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- Central Banks tightening, credit markets take cover
- Flood insurance works well as long as there is no flood
- Advice: Prepare for difficult times.
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
Doug Noland: “Bubbles Don’t Work In Reverse”
February 8, 2022
“I do subscribe to the view that the value of gold tends to correspond inversely to central bank credibility, right? When everybody’s confident in central bankers, then why hold gold as much? So I feel we’re moving in the direction of a crisis of confidence for full policymaking and financial assets more generally, and I think that bodes very well for gold and the precious metals. So as a longer-term store of value, the way I see things lining up, I personally much prefer hard assets to financial assets.” — Doug Noland
Kevin: Welcome to the McAlvany weekly commentary. I’m Kevin Orrick along with David McAlvany.
I’m really looking forward to this, Dave. You came over to my desk yesterday and you said we’re going to have Doug Noland on, and I said, “Gosh, I think we need to have him on more often.” But you told me the story. Most of us we work Monday to Friday, and we turn things off on Saturday morning. I know you go ski with the family. But before you ski with the family, you wake up, you look at the Credit Bubble Bulletin, which is Doug Noland’s report. And you told me this week, you said, after everything that was happening last week, you hadn’t even put your contacts in, you were just looking at a blurry screen. But you started to realize, “Oh my gosh, we’re going to have to have him on because things are dramatically changing, especially in the credit markets.
David: And Doug’s the right person to bring that into focus. So thanks Doug for joining us again on this week’s commentary. Oscar Wilde said, “I wouldn’t give a fig for simplicity on this side of complexity but I’d give my very life for simplicity on the other side.” And there are some simple takeaways at the end of the conversation with Doug Noland today, but I want you to appreciate how important it is to dig into some of the details and some of the complexity of the credit markets as we look at significant pivots in the global credit markets and the global financial system.
Doug, you and I have had the privilege of working together— It’s been my privilege to work with you since 2017. And you manage our Tactical Short product. And I remember years and years ago, having read the Credit Bubble Bulletin and posed a question to you, “What would it look like to someday work together?” And so that has become a reality and I love it. Thank you for being on the team. I want to cover as much ground as we can today. Our clients probably know your background. Perhaps for the sake of new listeners to the weekly commentary you could give a little background as a CPA, as a writer, as an analyst of money and credit, and as a portfolio manager for the last 30 years.
Doug Noland: Sure, David. And thanks a lot for having me, and it’s great to work with you. I love the relationship and it’s an honor to be on the Weekly Commentary. I listen to you and Kevin every week and I’m always just so impressed. So nice to be here.
I’m feeling kind of old. I guess I’d say I am a small town working class kid from Oregon. Proud graduate of the University of Oregon, accounting, finance. I loved finance back then. I tolerated accounting. I became a CPA just to get the certification. It was great experience at Pricewaterhouse. And in one of many of my lucky breaks, I left Pricewaterhouse, moved down to Los Angeles, and was a Treasury analyst at Toyota’s US headquarters down there—and what a great experience. Great people, sitting on a trading desk, fixed income trading desk back in 1987, with lots of volatility, currencies, bonds, stocks, and then the crash in ’87. And I just fell in love with the markets and with macro analysis.
Went back and received my MBA from Indiana University. In another lucky break, I began working for a very successful bearish hedge fund manager back in 1990. Just an incredible learning experience. Tough experience, but a greater learning experience. And I’ll just mention, David, for me, 1990 was such a key year. Not only that was my first year in investment management, working for a hedge fund, but also I was exposed to the brilliant work of Dr. Kurt Richebächer, a German economist who had a newsletter. He was a chief economist for Dresdner Bank and just loved economics, loved Austrian economics. Learned a tremendous amount from him.
1990 was also a year for going into recession. The banking system was severely impaired. And then I watched over years how that very impaired economic financial system morphed into this great bull market economic prosperity. I was on the wrong side of the markets, working for basically a mainly short hedge fund. So a lot of sleepless nights trying to understand what was going on. Invaluable learning experience. I then left the hedge fund industry and joined David Tyson, the Prudent Bear Fund, at the beginning of 1999. So I had seen a number of crises to that point.
By that time also, I was convinced that finance had fundamentally changed. I watched Fannie and Freddie act as quasi-central banks beginning in 1994. I watched the evolution away from banking finance to market-based finance, asset-backed securities, mortgage-backed securities. I mentioned the GSE derivatives, Wall Street finance. So then, working for David Tyson in 1999, I decided I would start writing my blog—before it was called a blog, the Credit Bubble Bulletin, and just chronicling on a weekly basis this phenomenal evolution of finance, evolution of policymaking, evolution of economic structure. It’s just been an incredible experience. I left Prudent Bear and then came to work with you, and then keep working in the market to keep chronicling what is clear to me is the greatest global bubble in history.
David: Multiple times a week we look at various indicators. And this last week, there were divergences between the equity markets and these indicators, suggesting that there’s stress within the credit markets that the equity markets were not picking up on. I want to come back to that in a minute. You also refer to models that give some explanatory power to what’s happening as risk starts at the periphery of the financial markets and then moves to the core. Could you elaborate on that periphery? The core model?
Doug: Sure. And this is the periphery-to-core framework. Think in terms of, we have this new financial structure. It’s unlimited finance, fiat finance, right? It’s not the old days where the bank restrained credit growth through lending. This is just a financial free for all here. So when financial conditions are loose and risk is being embraced, this finance will tend to flow to the riskiest assets where expected returns are higher. For example, the higher-risk emerging market data or junk bonds. If everything is stable and there’s liquidity abundance, you might as well get that extra return. So during the boom, finance flows to the periphery where it gets higher returns.
So these risky areas comprise the periphery of the risk spectrum, with the core being the perceived safer assets, say Treasurys, investment grade credit, such. So this framework is trying to discern the flow of finance at the margin. At the margin. Again, when times are good and the hedge funds are increasing leverage, this finance will tend to flow to the periphery. And this will tend to feed on itself, and when the other riskier borrowers have such easy access to finance, they will appear less risky, and that’s junk bonds, emerging market bonds, wherever the risk is it’ll appear less risky, and only more finance will flow their way. And that’s kind of a bubble dynamic.
But there’s always this latent fragility at the periphery. So if these high-risk borrowers lose access to cheap finance, they can find themselves unable to service all this debt they’ve accumulated during the boom. And we’ve seen this over the years repeatedly. And it’s at the risky credit, they will always be the first place—with the sophisticated players, the hedge funds and such—they’ll look to pare risk if they begin to take on less risk. And what begins with subtle changes in the flow of finance can morph into destabilizing reversals of speculative finance, and deleveraging.
We want to be on top of this dynamic. And it’s this deleveraging that just sucks liquidity out of a system, first at the periphery. But as the risk profile of the periphery deteriorates and liquidity becomes more of an issue, then concerns begin to shift from the periphery to the core, to the perceived safe areas of the marketplace. And when de-risking/deleveraging gains momentum at the core, that’s when crisis dynamics turn more serious.
And I’ve witnessed this repeatedly over the decades. I’m rambling here, but recall an example back with the subprime eruption in June of 2007. And then it took 15 months for this dynamic to make its way to the core, and then the core erupted with the collapse of Lehman Brothers.
One last point, it’s not uncommon for trouble at the periphery to initially stoke excesses at the core. So that’s something we have to be mindful of also. Subprime problems initially stoke the flow of finance and speculative excess into triple-A rated mortgage-backed securities, and that extended that boom, but it only compounded systemic fragility. But that’s the way the periphery to the core framework works.
David: We’ve got drama in the markets over the last week to 10 days. There’s no coincidence you’re joining us on the Weekly Commentary today. For months we’ve had China that’s been under pressure, particularly the developer sector. And in the same timeframe, the central bank community has been forced to respond to inflation. First the Bank of England, we’ve got two rate increases so far, then the Fed talking about tightening, and now the ECB. Walk us through the progression of pressures building and inflation pushing the issues from obscurity to center stage.
Doug: Okay. I’ll give it my best shot. From a high level— So this is an extraordinary global bubble environment. Unlike the previous bubble experiences, this is a global dynamic in these markets, and economies globally have become highly synchronized. And they’re all fueled by extremely loose global financial conditions. This central bank liquidity and government and private sector debt excess—it’s everywhere. So global bubble dynamics, it’s a phenomenon internationally, and we’re now seeing serious cracks in all the major bubbles. And generally people don’t connect them. They think they’re all— in Wall Street they’ll say idiosyncratic risk, right? Well, these are all related.
So these initial cracks are also all occurring where one would expect them to first, and these are the areas that experienced the greatest excess during the boom. For example, in China we’re witnessing the collapse of their massive apartment and real estate developer industry. And their real estate developer industry, it’s upwards of five trillion dollars of debt. I mean, it’s crazy how much money was borrowed. We hear of Evergrande, it’s $300 billion of the liabilities, well there’s a bunch of other ones that are huge also. This was the key source of finance for China’s historic apartment bubble. We’re now seeing cracks there.
In the US we’re seeing cracks now in the technology stocks, the big technology stocks. These companies that have no profit, no cash flows, they’ve just been part of this mania. The historic, speculative— I call it an arms race of spending excess, we’re seeing cracks there, which is where you would expect to see initial cracks.
And now in Europe, especially last week, there are cracks in the peripheral debt markets. Italy, Greece, Spain, Portugal. These are highly leveraged economies that because of the euro currency and all the ECB buying their QE, they’ve been able to continue to borrow at extremely favorable rate.
The problem is that monetary stimulus— it just got completely out of hand, right? We had five trillions from the Fed, many trillions more from the ECB, Bank of England, and others. System debt growth. It’s spiraled completely out of control, especially here in the US and China. I mean, the numbers are just unbelievable.
So not surprisingly, inflation has become a major issue. And now the major central banks are being forced— they have no choice. They have to pivot away from zero rates and massive liquidity injections. So this is leading to reduced appetites for risk taking and leverage, which is translating into waning liquidity excess. And we’re witnessing this in global markets, the bond markets, as well as the risk markets. Corporate credit, emerging markets, high yield debt, and manic speculative bubbles, they do not respond well to even a subtle increase in risk aversion. So that’s how I kind of try to tie all these different developments into one global bubble framework.
David: So Madam Inflation, as the press has taken to calling Christine Lagarde, head of the ECB, finally conceded she was wrong last week. Mid-December she was entrenched in that inflation was not going to be an issue. Now she’s staring at very uncomfortable data. Inflation in Germany, north of 5%; Spain, north of 6; Italy, 5.3; Austria, 5.1; France, a modest 3.3%. If inflation is now broad-based and enduring, how does this impact credit? How does the impact of credit further affect other asset classes? Then just keep in mind the audience of a retiree, a homeowner, and tie that into, “How’s it relevant for me?”
Doug: Sure, sure. So as far as Legarde, and I think at the December 16th ECB meeting, where after the meeting she completely dismissed inflation and voiced this determination not to begin raising rates until at least 2023. And at the time, you just scratch your head. So she and the ECB, they had no choice but to change course, right?
It was obvious they had to change course. So let me say here that global central bankers, they were really hoping that inflation was transitory. They know these markets will respond very poorly to a central bank tightening cycle and these bankers were hoping that if they delayed the process long enough that inflationary pressures, they would subside and you know, everybody would be happy. They wouldn’t have to tighten, the markets would be happy and everything would be great.
Well, they gambled, huge gamble, and they lost. Clearly. Inflationary pressures, they’ve taken root. Inflationary expectations have changed. And if you look, workers are demanding higher compensation. Companies, they’re growing— You’ll listen to the conference calls every quarter and companies are growing very comfortable raising prices, behaviors are changing. And keep in mind, inflation at this point is a global phenomenon. It’s not like the Fed can say, “Okay, we’re going to get inflation in check.” Well, it’s not going to be that easy. It’s global phenomenon.
So central bankers now, they have a much more difficult time, because they really have to rein in monetary excess to try to slow down inflation. And at this point to change inflationary expectations will require inflicting pain. That’s the way it happens, right? We haven’t been in the situation for a while. We all either know or have read of the situation with Volcker and how tough that was.
Basically they’re going to have to raise rates until the markets buckle. Unfortunately, that’s the way this is going to play out, I think. And that means borrowing costs are going up. It means we’re going to borrow more to buy homes, we’re going to borrow more to buy cars, credit cards. That means our mortgage payments go up, our monthly auto payments go up, our credit card bills, if we want to pay down our balances, we’re going to have to pay a higher interest rate and such, while the asset markets are very vulnerable too. Stocks, Treasurys, corporate credit, they’re all susceptible to tighter conditions of speculative leveraging.
So unfortunately, there’s a real risk here that we get hit with higher inflation, higher monthly payments on our debt, and weakening wealth from our portfolios of assets. Unfortunately, David, it’s just a very troubling backdrop that we’re all going to have to deal with here.
David: We have a central bank playbook, which includes a lot of talking: the forward guidance, the Draghi-esque 2011 verbals, “we’ll do whatever it takes.” That’s been in motion for some time now. What happens to the financial markets when talking is no longer sufficient for perception management or market impact? We’re in a new stage where maintaining credibility is A, tough, and B, comes at a higher cost.
Doug: Exactly. Yes, I think central bank credibility it’s already taken a big hit here. We haven’t really recognized it yet, but it’s taken a big hit. I doubt many believe that the Fed will actually orchestrate the type of aggressive policy tightening necessary to rein in inflation. The markets certainly believe that they have the central banks trapped. And the Fed had credibility that they would backstop the markets, but I don’t think they’ve had credibility on inflation for a while. And if you look at the talk of tightening these days, it’s not having much impact on the booming commodities markets. So the commodities market is not thinking there’s a big tightening coming.
So central bankers over the years, they developed this credibility to keep the stock market booms sustained. And now that’s going to come back to haunt them because they have these market bubbles out there expecting ongoing support, while inflation takes root and causes a lot of pain within a society already under stress. I worry that when markets falter there will be a problematic crisis with confidence in central banking. I fear it’s going to be just one more institution that lacks public confidence and trust. And that’s a place where we don’t want to be. We’ve never wanted to be there, and the central banks have put us in jeopardy by all this money printing and market intervention over decades, unfortunately.
David: Well, as I said earlier, there’s no coincidence you joining us today. On the one hand, equities globally looked decent by the end of the week last week. But how different were the credit market indicators?
Doug: Yes, it was really interesting. Another fascinating week last week. I follow—and David, we, I should say we, because we discuss these, we follow these together—a mosaic of indicators. And basically they all are essentially sending a similar message: the environment is changing. And that was very clear last week.
The cost of market insurance is rising, and that’s very important in my framework. And the cost of insurance— I follow a lot of credit default swap prices, which is the cost of insuring against defaults for corporate and sovereign debt. And all of these CDS prices, all of this market insurance, the price has been rising of late, and that’s for investment grade bonds, high yield bonds, emerging markets, even sovereign bonds, and importantly, even for the big financial institutions. And they really started—CDSs with the big banks started—to really move last week. In many cases, the cost of this insurance has jumped back to where it was back in 2020.
We’re also seeing corporate credit spreads, and that’s something that we follow closely also. And that’s the difference between the yields, how much the Treasury pays when it borrows and how much corporations pay when they borrow. When times are good, corporations can borrow—it’s small spreads over Treasurys, not that much of a premium over Treasurys. When the market starts to get more nervous, corporations have to pay more. And we’re starting to see that dynamic.
These indicators, they’re signaling heightened risk aversion, they’re signaling waning liquidity, which is problematic for a world of vulnerable speculative bubbles, and all of these economies that have come to be addicted to loose finance. And last week—this was last Friday—I titled my CBB, “A Changing World.” Indicators are telling me that the cycle is turning. And granted we’ve seen backdrops like this before where somewhat serious cracks in the bubble were appearing, and in each case central bank intervention reversed these dynamics, and bubbles inflated ever larger and the markets became ever more comfortable that this was the dynamic they could always count on.
Well, this time, things are different. At least, they look different to me. Inflation is a serious problem. And there is now a significant cost to bailing out the markets with additional monetary stimulus. That cost is higher inflation for everyone and the cost that imposes on society. Part of the cost is a crisis of confidence in central banking. So these indicators to me— I’m on my toes now. I come in more diligent than ever to try to discern where the stresses are starting to build.
David: There was a shift in tone in the Credit Bubble Bulletin, and it was better than a cup of coffee on Saturday morning. It’s seven o’clock in the morning on Saturday. I don’t have my contacts in. I’m looking at my phone reading the CBB kind of bleary eyed, and I just have this sense of, “Uh-oh.” Because your tone shifted on the basis of the indicators shifting, and something as simple as European bank stocks going higher. Well, that’s great. Everyone’s happy about that. And yet the credit default swaps for European banks were also going higher. Not something that everyone’s looking at, but it says in a subtle way, “Uh-oh, somebody’s got this wrong.” And it’s really not the people who are insuring against default. You’ve got a little too much enthusiasm there.
So before I headed off to ski on Saturday, I’m thinking, “Man, we need to have a conversation.” Because there are some things that are shifting that we haven’t had in motion for some time. And inflation seems to be the fulcrum for central bankers, and it seems to be universally rising after decades of loose credit and declining rates and low levels of consumer inflation. With asset price inflation, of course, but low levels of consumer inflation. Now we’re entertaining tightening of credit, rising rates, higher levels of consumer inflation. And for investors, we’ve got to consider, well, what are the adjustments to price that this implies, specifically the price of assets?
Doug: It’s a great question, David. It’s also a really tough one. With all the global fragility, there’s a clear possibility of a synchronized bursting of bubbles that could lead to a major contraction of speculative leverage and resulting disinflationary pressures on asset prices and related price levels. We’ve seen this. We’ve been in this movie before. The 2008-2009 crisis, significant deflationary, disinflationary forces globally. And I think this dynamic helps explain why, with inflation running at 7% year over year, 10-year yields remain just slightly below 2%. I think the bond markets are sniffing out that there’s risk here, and the inflation backdrop, certainly— I won’t go into too much detail, but in the market, there’s the 5-year— they call it the breakeven, the 10-year breakeven. It’s the market pricing in different installation scenarios over five years and 10 years. Right now, over 10 years they’re not fearful of a lot of inflation because of, I think, the global bubble risk.
At the same time, though, inflationary pressures in consumer and producer goods and commodities, they’ve gained powerful momentum more today than in the past. I could see consumer inflation withstanding faltering asset bubbles. I expect governments around the world, they will continue to run massive deficit spending programs. Moreover, I’m skeptical that central banks will be able to turn off the monetary spigot here. I’m skeptical. I expect the Fed, they’re going to have to resort to more balance sheet growth as it acts as buyer of last resort in a market crisis.
They’re not going to respond immediately. I don’t expect them to respond as quickly as they have in the past. But if we get into a crisis environment, they’re going to be out there printing more money. So I believe the bias for consumer and hard asset prices will be higher. But this is something— we’re going to be monitoring this daily, really on a real time basis. There’s just a lot of moving parts right now, the policymaking backdrop, market dynamics, geopolitics, the pandemic, and so on. So a lot of moving parts, we’re going to have to be at our best here as analysts to navigate through this.
David: We were coming back to this week and the move for Lagarde, the pivot, so to say. We’ve got European bond rates moving off of a very low base, of course, and we don’t tend to pay much attention to a few basis points move. But in this case, you’re talking, again off of a very low base, European bonds are rising 21%, 40%, 50%. In the case of German bunds, they’re up six times off of very microscopic levels. But yes, six times. Is it conceivable that this experiment with negative nominal yields is now behind us? That’s got to be disappointing for policymakers. They actually believe that they determine that reality.
Doug: Right. This grand experiment that’s been going on really going back to Greenspan when he started tinkering with the markets and promoting non-bank credit growth and markable credit growth and such. But I was reading an article the other day, it was a Chinese policymaker, and he was responding to a question if he expected the People’s Bank of China to, down the road, resort to negative interest rates if they faced significant problems, systemic problems.
His response was, “Well, we’ve looked at this, and we see no evidence that they’ve been beneficial, and we see plenty of evidence that they’ve led to excess.” So it’s obvious that, at the end of the day, these negative rates have been part of this extreme monetary stimulus, extremely loose financial conditions that have inflated a lot of bubbles and led to instability. The instability has been on the upside with the boom and credit bubbles and manias as such. Now we’ll see the instability on the downside when these speculative bubbles burst.
Anyway, I think that central banks, they know this is an experiment. I think when this is over, I think the public’s going to see this as an experiment that was unsuccessful. So I don’t expect we’re going to see a lot of negative rates down the road. And I think, overall, this is going to be a very humbling experience for central bankers, and hopefully, they’re going to have to return to traditional central banking where you don’t go out and just print money and intervene and manipulate markets and create negative interest rates and negative real rates, and they get back to the type of central banking that was proven stabilizing generally for the system for centuries.
David: This week our colleague Morgan Lewis referenced the euro chart, a long-term euro chart in our portfolio manager meeting discussions. I’m curious what your thoughts are on the euro as Lagarde pivots? Do you see that has any repercussions for the gold market?
Doug: Sure. As I mentioned, Lagarde, she was in an indefensible position. She just kept saying, inflation is transitory and not an issue. I was skeptical, well, a lot of people were skeptical, especially when you have 5% inflation in Germany, even higher in Spain and elsewhere. David, over the years, I’ve argued that I don’t think the euro, at the end of the day, is sustainable. I think down the road, the Germans and Italians will not share the same currency. It’s different cultures, it’s just different way of looking at money and credit and stability.
So I fear the unfolding crisis, one of the potential consequences will be stress on the euro. And when central bankers are so wrong on something so fundamental to sound monetary management, and it’s conspicuous to everyone, that’s a pretty major hit to credibility for central banking. So this all plays into our bullish view on gold.
I do subscribe to the view that the value of gold tends to correspond inversely to central bank credibility, right? When everybody’s confident in central bankers, then why hold gold as much? So I feel we’re moving in the direction of a crisis of confidence for both policymaking and financial assets more generally, and I think that bodes very well for gold and the precious metals.
So all of these things are pointing to, there could be some hiccups along the way. For example, we’ve seen this repeatedly in the market, de-risking deleveraging environment, the hedge funds, they may have to temporarily liquidate some gold holdings. So we could see a lot of volatility, but as a longer-term store of value, the way I see things lining up, I personally much prefer hard assets to financial assets right now, no doubt about that.
David: You mentioned the cultural differences between the various countries. A friend of ours used to call it a monetary Franc-enstein monster. I always liked that.
Turkey comes to mind as an extreme example, presently, of currency instability, of rampant inflation and unsustainable cross-border debts. Are they different from the rest of the world by degree only?
Doug: Well, Turkey enjoyed a heck of a boom to now the hangover and this global bubble, basically, gave Turkey a noose to hang itself unfortunately. So we now have this big inflation problem, around 50%. We have a president who is content to fire central bankers until he finds ones that will lower interest rates. So they’ve suffered a currency collapse. And an exodus of international investors. They’re a little bit different than a lot of countries in that they have a lot of foreign denominated debt—a huge amount of foreign denominated debt—that’s part of this periphery dynamic. When there’s all kinds of liquidity, why not lend to Turkey, especially if you can lend to them in euros and dollars to get a higher yield?
Well, that comes back to haunt you because Turkey, now they suffered a currency collapse, they have a lot of foreign debt, a lot coming due this year. And it’s not so obvious where they’re going to get the financial resources to make these payments. So the situation has remained somewhat stable because we’ve remained in global liquidity excess here. But now the backdrop’s changing, we’ve seen changes at the periphery. Turkey is at the periphery and I suspect that currency faces a really rough road ahead. There are certainly other Turkeys out there. But in a way, they’re the poster child of excess at the periphery, and the first major casualty of this change in this big cycle. Yes, I think it’s fair to say they are different only by degree. Here at home, we at least have the advantage that we don’t have to borrow in foreign currencies. But we’ve taken full advantage of loose finance and borrowed way too much, as a lot of countries have, unfortunately.
David: That foreign denominated debt, you would think that banks would learn. We even have one of the most significant political and financial powerhouses of all time, which collapsed because of this. You may remember the book The Sixth Great Power, talking of Barings Bank and how they failed on the basis of, again, cross-border lending, foreign denominated debt. The original sin, how is your debt denominated?
And yet, that’s the part that seems to— I just scratch my head, is it really that we have such short memories that no one really looks at the history and says, “We’re just kind of doing it again.” Now, there’s obviously differences between the US and Turkey, I don’t know that we’re heading towards 50% annual inflation like Turkey, but we are surpassing $30 trillion in debt. And now we’re in a rising interest rate environment. So there’s different versions of unsustainable. At what point does government begin to figure out that, in fact, this is kind of an end game, you run up debt, that’s fine as long as you can hold interest rates down from a cash flow standpoint, it seems to work. But now listen, they’re not in control of that. Interest rates rise on sustainability, how do you think politicians engage with this?
Doug: Yeah, it’s— they face a real problem. Debt had been growing tremendously. And then the pandemic comes and it’s like this blow off. I think non-financial debt is up $9 trillion since the pandemic started. Government debt, I think over two years, government debt increased 28% of GDP. Government debts increased fourfold since 2007. I won’t bore everyone with these ratios, but the ratios of debt to GDP, they’re all at record levels here in the US.
It all seemed sustainable as long as inflation data was at the Fed’s 2% target where it was supposedly magically going to remain forever. Well, of course, it’s not going to magically stay at 2% forever. So now they’re faced not only with so much more debt, they also have this inflation problem after trillions of central bank monetization. It will not withstand much of a tightening cycle. And that’s why I’m skeptical that the Fed will get very far with a tightening cycle.
So my baseline is ongoing, massive fiscal deficits and inflating balance sheet. I’m doubtful of QT. Maybe they get started. QT, quantitative tightening. Maybe they reduce the balance sheet a little bit. I don’t think that will go over for very long.
What was it? I think it was a few years ago, David, I wrote something in the CBB, probably repeated it, that seemed outlandish at the time. I said that I expected the Fed’s balance sheet to inflate to 10 trillion during the next crisis. And this was basically just looking at the world, trying to get a sense for how much global speculative leverage there was. And when that speculative leverage unwound—when hedge funds and others, the leveraged players, had to dump because of losses—who was going to buy? Only the central bankers.
So the Fed, in a crisis environment, to accommodate de-risking/deleveraging, they would have to expand their balance sheet I assumed about $5 trillion. But what happened instead, the Fed— well, we’re at 9 trillion, they haven’t made it to 10 trillion. But rather than accommodating speculative deleveraging, rather than to take these positions from the leveraged players that are forced to sell and there’s no liquidity in the marketplace, they injected this liquidity and they made the bubble only bigger.
So I don’t know if it was a week or two, recently, actually, I think I might have mentioned it on the Tactical Short quarterly call, I’m revising that to $15 trillion Fed balance sheet only because the next year is de-risking, deleveraging. The Fed is not going to have any choice but to expand its balance sheet.
How politicians respond during the next crisis we have to wait and see. Do they also say, “Okay, let’s just have more massive deficits”? Do we finally get to the point where the bond market says, “Wait a minute, we don’t like this game. We don’t like this game. This is inflationary. We’re going to get devalued forever, so we’re going to protest.” And then finally politicians and central bankers have to respond to the bond market. We haven’t seen that a long time. I think it’s inevitable, but we’ll just have to wait and see.
But this is a dilemma with inflation rising like this, with speculative leverage where it is and debt levels where they are. It’s a bad mixture of negative fundamentals.
David: I am still reflecting on the mixed signals in Europe last week: bank stocks higher, impressive year to date gains. The credit markets and credit default swap prices telling a different story. Can you venture a guess as to how one set of investors can disregard risk and another can keenly clue into it and begin the reallocation process?
Doug: Yeah, and there are different games that are played in the marketplace. And the markets often say— the bond market in general is more long term thinking. It’s concerned more about inflation and more long-term concerns. If you’re going to lend somebody money for 10, 30 years, you have long-term concerns, considerations, et cetera. The stock market? Short term. It doesn’t worry about too far out into the future. What’s the market going to do this afternoon? What’s it going to do tomorrow? I think in this environment also, there’s a big focus on these option expirations. We know there’s been record put buying.
David: That’s exactly what I was thinking, long term concerns in the bond market, short term concerns in the stock market. Is it like microsecond concerns in the option market? Just a nanosecond.
Doug: We have an option expiration coming a week from Friday, for example. We know that there’s been record put option purchasing there over the last few weeks. So the stock market, at least the more sophisticated guys, they’re saying okay, do we get the usual rally where the put buyers get crushed and they get forced into selling their puts and unwinding hedges in the exploration? So there’s that game because all of a sudden if the market starts to rally, then you can make a lot of quick money day trading those kinds of rallies.
So the market gets really focused on that. If tech stocks are weak, the game is, okay, if tech is week, buy financials, buy the banks. It’s Pavlovian response there. Do they have anything to do with fundamentals? I think not. So the stock market is playing that game.
Meanwhile, the credit traders last week, they’re seeing, “oh my god,” they’re seeing a big unwind in leveraging Italian debt, Greek debt, they’re seeing a big blowout in the price of insuring European credit. So that’s a huge development for the credit players. So they’re adjusting their position. They’re seeing ongoing confirmation of a scenario that’s not very comforting to them. So, they’re taking some risk off the table, they’re taking some leverage off the table.
Meanwhile, the stocks, they couldn’t care less about European credit default swap prices, there’s a different game. So you can get these really strange dynamics. We saw that in late ’07. We saw record stock prices in late ’07 and stocks held up really well for part of ’08, even though the credit markets were signaling, “oh my god, we’ve got major issues unfolding here.”
David: Yet last week in our podcast, we talked about oxygen being removed from the room, illustrating the impact to financial markets of removing liquidity. This week, we’ve got Morgan Stanley estimating that QT will suck $2.2 trillion out of the financial system over the next 12 months. Is that enough oxygen removal to challenge the financial assets currently sitting at record levels? Maybe 2.2 trillion’s a low side estimate?
Doug: That would do it. Yeah. And these bubbles, they need more credit. They need more of everything here. And if central bankers took out 2.2 trillion of liquidity, that’s going to have a major impact on global liquidity. My framework is different here. I look at it differently. 2.2 trillion of QE is not the risk for the markets. To me, I don’t expect that from central bankers.
The risk to the market, the oxygen being sucked out of the markets, that risk instead is from speculative leverage globally, carry trades in the emerging markets, leveraged trades in Turkey, Brazil, Russia. It’s leveraged trades in Italian bonds, Greek bonds, Spanish, Portuguese debt, it’s leverage in Treasurys, in US investment grade, in US high yield. We have speculative leverage. I did not even mentioned huge speculative leverage in China. So there’s all this speculative leverage. And it works like magic as long as it’s increasing. It keeps the markets liquid. But all of a sudden, if you have speculative deleveraging, if all of a sudden the leveraged players because they’re losing money, because they’re nervous, because they’re risking it, they start taking risk off the table, they start selling some of their leveraged positions, that sucks money out of the markets. That is what we’ve started to see.
And when we start to see waning liquidity, weakening asset prices, which means higher bond yields, lower stock prices, that encourages others to say, “Okay, I better start paring my risk. I better start de-risking, deleveraging.” And then it starts to feed on itself, and that’s how you have this sucking of liquidity out of the system. And that’s why bubbles don’t work well in reverse.
David: A great point. QT, well, it may be relevant. It remains to be seen if they’ll actually go through with it. Meanwhile, deleveraging, or an unwind of speculative leverage, is something that does the same thing, takes the oxygen out of the room.
One illustration, and you mentioned this earlier about options. And this is just one illustration of extreme behavior in the markets. We’ve got the increase in options trading, we’ve got Joe and Susie lunchbox trading options, and then now we have actually, occasionally, the value of options trading surpassing the dollar value of underlying stocks they reference. I mean, derivatives have always posed unique risks for the financial markets. At this scale, do you have any observations?
Doug: I’m very concerned. So this mania in options trading, wow. I mean, it’s got end-of-cycle crazy wild speculative blow-off excess written all over it. And I recall in early 1998, going back, I remember reading a Financial Times article. And it was highlighting the huge increase in derivative trading in Russian ruble hedging and Russian bonds. When I read that article, I grabbed it and I was telling everyone in the office, “Okay, this is a disaster.” Because I knew Russia was in a very difficult situation, all this debt. And I knew if there was this big derivative overhang, that means, one, that there’s a lot of speculative interest in these instruments, a lot of people want to speculate in them. A lot of people want to leverage in these instruments. And they’re counting on these derivatives, this flood insurance, in case all of a sudden you have torrential rains and they want protection. Okay. Well, if you write a lot of flood insurance and you have torrential rain, you better not go to the reinsurance market to try to protect yourself, because all of a sudden, there’s not going to be anyone that wants to take that risk.
So I really worry about the proliferation of hedging institutional retail. One, there’s a lot of people speculating. “So I’ll take a leveraged bet on the upside of the market.” Two, there’s a lot of people that have these strategies. “I’ll take a lot of risk and then I’ll just hedge it if necessary in the derivatives market. I’ll just offload my risk to the derivatives marketplace.” So you have a tremendous amount of risk that’s simply offloaded from the market to the derivatives market. Okay? So the thought is, okay, I’m protected.
So then the derivative players, what they have to do, they write this insurance, market insurance. But then as the market starts to go down and all of a sudden they fear that they could lose on this insurance, they have to short something. They have to short something to provide them winnings so they can pay against their losses of the insurance they wrote. And I know this gets a little complex, but it’s called dynamic hedging. So basically, when the market starts to go down, they have to go out and aggressively sell to create positions to protect themselves. Well, if they’ve written a huge amount of this insurance, they may have to just sell like crazy when the market goes down, and that selling feeds on itself and leads to illiquidity, market dislocations.
We’ve seen this repeatedly. We saw it in the’80s, then ’90s. But we’ve seen it in 2008, etc. Also, there’s a lot of people now that think that they can just protect themselves in the derivatives markets. So they think if the market starts to go down, they have these portfolios, they are just going to buy cheap insurance. Well, unfortunately, when the market starts to go down and the derivative players are under duress, you’re trying to hedge themselves, the price of this insurance skyrockets and it’s not easily purchased.
So then these people that had this plan to hedge in the insurance market all of a sudden say, “Oh, no, I can’t hedge. I’ve got to sell for my actual portfolio.” And that leads to just more cascading of sell orders. So I just look at this derivative market as this enormous dangerous market distortion. It’s Fed risk taking. It’s abetted this misperception that people be able to cheaply and easily protect themselves, which they certainly will not be able to in a crisis environment,
David: And the big surprise here, even in the last few days, have been these breathtaking moves in individual stocks. A $250 billion loss in market cap in a single day for Meta, Zuckerberg’s Facebook. And in the following day, Amazon records a different record, an increase of $191 billion in a single day. I mean, this is extreme volatility. You talk about trying to hedge, trying to offload risk. What does this extreme volatility tell us about the market structure?
Doug: Sure. I’ve worked through some pretty wild market environments, as you have, David. I could use the word unprecedented, which I use a lot, I won’t use it here. I’m going to say this environment, it’s unique. I’ve written about this, I just recently had a piece on Credit Bubble Bulletin where I talked about market structures.
I view current market structures, and I’ll focus first, the massive derivative speculating, all the leveraging, speculative leveraging, the hedging, although with these, the unprecedented speculative flows to the ETF complex, exchange traded funds, I just see this structure as being dysfunctional. And from my vantage point, such extreme volatility, it’s indicative of an accident waiting to happen here. I touched on this just a second ago, I clearly remember the role that portfolio insurance played back in the 1987 stock market crash. Derivatives, they were a key part of the bond market crisis in 1994 and crisis in 1997, the Russia LTCM crisis in 1998. Derivatives, they played a major role in the 2008 financial crisis. We saw more recently in March of 2020 the role derivatives played, the role that big outflows out of the ETF complex caused, just enormous volatility.
So derivative markets, they’ve grown significantly over the years. They’ve grown tremendously just since the start of the pandemic. And I’ve talked a lot about this in the past, derivatives and contemporary finance, it works miraculously, as long as finance is in abundance. Real flood insurance works well if there’s not a flood, as long as there’s liquidity markets, they don’t dislocate, policymakers have everything in control. But flood insurance works splendidly so long as there’s not torrential rain. This financial structure doesn’t work in reverse, that’s the problem.
And now we’re seeing these gyrations, we’re seeing these crazy intraday moves, these wild moves up and down in a week, a lot of it derivative buying. One minute a derivative dealer is selling if the market’s going down. If the market reverses all of a sudden, they’re going to buy to re-hedge their book. You’ve got the retail public buying calls, if the market goes down, they might dump their calls and buy puts, the market reverses, they’re going to dump their puts and buy calls. So this is just a system that is acutely unstable right now. Unfortunately, that’s the kind of instability, the uncertainty that you would expect to see leading into major changes of a trend. And, we’re seeing the type of volatility that I think confirms the thesis that we’re seeing a secular change in the backdrop.
David: I appreciate you mentioning dynamic hedging and how it has negative implications, even though it’s meant to be “portfolio” insurance. In fact, like throwing liquidity on a fire only to discover you’re pouring gasoline and not water. It has the opposite than the desired effect. So dynamic hedging might be a catchphrase we come back to in the months ahead.
Last month, the 60/40 portfolio split, typical mix between stocks and bonds. It lost on both sides. It lost on both sides. You mentioned ETFs, we’ve got so many auto pilot investors. Under what circumstance, whether it’s ETFs or that 60/40 split, under what circumstances would those investors continue to lose, in spite of being diversified between stocks and bonds? In essence, what does diversification require now to adequately balance market risk?
Doug: Sure. And, David, your question I immediately think of Hyman Minsky, one of my favorite analysts of finance, and he would say the framework is very complex. But simplifying it is, stability is destabilizing. If you create a stable environment, over time you’re going to have excesses that are going to make what appears to be stable unstable.
The 60/40 portfolio, jeez. I mean it looks like just gold. You can make money on both, plus your Treasurys help hedge your equity risk, so you can’t go wrong. So if you can’t go wrong, you better do it in size, and why not do it in leverage? Why not leverage it? So that strategy is being converted into all kinds of all-weather risk parity strategies and leveraged.
And right now, in my book, you can lose on both sides of that, stocks and bonds, it’s one big trade. It’s one of— I would see if— It’s one big risky play on central bank management, unfortunately. And I know for my family, I want to try to be truly diversified. I don’t want to say that, “Yeah, I can be diversified with some 60/40 portfolio.” Because I want to be protected against various risks, including financial bubble risk, inflation risk, general financial and economic instability.
So I look at risk much differently than someone who would be the, so I can buy a 60-40 portfolio and I’m protected against risk, that doesn’t protect against risk at all, the way I look at risk. So I want to have a hard asset component, precious metals, real estate, and such. I want to have a significant cash component, dampen the volatility of my overall portfolio, gives me liquidity, take advantage of opportunities that I expect to present themselves, having that cash to protect under some potentially really negative scenarios.
And today I’m really— I’m not too concerned about making strong returns, my focus is on wealth preservation, which I expect to be their prevailing focus for some time to come the way this is all unfolding. And 60/40 portfolio is not going to do it for me.
David: Well, today, the news flow highlights tensions between Russia over Ukraine. Just want you to imagine waking up tomorrow morning, and overnight, the PLA, People’s Liberation Army of China is they’ve entered Taipei. Taiwan has lost independence to mainland China. Now we get to reimagine the world supply chain constraints like we’ve never thought about. Talk about exaggerating inflationary pressures. Can you imagine globalization in full retreat? And doesn’t that factor into— When you say diversification, doesn’t that factor into a different way of looking at risk, hedging risk, and diversifying? Perhaps we’ve lived with peace so long and with globalization trends moving one direction so long, we don’t have the imagination for deglobalization and for potential war. Bring it back to the Nolan’s diversification in light of a surprise tomorrow morning. Taiwan’s lost.
Doug: Okay, David. And I want to begin by saying it’s a little embarrassing for me to talk geopolitics with you, you and Kevin’s Weekly Commentary, because you both are so knowledgeable and articulate. But let me give it a shot here, from my framework.
One way I would look at this, to start with, from the bubble framework, bubbles are mechanisms of wealth destruction and redistribution. We create all these new financial claims, and the markets go up, and economies boom, and it looks like you’re creating all this wealth. But later on, when the bubbles falter, then you realize a lot of this wealth was a shift into a small fortunate segment of the population of society. And you actually had a lot of malinvestment over investment and a lot of wealth destruction. So you have a lot of tension within society, that’s one of the real risks of bubbles.
My fear is we’ve had this global bubble, unlike anything in history, which means wealth, redistribution, and destruction on a global basis. So when I look at a global framework, I see social stress is an inevitable consequence of a bubble, domestic bubble. And I see geopolitical tension, conflict, a consequence of a global bubble. So it’s only in my framework. Unfortunately, during— When the bubble is inflating, you have integration, cooperation. Now that global bubble was faltering, we’re going to have— The pie is shrinking. Everybody’s going to fight for their piece of the pie, more disintegration, conflict.
Okay. So Taiwan, obviously is right in the thick of this because when it comes to wealth, redistribution, and destruction, we’re going to have issues with China, we’re already seen that. We’re already seeing that Taiwan is going to be a focal point of that. I fear China inevitably will go after Taiwan, maybe it deflects some domestic issues, maybe it’s just something they just— Xi wants to accomplish. I wake up that morning and China has control of much of the global capacity for semiconductors, that is a problematic scenario, the markets are in a tailspin, it is complete utter disarray in that scenario.
I’m assuming there would be signs of that, we wouldn’t wake up one morning in shock, we would see actions in the markets, we would have somewhat of an adjustment to get to that point. But that’s a very problematic scenario, it’ll only speed this deglobalization. And those dynamics, it will make inflation an only bigger problem, it will make financial instability an only more acute problem. And that’s part of this really negative scenario I fear that we could be moving towards. I hope I‘m too dire, but unfortunately, there’s too much evidence that that risk is growing,
David: Olfactory fatigue is when you smell something over and over and over again, and then begin to lose a sensitivity to that smell. Even if it is a nasty smell, you can grow used to it. I imagine a fishmonger or somebody who works in the cheese shop experiences that. It’s almost like we have had that with the repeated Chinese incursions into Taiwanese airspace, to your point of perhaps this will be heralded by something, we’ll see some leading indicators. To some degree, we do and we’ve stopped paying attention. I mean, it once was one incursion a week or maybe it’s two incursions a month. Now it can be as much as 29 or 39 incursions in just a few day period. The intensification factors there. But I think the sensitivity to what’s going on, unless you’re in sort of public policy circles, or international relations circles, I suppose if somebody’s at the CFR or something they’re probably paying attention. But for the vast majority of people, I do think it may come as a surprise, you wake up and it just happens in a day.
So as we finish, Doug, I appreciate your thoughts, your insights. If there’s an investor listening to this today, what should they take away from this? What are one, two, three concrete steps, the action list?
Doug: Sure, David. And you brought a memory to mind, paving my way through college working in a salmon processing ship off Naknek in Alaska. And after a couple of weeks, you didn’t even smell the rotten fish at all, you got so used to it, but I could smell it on my clothing when I got home, for months. I’d watch the clothing, wash and wash and I could still smell it. But when you’re up there, didn’t smell it.
We’re so used to this, we’re so used to the financial excess, we take it for granted that everybody’s going to speculate like this. We think what’s going on in the option markets and cryptocurrencies and NFT’s, we think this is just the normal progression of things. None of this is normal, central bank policymaking, there’s nothing normal about this. So we’ve got to get prepared for this new environment where I think things will return back more towards normal. But unfortunately, there’s going to be one wrenching adjustment process in the markets, in finance, in policymaking. Unfortunately, we’ve got a lot of social, geopolitical issues risk to deal with. So to me, it’s time to hunker down, it’s time to—
I think we’re all used to, it’s so easy to buy on Amazon and not pay attention to how much we spend. And we all got to focus on getting our financial house in order, getting some debt paid off, getting our investment portfolios, getting the risk down. And I think, just psychologically, just getting prepared ourselves, our families for more difficult times. And we can make this a positive, we can make this— I’m going to spend a lot more time with my son in the garden. We’re going to do a lot more biking, a lot more simple things, more time in nature, but I just want to be ready the best I can, and not be shocked when this potentially negative scenario unfolds. And again, I hope I’m just way too negative. I hope everyone thinks back at this and laughs at this analysis.
David: Preparing for a new environment. That’s certainly a big takeaway, paying down debt, reducing risk in portfolios in that psychological preparation. For you, it sounds like that includes the orientation toward spending time with people that you love, enjoying simple things. That’s really not a catastrophic shift. That sounds like a very positive investment. And it may include mental toughening if you’re throwing a hoe in the garden, but that’s okay too. And good for the back, good for the time with your son. I think hunkered down can take on a negative connotation, but in fact, there’s a lot of really positive things that can occur in the context of creating that more resilient psychological profile, so—
Doug: One last comment, I just want to throw this out. I’m an optimistic person, to survive in the kind of work I’ve done for a few decades, if I wouldn’t have been an optimistic person, I would have never persevered. And so I think it’s so important to stay positive, as difficult as it is to wake up and find something positive. I’m going to think about what kind of cucumbers am I going to grow this year? What kind of fertilizer works best with those cucumbers, and I’m going to watch them growing. And we’re going to do things like that and really, really work at trying to remain positive, because I— That’s going to be the key to having fulfilling lives here is to remain positive.
David: Well, we love the fact that our conversations internally happen with a routine to them. And so much of the good things that we experience in life are the routines, they’re repeatable. And so hopefully our listeners are thinking, not just what do we do on the wealth management side in terms of the routines that reduce risk and increase the probability of a healthy total return. But what are the routines that I can put into place that are good for my mind, good for my heart, the books that I read, the conversations that I have with friends and family members, the routines in terms of physical exercise, all these things factor into that optimistic ideal that you’re talking about, Doug. And there is no one I know on the planet who has more consistent routines and more discipline than you. So whatever it’s applied to, as much as you’re the master and king of the spreadsheet, you are also a master of routine. So, yeah, a lot to learn from you. Thanks for joining us today on the Commentary.
Doug: Dave, it’s so nice to be with you. And again, thanks for everything. I loved working with you and being part of the team. Thank you so much.
David: You’ve been listening to the McAlvany weekly commentary. I’m Kevin Orrick along with David McAlvany and our guest today, Doug Noland. You can find us at McAlvany.com. That’s M-C-A-L-V-Y-A-N-Y.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.
