Podcast: Play in new window
- Treasury auction reveals cracks in system
- San Francisco prettied up for Xi
- Private Equity time-bomb being pawned off to middle-class bag holders
“So the Treasury is issuing 32% more debt this year than last year with no Federal Reserve to buy the excess IOUs and suppress rates. Rates are rising, and pressure will pick up at the long end of the curve. Budget deficits of 2 trillion a year and the need to roll over 55% of outstanding Treasurys over the next three years. I think supply is greater than demand. That has to drive rates higher. So if you’re considering this idea that the tightening cycle in bonds is over and that monetary easing will begin in mid 2024, you’re not doing the math on supply and demand.” –David McAlvany
Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany.
Oftentimes I’m talking to my clients, and I’ll say, “Hey, what if you were Rip Van Winkle?” Remember the Rip Van Winkle story where he went off to the mountains and ended up sleeping for 20 years, and when he came back, a lot of things had changed? And so I ask my clients, I say, “Okay, if you were Rip Van Winkle, how would you invest your money?” 20 years is a little far out, but let’s say five. Let’s say if we were to come back in five years or 10 years, what would we put our money into today?
David: When you read the headlines today, my guess is that the last song that comes to mind, the last chorus to fill your ears is Bobby McFerrin’s “Don’t Worry Be Happy.” Let me suggest that at least a few of you listening are actually perfectly positioned for the next decade. And you could whistle that tune, you could sing that song. And if you’re not sure that that’s you, if you’re not sure that you could “don’t worry and be happy,” I highly recommend my colleague Morgan Lewis’s most recent Hard Asset Insights. McAlvany.com, check it out. It’s worth reading.
Kevin: I’ll tell you, it’s some of the best economic analysis I’ve ever read. But let’s pretend, Dave, that we do go to sleep for five years, 10 years. Is the Federal Reserve even going to be around?
David: Fed or fed up?
Kevin: Are we fed up?
David: I don’t know yet. Alex Pollock, he’s a Commentary guest from a few years back, really bright guy, very philosophical, worked with the Federal Home Loan Bank in an executive position and has been in the commercial banking sector for his entire career—
Kevin: He’s a philosopher like you. I mean philosophy was his passion.
David: What’s not to like, right? So he brings his banking experience and leadership insight from FHLB to bear on the Fed’s balance sheet. And not only are they losing money at a rate of nine and a half billion dollars a month.
Kevin: How do you do that?
David: But the accumulated losses have already erased their capital. Now, this is an amazing franchise to own. If you think about it, if you’re a business owner, in the good times, the owners collect a healthy dividend. And this is your member banks, regional member banks of the Federal Reserve. In the bad times, it doesn’t matter because all your dividends accrue and they’re going to be paid to you in the future. They are cumulative dividends. So you might not see them this year, but you’re going to see them pay doubly next year. And you can ask yourself, how can a franchise with a license to print money, how can it ever lose?
Kevin: Yeah, if you can print money, you would think it’d be around forever.
David: But one, there’s a long history of similar entities that simply didn’t rein in extra money printing, and they ended up blowing bubbles to such large proportions, financial market bubbles, which later catastrophically burst. So there is an issue, you can get ahead of yourself. Excess money creation, the degradation of the currency, it’s literally as old as currency itself. Only a system stabilized and anchored in gold has avoided a collapse in confidence.
Kevin: Right, that’s really what the paper game is. It’s a confidence scheme, isn’t it?
David: Yeah. The Fed’s mark-to-market losses as of June—and this is not something that underscores confidence in my book—the Fed’s mark-to-market losses as of June stood at over a trillion dollars, $1 trillion. And this ties to my second point; how can a franchise like this lose money? You go buy volatile assets with the money that you create out of nothing, and then see what happens. So on a bad day, you’re upside down a trillion dollars, and very few people can say that.
Kevin: That’s impressive, isn’t it?
David: “I lost a trillion dollars.” In our case, it took several hundred PhDs. So your man or woman of average intelligence is only capable of losing an average amount of money. It’s the extraordinary mind that can lose an extraordinary amount of money.
Kevin: But let’s face it, okay, when you close the books out every year, or when our accountants do, as a business, you have to actually use certain accounting principles that talk about profits and losses. The Fed doesn’t have to do that.
David: No, it’s really interesting. It’s like they had a different set of courses that they took—instead of double column, maybe there was a triple column. And in that triple column, it was sort of all the phantom items that you wanted to exist that didn’t really exist—
Kevin: And you can count those as real.
David: So the Fed, as we’ve previously discussed, does not have to report using GAAP numbers. GAAP is the acronym for Generally Accepted Accounting Principles.
Kevin: That we all have to adhere to.
David: Yeah, and instead it uses what I call the DCAP, it’s a Discretionary and Creative Accounting Principles.
Kevin: DCAP, I like that. Decapitated.
David: Yeah, it is. I mean it’s a DCAP to reality, anyways, and this is a unique characteristic of the Fed. So why is GAAP skewed? Perhaps because if it were included, if it was used, at the end of August the Fed’s consolidated capital would’ve been negative by $52 billion, and it’s expected to exceed minus $100 billion in the early part of next year. So, accumulated losses exceed total capital by over $50 billion, and it’s getting worse. But solvency is not a concern when you own the money printing franchise.
Kevin: Right, DCAP. DCAP.
David: When earnings don’t cover expenses and you lose money, taking you into negative equity territory, you usually or eventually go broke. That’s normal business. That’s normal business. But this is a unique franchise. The Fed takes those losses and puts them into an out of sight, out of mind accounting structure called a deferred asset. I kid you not, when the Fed loses money—
Kevin: They call it a deferred, but they still call it an asset.
David: Now, I was joking about the DCAP, right?
Kevin: Right.
David: And somebody’s going to send us an email, what does the Fed serve at break time? A DCAPpuccino. But this is for real.
Kevin: Deferred assets. It’s still not a loss. They make an asset out of you and I by making us think that it’s an asset.
David: Losses at the Fed are called deferred assets. These are PhDs in economics, not PhDs in creative writing. Bankruptcy is not possible with the Fed, but a crisis of confidence, and this is sort of a street level appraisal of how the Fed’s conducting itself, that’s not only possible, it’s likely.
Kevin: And see, we’re talking about a bank here. We’re talking about our central bank, but let’s go to the Treasury auction that we talked about last week. I mean, how did that go?
David: All the short-dated paper was welcomed. And again, this is last week’s auctions. Markets like the magic 5%, particularly if you don’t have to exchange a kidney for it or wait for decades to get your principle back. So the 2-year, 3-year, even the 10-year seemed reasonably well received, and there was no drama, no surprise. But with the 30-years, well, not so much.
Kevin: Yeah. In fact, Barron’s magazine sort of referred to a television show that a lot of people are fond of.
David: Yeah, it’s a television show about, what’s the drug?
Kevin: Breaking Bad. It’s about meth, isn’t it?
David: Yeah, crystal meth. The implication of the desperate things you do to make ends meet, I don’t know.
Kevin: So who would compare the 30-year auction to Breaking Bad unless it really was very bad?
David: Yeah. And I said it would be telling, or there would be telling information in the auction, and so that headline does capture it.
Several key facts. The Treasury had to sweeten the offering to entice investors, so paid a premium interest over the initial offering rate, higher yields. Even with that, even with that enticement, the primary dealers who pick up the excess supply that investors don’t buy, they had to buy 24.7% of the debt on offer.
Kevin: You’re kidding. A quarter of the debt, the long debt that was offered had to be basically bailed out by the people who bail it out?
David: Ordinarily. I mean they’re there to make a market in this stuff. So they’ll buy 10%, 12% on average. That’s what it’s looked like over the past year, but now it doubles to almost 25%.
Kevin: Wow.
David: So yeah, I mean 5% for 1- to 2-year paper seems like a good deal. 4.77% for 30 years?
Kevin: Who would take that bet?
David: Does not look good. CNBC reported the bid-to-cover ratio is the weakest in two years. And as we mentioned last week, the un-inversion process—where the long rates return to being higher than the short rates, where they should be naturally—has yet to occur, and likely will, as higher rates linger here for longer— Investors are saying that if you were put in a bubble for the next 10 years, if you took that vacation you’re talking about for five years or 10 years, long bonds would be the wrong place to be.
Kevin: Well, and so let’s think about this. If you’re looking from the borrower’s point of view, the government is really in a pickle at this point because if interest rates are going to stay higher and they can’t sell long debt at these lower rates—they’re higher lower rates—but if they can’t do that, they have to continue to sell or renew that debt. They have to renew that debt on shorter-term basis. If rates are high, that’s going to be unaffordable.
David: Yeah. What the market said last week was, very simply, if you’re going to issue that kind of paper, you’re going to have to pay us more for that kind of paper. And one of the things that Morgan pointed out in our conversation this morning was that this is now a market that’s driven by price-sensitive buyers. And that is a significant change in the bond market, where, particularly with mortgage-backed securities and Treasurys, it used to be the case that you had government sovereign wealth funds who were buying this paper and just recycling, whether it’s trade dollars in Asia or petrodollars in the Middle East, more than happy to buy Treasurys just to keep the game going. And they were not price sensitive. You’re offering, we’re buying. And now it’s, you’re offering, at what price are you offering? At what yield are you offering? We’ll let you know if we’re buying.
Kevin: He was saying that it went from 50% to 70%, 50% of the buyers being price sensitive now, which in a way, that’s hot money on a bank account, isn’t it? I mean hot money in a bank is the money that’s not loyal, that will go wherever the rate is the highest.
David: That’s right.
Kevin: And what you’re saying is the Treasury buyers right now, it’s not just 50% that are price sensitive. Morgan said 70%.
David: Yeah. So higher rates are gradually impacting every nook and cranny of the financial markets.
Kevin: Wow.
David: And the Financial Times reports that delinquent commercial real estate loans at US banks have hit their highest level in a decade, and they attribute this specifically to higher interest rates and uncertain economy and the rise of remote working. And that piles pressure on building owners. And then, of course, last week we had WeWork, this sort of collective workspace.
Kevin: Right, the greatest idea since the internet, I think, and it’s gone.
David: Well, yeah. It bit the dust, it bit the dust. Cue Queen. In another Financial Times article from the eighth. “After a decade of rock bottom rates, a Schumpeterian cold shower may not be a bad thing. Corporate bankruptcies in America are on course to hit their highest level since 2010.” And the article is describing that we’re seeing rates increase, and we’re seeing the corporate zombies disappear. And that’s the cold shower.
Kevin: That’s the Schumpeter. What is that? Creative destruction, isn’t it?
David: Correct. Correct. This is not a bad thing. You just need to clear out the room for good ideas and good business plans because the bad ideas and bad business plans have been subsidized by cheap credit for many years now.
Kevin: So the zombies need to go, like WeWork, right? They need to go, but it’s probably affecting others.
David: Exactly. WeWork never figured out how to make money. The founder did end up pocketing— As he was forced out of leadership, he had to cash in his chips, so to say. So he’s out the door with $1.7 billion. Everyone else gets a goose egg, including SoftBank in Japan, one of their big, big investments, which— I mean, it’s just amazing to me when you think about what a company can be valued at and what it’s actually worth. I mean, on paper, WeWork was valued at something like $40 billion or something.
Kevin: I remember, it was huge.
David: And it never made any money.
Kevin: What did PT Barnum say about suckers and minutes and how often they’re born?
David: Well, so the first round of failures are the zombies which were only afloat from cheap financing, easy access to credit. Then comes next in the sequence, the well-run firm with a maturity cliff. In other words, there’s lots of debt coming due at this, what is now an inopportune time. And finally, when you have a recession—which I explained last week comes with the un-inverting of the curve just about every time—shrinkage of sales and revenue, coupled with higher interest costs. That’s enough to pressure the non-zombie corporate towards extinction.
So higher rates are gradually impacting every nook and cranny of the financial markets, and it takes time, but the worst is not behind us. Even as investors put money into the hope thesis, and the hope thesis is that the credit tightening cycle is already finished. It’s already behind us. It was rapid, and it was done. And I guess all I can say is, I still say it has paused, and it will resume.
Kevin: Yeah. I think of the times, remember the movie Wall Street, Michael Douglas, years ago? This was during a period of time of the leveraged buyout craze, and you had a few key idols out there that were like Carl Icahn and some of these guys who were doing LBOs. But if you’re going to finance that, you need to do it at low rates, otherwise it doesn’t work. As rates rise, that seems to end the game, doesn’t it?
David: Yeah. It’s fascinating. I love— A great article from the Financial Times laying out the end of an era for leveraged buyouts, and it goes through this sort of short reiteration of what has happened. Because you used to have the corporate raiders, and these were kind of the bad guys. They didn’t care what you thought. They were going to borrow a ton of money, and they were going to take your business from you.
Kevin: Fire everybody, sell the business, whatever it was.
David: But they did it with such massive amounts of capital. It was all borrowed. And so the leveraged buyout, the corporate raider, they recognized at some point that they had a PR issue, and that they were still working with limited amounts of capital even though they were leveraged to the hilt. And that if they rebranded themselves as activist investors, that as an activist investor, now it looks like you have the best interest of the company in mind and you’re after shareholder capital, or unlocking a new dimension of shareholder capital.
Kevin: Well, has it been renamed? Is there a euphemism, private equity?
David: Yeah. Private equity is the old corporate raider. And it’s gone from being a select few, gun slinging, and you really don’t like them. If you’re downtown Manhattan and you see these guys at the bar, those are the jerks. Those are the guys who are heartless, probably lack moral fiber.
Kevin: He eats his meat raw and he doesn’t mind spending 300 bucks on a plate.
David: But today it’s been refashioned and everybody wants a piece of the action, but that’s because it’s private equity and it’s been polished and cleaned.
Kevin: So from Gordon Gecko to here we go. Right? Everybody gets to be included in private equity.
David: That’s right. So what we now call private equity and private credit, it’s the old LBO corporate raider guys. With rising rates has come an unraveling of an asset class. And this is very underappreciated, even by well-intentioned folks on Wall Street. They have no idea that the context has shifted, and what made this game successful has already changed.
We’ve been talking for weeks, even months, about a new set of rules, a new context for investing, the frailty of financial assets and the priority of hard assets. What I think is hilarious, predictable, maybe even a touch tragic all at once, is the move by brokerage firms to be pushing both private equity and private credit to the upper middle class investor at a time when the cycle has already ended. Think about that.
Kevin: Isn’t that how you do it though? I mean that’s the buyer of last resort out in the markets is just to sell them garbage. I mean, we saw that back in 2006, ’7 and ’8 before the crash and the global financial crisis.
David: The end of every cycle includes the little guy getting screwed. And this is classic. Corporate raiders buy assets on leverage. Just to recap what this looks like: you buy assets on leverage and then allow the credit markets, as rates are coming down, to re-price the assets at higher levels. Again, because, as rates decline, it’s allowing for fat dividends, it’s allowing for huge multiples, bigger multiples, and it allows for the corporate raiders to exit.
That was then, in a declining rate environment, the whole model breaks in a rising rate environment. Private equity is dead. And to this, the gradual seizing up of the private equity markets, you’re looking at this happening and the unraveling happening in slow motion. They’re having to refinance all this debt because they can’t exit their positions fast enough. So they’re being forced to refinance—
Kevin: At higher and higher levels.
David: Double digits.
Kevin: Wow.
David: So the illiquidity premium that investors were standing in line for is now just illiquidity and trading of assets at discounts. We mentioned last week that private equity refinancing is in the 12 to 16% range. That’s 3 to 7% higher than junk bonds. And there’s very little awareness of the reckoning in private equity, in part because these things don’t price in real time. They have about a six to 12-month lag. So, too typical, too predictable. Now that institutions and endowments have topped off their private equity and private credit allocations, you’ve got the promoters who are moving to the final stage, the middle class bag holder.
Kevin: Yeah. It reminds me of a couple of games when we were kids. There’s hot potato. You don’t want to be holding that potato for too long because it’s hot and you’ve got to pass it on. Or musical chairs, same thing. The music stops at some point and there’s not a chair. And it’s the middle class, isn’t it? It’s the middle class.
David: It’s like the music has stopped, but you’ve got the chorus of private equity promoters who are, like, singing. You think, oh, well, the music didn’t stop. I still hear the tune.
Kevin: I’ll take that potato.
David: Exactly. And they know. Maybe they don’t. I don’t know. Wall Street did the same in democratizing access to hedge funds a few years back.
Kevin: Right.
David: So, lowered the minimums from one million, five million, to 50,000. Think about that. Then came massive underperformance in hedge funds. And that sort of bringing in the last few suckers was a sign. It was symptomatic. And what we’ve had following that is the sales pitch for private equity instead. Capture the illiquidity premium. Go to the private markets where valuations are not as egregious as the public markets. That has been the mantra.
And I ask you this, who wants illiquid, unmarketable assets in the years ahead? If I’m going on vacation for a couple of years, and I’m just going to come back and hope for the best. We’re not talking about an asset class that is in the “value category” anymore. You’re paying pretty steep prices on not too favorable terms. We’re still, I think, as an investing public, over-impressed with backward-looking returns on capital, returns on capital, again, in the rear view mirror, as opposed to future oriented returns of—of capital.
Kevin: I had an amazing conversation last week with a client who was worried about the banks, and I was giving him bank ratings. And he had a couple of banks that had dropped from a B down to a D, but he kept telling me, “Yes, but I’m getting point something over five more than I could get in these A-rated banks.” And I was amazed because he expressed two conflicting things. One is fear over the banks. “Kevin, give me some bank ratings.” And then he wanted to brag on the CDs that he had locked in in these banks that had dropped to a D.
David: You know what I don’t understand is the fixation on bank safety. I mean, we’ve basically said we’re not going to redo the 1930s again. So this rash of bank failures which causes absolute loss, we’re not going to let that happen. So we created the FDIC and this is a confidence game. Obviously they’re under capitalized, I think less than seven cents for every dollar in deposit, maybe even less since the big ramp-up in deposits over the last few years with COVID cash coming through the system.
But to be honest, why are we concerned about bank failures when, more to the point, we have the Federal Reserve who is saying, “You are going to be a part of our failed system, but you’re not going to notice or care about it because it’s below the level of perception. So it’s at a 2% loss rate per year. And over time, we got you, over time, it’s a guaranteed failure.” So I mean, we play these mental games like, oh, maybe this bank’s going to fail. Well, what’s happened in the last 20, 30 years as banks have failed? They get gobbled up by someone else. No depositor loses money, assuming that you’re under the FDIC limits. Actually, with SVB, apparently that doesn’t matter either. You just have to be in sort of a most-favored-investor status. So what checks were you writing to the Democratic National Committee? You won’t have to worry or be bothered by any FDIC limits.
Kevin: Well, let’s talk about private equity, though. A lot of people right now still are chasing private equity returns, and what you’re saying is, there’s a day of reckoning there. There is no FDIC for private equity.
David: Wall Street is raising capital for these products without regard to the credit cycle shifting. Read the Financial Times article, November 10th, titled, “Private Equity Faces a Reckoning.” At every foundation meeting I’m a part of—
Kevin: This is the college foundation.
David: Yeah. The conversation has been the same for two years. Increase the allocation to private equity. I quit fighting. I brought them a couple of articles two years ago saying that the cycle had already peaked, and it was now shifting. Now obviously it takes time for the cracks to be revealed, and the cracks are revealed at this point. But I quit fighting the fight. The assets are not marked to market in real time, and I think this is one of the things that is loved about embedding them in a portfolio. It appears that a portfolio with private equity holdings has diminished volatility. And it looks like the portfolio’s outperforming versus an equity index. But the reality is all you’re dealing with is a six to 12 month lag in performance reporting.
So if the market’s down 10%, you’re like, “Oh, my portfolio is doing great. I’m glad I allocated to private equity. Should probably increase the allocation. See it’s holding up just fine in the context of the market selling off.” No, you haven’t been marked to market. You’re in a delay period. You have no idea what you own. You have no idea what the price is, and the best you’re going to get is a model. A model that says maybe it’s worth X. But we haven’t taken it to market, and it’s not publicly traded. So it’s just guesswork.
Kevin: It doesn’t matter what you think something’s worth, you still have to have a buyer.
David: I see limited liquidity, and limited opportunity for those assets to trade at premiums as rates stay higher for longer. And we encounter what are changed credit conditions.
Kevin: And whether it’s private equity or leverage buyout or whatever you want to call it, corporate rating, you need lower rates. The rates need to continue to go lower, not higher.
David: Well, that was the big game. The LBO game was driven by a secular trend lower in rates, and that secular trend is broken and is now moving the opposite direction. But nobody in the private equity space is concerned about this. They’re not sounding an alarm. They’re trying to find new deals. I mean, it’s always new deals. I feel like anyone who uses leverage is just flat addicted to it. You see it in real estate. I’ve never known a developer who hasn’t gone broke at least once or twice, and it’s because they overstay. They don’t see secular trends because they’re addicted to the deal. They’re addicted to making the next thing happen. And they’re just assuming that, well, it’s going to work. You got to be positive. You got to think positive.
Kevin: So for the listener who’s listening and they’re like, “All right, I buy that. I’m not going to buy any private equity, but I do have dollars.” Moody’s is warning us right now.
David: And my point is that you’re seeing the pervasive impact of higher rates, and it’s reaching a lot of areas in the financial markets.
Kevin: Every nook and cranny.
David: Every nook and cranny. So yes, it’s commercial real estate. Yes, it will ultimately be residential real estate. Yes, it is private equity and private credit. Yes, it will ultimately be the equity markets.
Kevin: And yes it will be US credit. That’s what Moody’s is saying.
David: The granddaddy. The granddaddy of all bubbles, government debt. Moody’s is in the mode to reassess US credit. We closed last week and they said, “Look, you’re on a downgrade watch.” And the language in their report was acknowledging what is still largely ignored by the financial markets. The trend change is secular in nature. So it’s a fascinating thing. This week CPI comes out, it’s better than expected, and lo and behold everybody says therefore we’re back to monetary easing, not monetary tightening. QE versus QT.
Happy days are here again. We told you that the rate hike cycle, the tightening cycle is done. It’s like, oh my gosh. A long-term trend, a secular trend. A structural trend is something that takes not only years, but decades. What happens today is irrelevant. It’s what happens in the duration of the next 3, 4, 5, 10 years that really matters. The trend change is secular in nature. Moody’s is acknowledging this, not only is US national debt increasing, but it’s doing so as rates are structurally shifting to higher levels. No more is it 800 to 1,000 year lows—actually, we got to 4,000 year lows on the interest rates—
Kevin: When they went negative, for the first time actually. Yeah.
David: Rate normalization and the refinancing of record levels of debt at higher and higher rates is a reality that makes for a massive negative compounding of our debts. Moody’s sees it. It’s not going away anytime soon. Whatever blip you see in terms of trading, whatever a hedge fund does for the next six to 12 months is irrelevant. Moody’s is suggesting, and we agree, it’s structural. It’s secular. So to recap, corporate bankruptcies are at 2009, 2010 levels.
Kevin: And we’re not even in a recession.
David: Yeah, kind of surprising since we’re not in a recession. Commercial real estate, it’s breaking down rapidly in what will be the second shoe to drop for many commercial banks, because they have by far the largest exposure to that declining asset class. And by the way, the decline is increasing. The rate of change on the downside is accelerating. Private equity. Private equity has yet to adjust to a new landscape and is trying as best they can to pivot to lending—lending—instead of buying equity. They’d rather own the debt. This is a leveraged game. In the meantime, the marketing machine to Main Street is cranking all out, even as the private equity gears begin to seize.
Kevin: Well, they need the buyer. Yeah, that’s right.
David: Doug Noland describes the granddaddy of all bubbles, government debt. And this is where you can see Moody’s joining S&P, joining Fitch, who’ve already downgraded US debt. And the conclusion is, maybe the doom loop is already in motion. So reappraising the fiscal state of the US Treasury, the stability of the US debt markets, and the vulnerability particularly as you extend maturities out 10, 20, 30 years—
Kevin: Don’t get suckered into playing these games right now as they’re trying to sell it to you.
David: The secular trends are the ones that I think are the most key to clue off of. And if I’m taking a 10-year vacation, I need to know. I don’t care what happens tomorrow or the next six months or the next two years if I’m on vacation for five to 10, finding a nice warm spot on the beach.
Kevin: Rip Van Winkle. If you knew you were going to go to sleep, what would your portfolio look like right before you did?
David: Bloomberg is discussing how rates traders are betting that the tightening cycle in bonds is over. Again, these are the guys who are like ADHD. What’s doing today? No, right now. Right now. I mean, second by second, these changes matter, and the view is that monetary easing will begin in mid 2024, and that’ll bring rates down by 50 to 100 points. Okay, I grant you. Rates are down 50 to 100 basis points next year. It misses the point. The structural shift is to higher rates for longer. What happens in the short run is virtually irrelevant. Unless you’re a first time homebuyer, then maybe you’re going to save yourself 50 basis points instead of paying eight, you’ll pay seven and a half. Or instead of seven and three quarters, seven and a quarter.
The question is really one of supply and demand when you look at the bond market. And this is why we talked about the Treasury auction last week. Will there be demand for IOUs, and will that demand keep ahead of the supply, which is absolutely massive.
Kevin: Well, and the Treasury auction obviously showed that that’s not going to be the case, and we’re having to borrow more and more. Morgan this morning before we came into the studio said we’ve topped the $1 trillion mark on our interest on the debt.
David: Yeah. And I’ve thought about that. We’ve talked about it on the program, but it was always, we are nearing and we will by the end of the year eclipse this number. But one thing he said stood out to me, “This year’s interest payment is more than we spend on all of our military expenditures.”
Kevin: That’s amazing.
David: First time ever.
Kevin: Think of all those carriers, think of all those jets, think of all those soldiers.
David: But we’re paying the bank even more just to keep this game going.
Kevin: Wow.
David: Treasury debt issuance is 32% higher than a year earlier. 32% higher. So there’s more debt coming out. Plus they’re in QT mode. They’re not buying as they were. They were for some time for a while there. The buyer of first resort, the buyer of last resort, and they realized, actually, if we keep on doing this, we’re going to have balance sheet issues. Which is where we started the conversation today. Remember the balance sheet issues? Remember they’ve lost a trillion dollars. They bought a bunch of assets when interest rates were half a percent, 1%, 2%. Five trillion worth of those assets. And now they’re upside down on those positions. Oh, I forgot, they’re curating deferred assets.
Kevin: Deferred assets.
David: Curating deferred assets.
Kevin: What it really tells us is the turkey next year is going to cost more than the turkey this year. Right?
David: And that’s it. Yeah. So the Treasury is issuing 32% more debt this year than last year, with no Federal Reserve to buy the excess IOUs and suppress rates as they’ve been doing. Rates are rising, and pressure will pick up at the long end of the curve. Budget deficits of $2 trillion a year—$2 trillion a year—and the need to roll over 55% of outstanding Treasurys over the next 36 months, three years. I think supply is greater than demand. That has to drive rates higher.
So if you’re considering this idea, this idea that the tightening cycle in bonds is over and that monetary easing will begin in mid 2024, you’re not doing the math on supply and demand. If the Federal Reserve is finished raising rates, the market has just begun to do its part. Credit quality is this factor which hasn’t even been brought into the fixed income arena, and the sober appraisal of solvency, alongside the resurgent inflation concerns. Markets are going to demand a higher return, a positive real return. And that to me seems to conspire against the Fed, conspire against those positive-minded rate traders, hoping for an easing cycle. As we’ve said before, is this a trade? Yes, absolutely. Is it a trend? No.
Kevin: And if it’s not the trend, you don’t want to be caught in the wrong trade. So yeah, maybe it is a trade, but there’s a danger there.
David: Yeah. The trade is just a relief of deeply oversold fixed income assets.
Kevin: Right.
David: The trend is higher rates for much longer. Risk is in the areas where we are blinded by confidence or misperception. Again, Pollack, I appreciate him. He’s always learning, always distilling, and always teaching. He says, “Risk is the price you never thought you would have to pay.”
Kevin: I love that quote. Risk is the price you never thought you would ever have to pay. Wow.
David: It seems like risk, as defined, is precisely what the Fed has encountered in its upside down portfolio of mortgage-backed securities and Treasury securities, a trillion dollar loss, a $5 trillion interest rate risk position, and a rate of new losses accruing: 9.5 billion a month. But confidence remains. Confidence remains. Commercial banks are allowed to hold their upside down positions to maturity. Makes sense. They could go broke very easily otherwise. Most don’t go broke, unless there’s a surprise flight, and that’s what we saw with SVB. So the broader the base of depositors, the better, the more stable. But there’s no smoke and mirrors with the commercial banks. What you see is what you get. You’ve got commercial real estate which is going to be another shoe to drop. You’ve got the securities portfolios which are a very real issue and a reason for concern, but not a reason for panic. There’s no smoke and mirrors. There’s no creation of a deferred asset account.
Kevin: Like with the Fed, yeah.
David: Yeah, certainly no accrual of dividends. Again, like the Fed, where essentially the taxpayer will end up covering that distribution to the Fed member banks over time, even if they’re losing today, they will lose nothing in the fullness of time. And you, my friend, the taxpayer, guarantee that they will be made whole.
Kevin: Well, and the one thing you can say is so consistent, okay, is traders will trade. They don’t care about the trend. Short-term thinking doesn’t care about the trend. And what’s interesting is the traders really don’t seem like they’re concerned about inflation right now, but that’s not what University of Michigan is showing.
David: Well and so much in life is what you put emphasis on. So much in life comes down to hermeneutics and what you see in a text. And today the CPI comes out, and it’s a better than expected number.
Kevin: And the traders will trade.
David: No one’s concerned about inflation anymore.
Kevin: Well, traders aren’t anyway.
David: CPI is lower for the month. Energy helped a lot, but this is where— We’re not talking by much. If you’re looking at the core reading, supposed to be 4.1, and it came in at 4.0, so the tenth of 1% better. Okay, great. Not arguing its significance. CPI is lower for the month. Energy helps, as the recent Hard Asset Insights by Morgan discusses. Consumer inflation expectations are not consistent with the CPI. Consumer inflation expectations are looking ahead. They’re anticipating even higher numbers. So the University of Michigan numbers out on Friday showed an uncomfortable mass of people with the view that the inflation fight is far from over. In fact, the enemy surge, if you think about this in terms of a conflict, we had the 9% number and now it’s receded. There’s this idea amongst the consumer that there will be another surge of inflation, and it’s just around the corner.
The PhD says, “Nope, inflation’s going to be at 2%. Interest rates are declining by 100, 150 basis points. It’ll be lower, in that range, within 18 months.” The consumer disagrees. Maybe the consumer should be allowed. Let’s be fair. Maybe the consumer should be allowed to take lost purchasing power, take their lost purchasing power and put it in a deferred asset category.
Kevin: Yeah, like the Fed. Yeah.
David: Maybe all we need is a new dictionary to understand the world we live in. It seems to work for the Fed.
Kevin: Well. Yeah, because their salaries are paid no matter what. My wife was talking to me last night about, a couple of years ago you could go to the grocery store and there would be prepared Thanksgiving meals. There’s several restaurants here that did the same thing, that you could bring the meal home. And the prices right now: one, prices are rising, but two, the help to put it together, the people who would actually be building that stuff, either working for the restaurants or the stores, they can’t pay enough people to do it, so they’re not offering it anymore, at least here in Durango.
And she said, you think about the person who has to live here with the inflation rate right now, the ones who would be preparing those Thanksgiving meals, they can’t afford to be here anymore.
David: Yeah, it’s not easy.
Kevin: So you have this double whammy with prices rising. Let’s face it, the consumer, I’m going to bring it to Thanksgiving next week. What did it cost last year? What did it cost the year before? What did it cost Rip Van Winkle 10 years ago, let’s say, or 20 years ago. This is how we’re paying for these deferred assets, Dave. This is how they really are. They’re making assets out of us.
David: Consumer frustration.
Kevin: Yeah.
David: It’s a gift. It’s a gift. You just have to rethink of it. You’re not losing. You’re winning.
Kevin: Speaking from a Fed point of view. Thank you. Yeah. Who was it? Charlie Sheen? Winning.
David: It’s all a deferred asset.
Kevin: Yeah.
David: Well, China, big week this week, great time to visit San Francisco. Finally, the feces are off the street and the used needles have been swept out of view, the homeless encampments.
Kevin: Is that because Xi is coming?
David: Exactly. Xi visits to see the glories of a once-great city. The Chinese are coming, so San Francisco leadership finally gives a flip.
Kevin: Wow.
David: The bigger news, of course, is that exports out of China fell 6.4% in October, steeper than the 6.2% decline in September. The economy continues to be under pressure. Particularly telling is the economic decay in the context of record credit growth. And if you think about this, imagine Powell, we’ve seen this, $5 trillion in liquidity infusion, and massive economic activity that follows. The Chinese have infused massive liquidity, and there’s no economic traction gained. That’s the fascinating piece here. No benefit. It’s a dud. Record youth unemployment, at least since Deng Xiaoping, a real estate crisis that makes our 2008, 2009 mortgage crisis look trivial by comparison. And now the RMB under pressure with the Chinese being put in this tough spot. They are defending the currency aggressively. Any surprise? Any surprise at all that gold demand in that part of the world is leading consumption trends globally?
Kevin: Yeah. Well, gold does tell the story, so I’m going to ask the question again from where we started. Let’s pretend that you’re going to go away for 10 years. Okay? The Rip Van Winkle factor, whether you’re going to go to sleep or you’re just going to go on a vacation. Where do you put your money right now with everything breaking on the credit side of things?
David: Yeah. If you’re going away for a week, yeah, it’s tough to say because anything can happen. A month? Well, again, it’s tough to say. A lot can happen. A year? Well, now you’re talking about the secular trends, the long-term trends becoming even more important. And now all of a sudden, yeah, if you step back and did the, I’m taking a break from the markets for the next 10 years, if you allocated your portfolio on that basis, you’d have to consider these things, the breakdown in globalization, which is something that is not an event which is on the newsreel, here today, gone tomorrow. That is something that has an effect over time. Interest rates begin to affect every asset class, but it takes time for them to seep in and have their effect. So you get the breakdown in globalization, the increase in international relations pressures, the government debt crisis of confidence, which is not in the first inning, but it’s not in the ninth either. Maybe it’s in the third inning. You’ve got the overvaluation of equities.
And what do you do? I think you increase your allocation to gold. You buy a hundred books to study deeply for the next decade and find your spot on the beach to care less with the option to reengage 10 years from now, to then deploy your ounces into shares and acres and square feet. Don’t worry, be happy. That song, you could be in that frame of mind if you’re sufficiently positioned in hard assets with a bias to physical gold.
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You’ve been listening to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany. You can find us at mcalvany.com, and you can call us at 800-525-9556.
This has been the McAlvany Weekly commentary. The views expressed should not be considered to be a solicitation or a recommendation for your investment portfolio. You should consult a professional financial advisor to assess your suitability for risk and investment. Join us again next week for a new edition of the McAlvany Weekly Commentary.
