 2007 to you?

David:In some respects, you’re right. We’ve been here before. Back in 2007 the world watched in amazement as our financial markets were melting up, and the bond market at that point was less enthusiastic, and it was signaling that maybe you needed to move to higher ground. Maybe you need to consider safer territory. Maybe you needed to take some risk out of the equation.

Again, it was the bond investor while the stock market was partying like it was 1999. S&P was motoring higher. Sophisticated market operators were moving out of high-risk areas, and you were seeing rate compression again, so the value of a bond is going up as people are buying it and rates, the interest that you receive on that bond, are coming down as an indication of strong demand for that asset. That was in full swing as investors were trafficking into bonds. And it’s kind of what we have today.

Kevin:But haven’t we been talking about credit expanding dramatically? Wouldn’t you think interest rates would be needing to rise as more and more people are seeking credit?

David:Well, it is difficult to see interest rates rise in an environment where you have an artificial buyer. And as Doug Noland asks this last week in the Credit Bubble Bulletin, “Why were yields collapsing in the face of booming credit growth and inflating risk markets?” Because the preservation of terminal phase excess was fomenting a late cycle parabolic rise in systemic risk. You have inflating quantities of increasingly risky credit instruments, you have dysfunctional risk intermediation, destabilizing market speculation, and extreme late cycle imbalances. In other words, the bond market was discerning an increasingly untenable situation.

Kevin:You’ve been talking about bond vigilantes. The bond market is a little bit more of a signaling device than, say, the equities market is. Are we seeing a signal?

David:As we discussed last week, the signaling function of rates with higher yields and widening credit spreads indicates stress, and that is an important dynamic to remember. There is also the indication of traffic, a different kind of signal, into perceived safe havens, which marks lower rates and higher prices, as you see demand increase for safe havens. So that’s the signaling function we have today. Investor enthusiasm for stocks is running in parallel with safe haven buying of bonds, and it is in a fairly incongruous message that the market is operating and communicating today. I think if past experience offers any wisdom, the bond buyer and the price action in bonds today is offering up a pretty bad omen.

Kevin:So in a way, if you had to picture it, it’s like a bunch of people are running onto the Titanic at the same time there is a whole different group of people who are lowering the lifeboats and getting off.

David:Yes, and the beauty of that analogy is that the people who are clambering onto the boat are fascinated with all the new whiz-bang gadgets.

Kevin:They’re listening to the music, and drinking the wine.

David:They love that. It’s a luxury cruise and everybody has the money to enjoy it. The people getting into the lifeboats are the boat operators, which should suggest something to you. You have the non-sophisticated, therefore the appeal of “Isn’t this great? I’m just loving the experience,” while the operators are saying… (laughs)

Kevin:Look at the central banks. The central banks last year bought over 70% more gold than they did the year before. They are part of the operators, but also, there are big name investors who we have seen in the past have a tendency to know ahead of time the signals, and some of those big name investors right now are showing up in gold.

David:And they have been, actually, for a couple of months. Last week was very interesting because you saw an allocation to gold in smaller numbers – call it the investor class, the street level investor class here in the United States – a billion dollars of in-flows into GLD last week.

Kevin:And that’s the smaller investor?

David:I think so, but at the same time, you have had, as you mentioned, the chorus of hedge fund guys interested in gold, and that number – the members of the chorus, so to say, is growing. You have Jeff Gundlach and Kyle Bass and Ray Dalio and Stanley Druckenmiller, a few notable names, interested in gold as one of the best trades of 2019.

Kevin:Interested, even though we now know again, and again, and again, that gold is a manipulated price asset. When you can trade hundreds and hundreds of times the amount of actual physical metal on paper – look at Merrill Lynch. You can naked short the market anytime you want. You pay millions in fines when you get our hand slapped, and you make billions in profits.

David:And I think this is the message. You’re talking about the DOJ prosecution of Merrill Lynch for manipulating precious metals prices.

Kevin:“Bad boys. Bad boys. Stop doing that.”

David:It wasn’t like once and they caught them, but they were being scolded for having done this thousands of time over a seven-year period. And in recent days Merrill agrees to pay 25 million dollars – million with an “m” – million in fines connected to deceptive trading practices, spoofing and things like that. So the time period in question, 2008-2014, lots of downside volatility in the metals market as you got into the 2013-2014 period, lots of upside market movement in the 2009-2011 period. So there are thousands of what the DOJ called fraudulent orders which they are being held responsible for.

And it brings to mind, who else trades the metals in these markets? Who else has mastered creating false impressions of supply and demand? And where else is the manipulation of price a common effort? This is where, again, your point well taken, 25 million is a pittance. On that basis, you have just told the investment community that the commodities pits is the place to play games of price manipulation because profits are in the billions, fines are in the millions. That is, by definition, regulatory and market arbitrage.

Kevin:You told me when you were traveling in South America, one of the smaller countries in South America, you actually had to keep cash with you because when the cops pull you over – it’s just assumed, you’re going to get pulled over, first of all. And it’s also assumed you’re going to pay them off so that you can keep going down the highway. It’s almost like a toll. Don’t you think, in a way, 25 million dollars – they make that on a single trade. This is a toll booth – that’s really what it is.

David:Did I ever tell you the story about getting pulled over in Paraguay?

Kevin:Yes. I didn’t want to name the country, but you named it.

David:So I’m there in Paraguay with a good friend, and we get pulled over. And I don’t think I was speeding, but I started talking to this guy and he said, “Well, here’s the ticket, and these are big implications, and I can’t believe you were doing this, and if you’ll just provide…” – I don’t remember, I think it was $500 – “We can make this go away.” I was like, “$500 U.S.? Not a chance, I wasn’t speeding!” So we go into this debate. I’m debating with the guy. Who knows? I mean, he could drag me out into the weeds and shoot me in the back of the head.

Kevin:I’m sure Mary-Catherine was really happy that you were debating with a cop in Paraguay.

David:But she wasn’t with me. It was a fascinating conversation. I had a satellite phone that was not working, and I pulled out a business card that I had of a local lawyer in town who was very well connected with some of the local judges. And I said, “Let me just get a friend on the phone. He needs to talk to you about this, because what you’re doing is illegal.” It was a Mexican – not a Mexican standoff, I’m sorry, it was a Paraguayan standoff.

Kevin:(laughs) Okay, so is Merrill Lynch doing the same thing with the DOJ?

David:Again, I think what they have said is, “This happens. We won’t let it happen again.” But for 25 million dollars, of course it’s going to happen again. If they had said it’s 500 million, or it’s a billion – it has to be a sizeable enough number that people say it actually doesn’t pay to play. In this case it really does still pay to play the game of price manipulation.

Kevin:And they probably will. But we can’t live in a bubble anymore. The world is a so interconnected at this point, if you have equities going up and bond yields going way down, which shows that there is a flight to safety, that may not even be a factor of something happening in this country. It may be something happening in another region of the world.

I’ve been brushing up a little on financial market history from the mid 19thcentury. There is a series of crises that occurred, and it is fascinating as you look through the annals of financial history, nothing is new. There are variations on a theme and the idea that it doesn’t repeat but it rhymes. There are enough similarities that you can learn from various circumstances and apply that to present and future circumstances.

Kevin:And you’re reading Jim Grant’s book before we get to. You’re getting to pre-read a book that I would love to read. So what are you learning?

David:I’ve got an advanced reader copy of The Biography of Walter Bagehot, who was the first editor of the Economistmagazine.

Kevin:Which was a conservative magazine back in the 1800s.

David:Yes. And what I find fascinating is the world then was a slightly lesser developed, completely globalized world. So again, everything was on a smaller scale, a lesser developed phase of globalization than compared to now, but the financial system was powerfully interconnected. In the late 1840s you had a tremendous amount of stress in the U.S. markets and again, the signaling function, you have interest rates in the United States which vary. If you are funding a corporation they varied from 18 to as high as 60%. So it’s chaos. And real stress. But that gets translated, it’s quickly apparent in the London markets, as well.

Kevin:Across the Atlantic. There was no telegraph at that time either.

David:And you have London dwarfing the U.S. at that stage in terms of size and scale, but the lesser sized financial market disturbances in the U.S. led to British extreme interventions in the money markets and the impact in interest rates in a very powerful way. Things function differently, of course, during the gold standard period, and under the gold standard central bank activism looked different. You still could be activist, but credibly active, in this case. Lending rates set by the Bank of England were raised from 5.5% to 11% over a 60-day period – 5.5 to 11, that’s a radical shift.

But that was to assuage panicky investors, to keep them interested in their pound sterling holdings and to prevent a mass exodus from gold within the banking system, because anyone could come in and say, “I want my deposits back.” What were your deposits? Well, you could take them in the form of gold, and if you had too much gold leave the system, now you have a real issue. So the way that they induced people to stay in the system was to pay them more in interest. In this case, 5.5 went to 6, 6.5 went to 8, 8 went to 9, 9 went to 11%, in a 60-day period.

Kevin:So let’s go back to the 1800s. Somebody sneezed in the United States, and England caught a cold. In this particular case, we have been seeing what has been going on with the banking in China. You mentioned last week the too-big-to-fail in China. The big banks are getting the bailout money right now. The little banks are liquidity starved.

David:We’re at a more advanced stage of globalization. In some respects it is different. In some respects it is even more interconnected today.

Kevin:Twitter diplomacy. Remember when you were talking to Jervis? It’s instant.

David:Right. So the credit markets in China, I think, do offer a parallel of that 19thcentury market bruising, and perhaps even more so today given the interlinkages. The interlinkages in the global financial system are very tight and the response time is instantaneous. The primary take-away, as I’m reflecting back to the late 1840s is that we live in an interconnected world. What happens somewhere else matters. And what is happening in China at present is absolutely important for the U.S. and for the European financial markets.

And the reality is, the Lehman moment may already have occurred in China, with the impact in European and U.S. markets. In fact, it may be in motion as we speak. If you remember, between the time that Lehman occurred and the full-blown meltdown you’re talking about a 12-18 month period of time. But safe havens, we talked about just a moment ago, are catching the attention of astute investors the world over. The equity party is continuing even as you are seeing some sobriety in the making. That is making a comeback in other quarters of the world.

Kevin:What you are referring to, the Lehman moment, we actually had started the Commentary by the time the Lehman moment occurred, if you recall, in 2008. But actually, the Lehman moment had started a year before with Bear Stearns coming out and trying to sell bonds. I remember – boy, I’ll tell you, I called clients and said, “They just tried to sell 400 million” – with an m, it was a small amount – in bad bonds, bad debt, and they couldn’t do it. So they immediately said, “Oops, never mind, we didn’t mean that.” And they pulled it back off the market. But it sent a signal that at this point these big firms are going to be in trouble. Now, Lehman was the one that was not bailed out. But we saw bailout after bailout after bailout going that way. And we’re seeing this in China right now. China, in May, bailed out a massive institution.

David:It is fascinating, when you look at Bear and Lehman being at the receiving end of hardship when others were bailed out – shotgun wedding style, perhaps, but they still were accommodated in some way. Well, Lehman and Bear were firms that didn’t pony up and participate in the old boys bailout club during the Long Term Capital Management incident.

Kevin:So they’re the ones that got punished.

David:Yes, absolutely. It was an internal market discipline. It was the old boys’ club saying, “Next time we call and we ask you to pony up, you pony up. Because this time we’re not. And we don’t care what happens to you.”

Kevin:Is that happening in China right now?

David:Well, what is happening in China is the Lehman moment in the sense that you have the first bank to go. Baoshang Bank was taken over by the Chinese government in May. Earlier in the year you had Anbang Insurance just months before that, but now it’s Baoshang. We mentioned the interventions of the PBOC, the People’s Bank of China, last week, to the tune of 45 billion U.S. Unfortunately, that liquidity is only circulating in the biggest of Chinese financial institutions. You have the small banks and the non-bank financial firms which are still liquidity starved. Baoshang has everyone in China thinking differently about risk and credit quality.

Kevin:Nobody has packed up their brown box. They haven’t packed their desk up. The government came in and took them over.

David:That’s right. You’re just talking about a tone change, and it is similar to Lehman in that prior to Baoshang counter-party exposure was not a primary consideration. Not it is. Who is on the other side of a transaction is now very important. If liquidity is in the system it is not going to certain people because now people are asking, “Should they get it? Will we get it back?” Again, it is just a tone change where counter-party exposure is a primary consideration today. Six months ago it wouldn’t have been. And I think that is a tone change, like Lehman.

Kevin:And it’s not just banks. It’s trust companies. It’s other types of institutions that are starting to fall off the cliff.

David:Financial Timespointed out a significant Shanghai listed trust, and it’s pretty rare for them to default, but because the company was Shanghai listed we got a little bit more clarity as to what was going on, who they were lending to, some insight into what went wrong for the trust company. Suffice it to say, you have lots of loans for real estate development in China.

Kevin:This is their subprime, right?

David:You can think in those terms. And these are real estate loans that were probably not economically viable from the start, so like Baoshang, I think what the trust company failure points to is a tone which is changing and a caution in lending, again, more of a factor today than it was three to six months ago. What are the implications? Caution slows volumes and volumes dictate market pricing of assets. So that is, I think, an important thing. When you start to slow down this grand credit machine there are implications because caution slows the total volumes of transactions, and the volumes of transaction dictate the market pricing of assets and the terms on which those transactions occur.

Kevin:Well, going back six or seven months ago, you remember December was a dangerous period of time to be in the markets because it looked like we were having the downturn we are talking about. China came out in January and just went whoosh!The just threw tens of billions of dollars into the market. This expansion – you have these two things going on. You have the debt getting worse and worse and worse, but you have the expansion of the very debt we are talking about.

David:So major expansion of credit in China drives economic growth rates. That’s the intention. Keep those high, keep them focused on a six above number in terms of GDP growth. Maintain positive atmospheres. And here is where we can even see cracks – we’re seeing cracks in the structure of the financial markets, which suggests that other challenges lie ahead for them, and for us. And for us.

Last week we discussed the cost of shipped goods. We talked about the Cass [Freight Index]. We talked about the Baltic Dry, the various freight numbers, both international and domestic trucking rates – we mentioned those, as well. Again, just a further indication that financial market frailty is one dimension of concern, but you also have the global economic activity which is also a real issue to watch. I think right now you need to watch it like a hawk. From this point of view, you have Chinese imports falling rapidly.

And you might say, “Well, yes, that’s not a surprise. We’re in a trade and tariff war with China.” So the import numbers from the U.S. are down 27%. What is surprising, and Bloomberg pointed this out, is a drop of 16% in Japanese imports into China, a decline of 18% of imports from South Korea into China. Again, slowing trade is more and more broad-based. So earlier today we talked about the financial structural issues, structural issues within the financial markets.

The things we are a talking about now reflect a slowing of the global economy and it is apparent that it is not countries that are just caught in that trade and tariff debate. Add to that, merger and acquisition activity here in the second quarter, actually, in the U.S., pretty consistent with the IPO activity.

Kevin:So, it’s boom.

David:Yes, fairly robust. MNA activity is down a few percentage points quarter-over-quarter, if you’re talking U.S. whereas IPOs are pretty robust. But the MNA merger activity, acquisition activity, European deal flow – that’s down 54%. And Asian MNA is down 49%. So again, slowing trade, slowing deal flow, and you have to say this is becoming a global economic issue.

Kevin:Our guest about a month ago, Robert Jervis, who wrote How Statesmen Think, his specialty was looking at countries as people, and realizing that they have personalities, they have egos, they have fears, they have foibles, and you have to take that into account when you are dealing from a statesmanship approach. That also applies to economics. Remember when we were growing up and there was the thrust of buying United States only products? And so there were a lot of people who would only buy something that wasn’t either made in Japan or China, but in the United States, and in fact, a flag was put on those products to encourage that. I’ve heard and read that the Chinese are starting to learn from that. Their dislike for Trump, their dislike for the Americans, their dislike for these tariffs and these talks – they are actually shifting their buying patterns away from anything the United States might make.

David:And I think Jervis’ point was excellent. When you are talking about systems, don’t divorce them from the people who make up the systems.

Kevin:It’s psychology, as well.

David:It is, and so we tend to think of bureaucracy as somehow above the fray, and actually ,it’s not the case. You have people who take offense, you have biases which are either ingrained or can be created by circumstantial issues. There is an advisory in London, Brunswick, which just did a poll in China, and they were asking about consumption of U.S. imported goods into China. 56% of the consumers polled said that they had recently avoided U.S. products. 68% said their opinion of U.S. firms was more negative.

So you have Trump focusing on the trade numbers, and scrutinized are the imports of Chinese goods into the United States. But the other side of the equation is U.S. exports to China. By the way, every Fortune 500 company in the world has wanted access to China. Why? Because if you can tap billions of consumers it might be good for retail business. But with enough negative press, these potential customers can go elsewhere for their consumption needs, for their wants.

Kevin:And I would feel bullied, if I was from another country, and I was told unless we played by U.S. rules, we couldn’t even transfer money using the SWIFT system. We couldn’t do business with other countries based on the bullying of the United States. Now, I’m a patriotic guy, but I’m not proud of the way we carry on international politics by limiting the way a person can do business outside of the United States.

David:There is also this issue of international law versus domestic law, and somehow we conflate our U.S. domestic law as having universal application, and so we feel that it is appropriate to fine international companies, or even using the Treasury arm, to go after countries that are not operating consistent in abiding by U.S. law. And the question is, why would a citizen or a country independent of the United States be required to be subject to the laws of our land? I’m not saying this as an out-and-out critique of the U.S., but as a way of asking the question, isn’t it reasonable for people experiencing that pressure to have some resentment toward U.S. foreign policy?

Kevin:Well, what if the shoe was on the other foot? What if it was Russia, China, India – you name the country – that was actually dictating the way the United States did business?

David:It would be treated as an absurdity. So we see the anti Made-in-the-USA trend there in China. It’s a growing trend. Last week we threatened three Chinese banks with being cut off from the SWIFT transfer system if they continued to work with North Korea. So again, this is not a domicile nexus that includes the United States, but we’re carrying out these threats and giving them daily fines if they continue to do business with North Korea.

Kevin:Well, who makes that decision?

David:The U.S. Attorney General, the Treasury Secretary. They can choose to go from saber-rattling to sort of taking out the financial saver, if you will, and cut these institutions off from U.S. markets. And further hinder global transfers via SWIFT. So this is where all of a sudden because we have control or influence over the capital plumbing of the world, we can use that control and influence over the capital plumbing to stop flows, redirect flows, etc., and create a real problem for other countries, other companies, what have you.

Kevin:If somebody was controlling the plumbing in my house, I would do a re-route.

David:That’s right. So you have great fodder here for an anti U.S. propaganda campaign, and I think that is what we will continue to see with China. Europe has made a move to replace SWIFT.

Kevin:There’s the re-route.

David:And this is a big deal because not only have we had trade and tariff talks with China, but this is what brings the European group into the mix. You have INSTEX which is a work-around for European parties to trade with Iran, and to not be implicated by using U.S controlled or influenced plumbing, so to say. For a moment, think about the risks within the financial markets if we begin to move in a retaliatory fashion against EU countries and companies that are using this INSTEX work-around, again, avoiding the U.S. Iranian sanctions.

Look, we’ve already got manufacturing PMIs which are weak in Europe, and the countries that are the sponsors of INSTEX are Germany, France, the U.K. Our big threat to all of them is loss of access to the U.S. based financial and capital flow system. And I think, to some degree, when we start saber-rattling, this time around they have an alternative. You remember, we’ve read and we’ve discussed The Structure of Scientific Revolutions.

Kevin:Right. Kuhn.

David:And there really is never a shift in paradigm unless there is an alternative. So you can gripe and complain, you can come up with problems with the system, but nothing is ever done until there is a replacement there and you can step from one to the other. And I think that is really what is interesting about this particular period in financial history. We are, in essence, forcing their hand. Not only are they creating the alternative to SWIFT, but we’re actually damaging our power and influence in the world by forcing the issue with them on this particular point because as they create an alternative it degrades our effectiveness. Think about how critical the Treasury Department has been to the implementation of our foreign policy objectives. And to lose that SWIFT lever, that leverage over the control of capital flows, is a very big deal.

Kevin:A repeating theme over the last few months here on this Commentary, not just with you and I, but with guests like Napier, is that this is not a trade war. This is a war of hegemony.

David:This is a battle for hegemony.

Kevin:China has gotten to the point where they are, potentially, the replacement superpower, and they are feeling their oats.

David:And you have other countries that are just saying, “Look, in aggregate, we have some power to wield, ourselves. Maybe individually we can’t, but standing together – kind of the Fareed Zakaria restive, rise of the rest type thing – we can have a unified voice. So capital flows and technology gates – if you think about those two areas, capital flows and the gates for how information flows – these are the arenas of conflict here at the front end of the conflict.

Hot wars – you can fight them, maybe we don’t see that, but what we have is the initial forays now based on capital and technology. And maybe it heats up. As we suggested last week, you have Iran who is like that tee-ball already set up on the tee. Any time we need to shift gears or change emphasis, or maybe Trump needs to throw a little weight into the election process, he’s going to swing hard at the ball that is already sitting on the tee.

Kevin:Remember, he has already shown restraint, and that’s what you do first. You show restraint on the first thing, and then whatever the second thing is, if you need to not show restraint, you are perfectly validated because you showed restraint the first time.

David:That’s exactly right.

Kevin:Let’s go back, though, before we finish up. I just think the unusualness of this period of time is hard to overstate, as far as negative rates and extraordinarily low rates for high-risk debt. Portugal, Greece, Spain – countries that we were talking about just a few years ago possibly failing, completely defaulting on their debt, now are only having to pay just pennies on the dollar in interest on their debt because they know they have a backer.

David:You showed me a chart here recently of an overlay of the price of gold and the quantities of debt trading in negative territory. I think Marc Faber had published that. We haven’t had Faber on the program for a while, it would be fun to have a conversation with him.

Kevin:We need him back.

David:The Faber chart was interesting because you have negative rates and the quantity of debt which is trading at negative rates set alongside, in this picture, gold, and gold is performing very well, and in lockstep. The correlation is almost 1-to-1. The increase in the quantity of negative-yielding debt and the increase in the price and demand for gold is right there.

Kevin:The fluctuations –­ you could use either chart to explain the other thing.

David:It was fascinating. Thank you for sharing that with me. But the backdrop is, these rates in a variety of countries – the Greek ten-year treasury is yielding 2.43%.

Kevin:This is a country that we thought was going to default six years ago.

David:Yes. You could argue it technically remains in default, but it doesn’t matter because the ECB will do whatever it takes. Mario Draghi will do whatever it takes to paper over it like papier mâché.

Kevin:Portugal and Spain.

David:This is crazy. The Portuguese ten-year is at 0.48 – that’s less than half a percent yield on ten-year paper. This is Portugal. Keep in mind – Portugal. The first letter of what acronym? PIGS. Remember that from the 2011-2012 timeframe? Portugal, Italy, Greece and Spain?

Kevin:Not too complimentary, but actually, yes, they were on the verge of extinction. And now, just to remind the listener, what we are talking about is the interest that needs to be paid for the risk of default in that period of time. And we are talking less than half of one percent from Portugal.

David:The ten-year treasury here in the United States is kind of the benchmark for a lot of things. It is one of the numbers that informs our 30-year mortgage. And the importance of the ten-year treasury all over the world can’t be understated. Portugal is at 0.48, Italy is at 2.1, Spain is at 0.4. The German ten-year is negative 33 basis points. The French is negative just about five basis points. And in the U.K. they are at positive 83 basis points, just under 1%.

The U.S. ten-year is at 2.01. And it is amazing because the benchmark right here in the United States, the U.S. ten-year treasury, is yielding more than Portugal and Spain. We are running neck and neck with the Greeks and the Italian paper. So something has been lost – and this sounds like a broken record, perhaps, but something has been lost in the information that is supposed to be conveyed from this interest rate.

Kevin:Remember limbo? How low can you go? At this point you have Germany negative 33 basis points. It’s hard to retire on negative interest.

David:We need to keep an eye on one thing, Kevin, here as we move toward June/July and getting the numbers from home sales. U.S. mortgages are backed today at 3.77 percent for the 30-year. That is tied to a low ten-year treasury. As the U.S. ten-year has dropped, so has the 30-year mortgage. And yet, the May numbers for new home sales sank 7.8%. So that is surprising, with rates contracting.

Kevin:You would think more homes would sell.

David:But new home sales sank almost 8% in May. If June and July numbers of home sales don’t improve considerably, now you’re talking about a factor which is likely to pressure the Fed to cut rates much more decisively July and into the fall. So this is really critical. Kevin, with this backdrop I can’t help but think, this is weird stuff.

Kevin:This is weird. Okay, but a 30-year mortgage. Why would you leave it at 30 years, when it could be 50, 70, 80, 100? I wonder how low I could get my own mortgage down to if I just talk to somebody about a 100-year loan?

David:I’m going to be in Austria this fall and one of the things that I think is interesting, the Austrians, two years ago, successfully sold 100-year bonds, and they sold them at a yield of 2%.


David:You may think, “Well, that’s not very smart. If you know the history of money or the history of interest rates, a lot can happen in a day, in a week, in a year, and certainly in a century.”

Kevin:But that’s assuming inflation is going to stay under 2% for a hundred years in Austria.

David:Two years ago, that was then. The talk is now that they are coming back to the market with another 100-year offering, 100-year paper, but the yield this time is 1%.


David:A generous offer if you are in Europe, of course, but this is a great time to issue 100-year bonds. I guess the question before the audience today is, who is the genius in that transaction?

We live in interesting, perhaps curious, times, where even PIGS fly.

Kevin:Dave, if I walked out of the studio right now and I saw pigs flying, and that had never happened before, I could either invest in pig airlines and just say, “Well, I guess that is something that happens.” Or I could keep my feet firmly on the ground and not play. I still go back to what you and your family have been doing, and I’ve been part of that for 32 years. When things don’t make sense, exit that room. That’s an old theory, actually, for people who are even in security – guys who have security detail, or what have you. They understand that something changes, things stop making sense, right before an event. And my thought would be, keep your gold, keep your cash, add to it, because things will make sense soon.

David:The next several years are going to provide, I think, an immense opportunity for those who have their feet firmly on the ground. This technical breakout above $1400 for gold is significant, not because it is the end of the line, or the end of the story. I don’t care, frankly, what gold is doing over the next month, two months, three months, but over the next two to three years I think it is very significant, and that Jeff Gundlach and Kyle Bass and Ray Dalio and Stanley Druckenmiller look at the pigs flying and saying, “This does not make sense, and I do think I want to own gold, I want to own real estate, I want to own real things.”

They are looking for things that do continue to make sense because they are real and basic in the context of things just getting crazy. Please don’t ignore some of the “masters of the universe” and the fact that the world is getting topsy-turvy, but there are still some very clear-headed things that can be done.

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