Podcast: Play in new window
This week, David McAlvany looks at new Fed Chair Kevin Warsh and what his leadership may mean for rates, inflation, the Fed’s balance sheet, and America’s growing debt problem. He also asks whether a new Fed regime can really “Warsh” away years of monetary excess and fiscal strain. On the geopolitical front, David breaks down Trump’s need for a deal with Iran and why Iran understood its leverage. Plus, register for the upcoming MWM webinar with David McAlvany, Morgan Lewis, Philip Wortman, and Robert Draper. Register here
“The bond market wants confirmation that the Federal Reserve is not a shadow White House operator. They want to know that the institution has independence, and if it doesn’t, there’s massive implications in terms of higher rates priced into the long end of the curve. Warsh has to choose this week and of course in future months who he wants to be reviled by. He is not in an enviable position. This is not a great role. Popularity, you got to kind of check that at the door. So Trump plus the stock market, do you want them to be on your side, or the bond market, which would include the nearly 16 trillion in foreign capital sitting in US fixed income assets?” —David McAlvany
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Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick along with David McAlvany.
David, today we were just sitting in our meeting with everyone and I was thinking, who gets this every week? I just have to pinch myself. I’ve done this almost 39 years. I used to think that with your dad before you ever took over. I was like, how do we get such amazing market analysis? And so many people don’t.
David: I wondered what you were grinning about. You’re sitting there with a big grin on your face.
Kevin: I was listening to Morgan Lewis, and I was just going, “Wow, he’s giving me information about the ‘Warshing machine,'” is I think what you said. Kevin Warsh coming in. And you were talking about this memorandum of understanding that’s coming up here. And I was thinking anybody who would really want to hear what’s going on would want to be in the room at that time. And there’s going to be an opportunity for that today.
David: Yeah. Yeah. Before we begin our comments today, just to invite you to our conversation taking place Wednesday, June 17th, 2:00 PM Mountain Time, I’ll be joined by Morgan Lewis, Philip Wortman, Robert Draper, the McAlvany Wealth Management Team, for a live webinar titled “When Old Assumptions Fray: Positioning for the New Market Order.”
The conversation will examine what happens when the assumptions investors have relied on for decades begin to break, and we’ll connect the forces shaping debt, inflation, currencies, commodities, and real assets, and discuss what those changes may mean for the way investors think about risk and about opportunity, portfolio strategy, all of those things in the years ahead.
To register, you can use the link in the description of this YouTube video, and if you’re listening through a podcast app you’ll find the registration link in the show notes. So even if you’re hearing this after the live event, I still encourage you to register. You’ll receive access to the recording, to the transcript, the slide deck, which is, I think, very important, and of course the highlights, summary of the presentation.
Kevin: David, it’s interesting. We’ve been broken into two camps as a society. You’ve got people who are going to get their news from CNN, if you want to call it news, or they’re going to get their news from Fox, if you want to call it news. Either way, everybody has their way of analyzing the headlines. So let’s talk about the headlines because this is a week of major headlines.
David: It is. The headlines drive market assumptions, and we know how fast those headlines can change, of course. At least for now, we’ve got risk-on in the marketplace. Risk indicators are in line with the headlines, and expectations are for some form of resolution in Iran. So stress in the financial markets is almost nonexistent, with liquidity measures extremely loose, with great enthusiasm over the SpaceX launch last week, and the first trillionaire has been minted.
Kevin: Well, okay, so let’s go back to the headlines on Iran. Is this going to be the first time in our recent history that we actually have an agreement with Iran, or is this just really for political reasons that we’re being told that?
David: The headlines Saturday, Sunday, heralding peace in the Middle East, and what is it truly? I think you could describe it as the super TACO. Trump always chickening out is the acronym for TACO, and capitulation is really what you have from the administration, and the perception by the world is that in the wake of this memorandum of understanding, Trump is the greatest paper tiger in US history.
Kevin: Yeah. So they still have the uranium. They still are at war. They still have the old regime in power. So I’m wondering what exactly got accomplished.
David: Yeah. I mean, the US ability to leverage change in the Middle East, it’s done. Domestic political priorities have displaced finishing the engagement with Iran, where a radical regime has less control and influence than before the conflict began. You could argue that given the cooperation with Oman, they have more control and influence in the region and instead, this influence that Iran has, they’re essentially dictating the terms of agreement.
Kevin: Well, they’re calling it an agreement, but it’s a memorandum of understanding, isn’t it? I mean, what is that?
David: Yeah. A signing ceremony is slated for this Friday, and immediately following the signing of the MOU, the straits are scheduled to open. So Trump originally said that the strait would open immediately, and then he backtracked to Friday and the signing of the MOU. Pakistan says that it is a permanent termination of military operations.
Kevin: I’m glad Pakistan thinks that.
David: Well, and of course they’ve been a part of the negotiation. So they have sort of the insider view, they’ve seen all of the talking points, they’ve seen the agreement, except it’s not really an agreement. So if you read it less generously, we have a 60-day ceasefire extension in which discussions for a final deal will continue. So we’ve got 60 days to discuss what it looks like. We still don’t know what it actually looks like.
Kevin: Yeah. But what happens to the frozen assets?
David: Yeah. During that time frame, the 60 days, Iran will be able to export oil—all throughout that extension—with the US naval blockade ending, and of course with that ending, Iran will be able to import goods of any kind. The US is expected to release billions in frozen assets.
Kevin: Right.
David: And again, there’s the difference of opinion on what is actually going to happen. You’ve got the deputy foreign minister of Iran saying that only then, when they receive the frozen assets, will they be discussing the nuclear issue.
Kevin: Well, I hate to say it. I remember 2015 quite well, and it was like Obama just caved and gave a lot of money to Iran, which it sounds like they still have the uranium.
David: Well, what has shifted dramatically, Trump’s original unconditional surrender, and this is just a hundred days ago. Well, there is no immediate requirement to remove nuclear material. There is no unconditional surrender. In fact, he’s talking about the nuclear material as nuclear dust, and according to Trump, there’s no rush to deal with that because it’s harmless.
It makes you think, what was the justification for US involvement in Iran if the nuclear issue is now a minimal concern? Is it that we bombed them into the Stone Age? I don’t think so. I don’t think so. Because even two weeks ago there was a discussion of putting troops on the ground in order to go get what was a very existential threat, not only to Washington, DC but to the world, and the proclamations to leadership in Europe. You should be grateful for what we’ve committed to. We’re saving you from a nuclear Holocaust. And now it is nuclear dust, it is harmless, it is trivial.
Kevin: Could you imagine what Trump would have said about anyone who said that it was trivial or harmless three weeks ago, four weeks ago?
David: Yeah. And he’s also saying that Iran will not receive cash funds, which again is not the same thing as what Iran’s deputy foreign minister has very clearly stated, but we will lift sanctions so that there’s— I guess what I’m saying is not everybody is on the same page. Cash refunds released, enriched uranium. The list goes on.
Kevin: Well, we don’t take cash, but we take released sanctions, right? Yeah. Relieved sanctions.
David: The wild card in the mix remains Israel. Israel, according to the Wall Street Journal, was caught off guard by Trump’s saying that there would be no more attacks in Lebanon from Israel, as if that hadn’t been discussed or vetted. In fact, Trump has demanded that Netanyahu halt all firing on Lebanon and begin withdrawals of the IDF forces, both demands which Netanyahu has completely rejected.
Kevin: Well, and I’m wondering what right does he have to demand anything of another head of state? At that point you start to go, “Okay, well, who’s boss here?” And Trump says he’s boss.
David: Well, there’s some irony because if you go back and look at the history of Reza Pahlavi and the overthrow of the Shah and putting Khomeini in power, it was our presumption that we could and would tell the Iranian regime exactly what to do. And it was the nationalist interests of the Shah which were at odds with what we wanted to see happen in the Middle East. And so we put our man in place.
Kevin: Yeah, the Ayatollah.
David: Correct. And it didn’t turn out so well. But again, it’s this presumption that what we want, we get. And there’s a senior Israeli cabinet minister who said this week that, “As far as we’re concerned, Iran is Trump’s issue and he has the right to pursue an agreement, but Lebanon is ours, and we must not agree to the Iranian equation even at the cost of severe confrontation with the US.” I think Israel is preparing for there being a parting of ways.
Kevin: Do you think Israel sees the nuclear dust as harmless?
David: There’s a real difference of perspective between Trump seeing nuclear dust as harmless and Israeli leadership still seeing it as an existential threat, and Israel is not going to give up the freedom to strike Iran to stop its nuclear program, regardless of how the US president characterizes it. So Trump assumes that he makes the calls. Whatever he says, goes. He said in a Financial Times interview, “I call the shots. He,” speaking of Netanyahu, “won’t have any choice.” And again, this is what he told the Financial Times. “I call the shots. I call all the shots. He doesn’t call the shots.” And it was interesting, the day those quotes were printed in the Financial Times Israel was bombing Lebanon. So it was very clear like, “Really? You call which shots?”
Kevin: Okay. So within his own administration, though, we’re talking about the difference between Netanyahu and Trump seems to be stark right now, but how about within his own administration?
David: Bessent has said basically we should not lift sanctions. Number one, it’s having a good effect. It’s having the kind of effect that they want to see, pressuring Iran, and to re-implement them is difficult. You’ve got Rubio and Hegseth, which think that the pressure campaign is working, and that is the right way to achieve surrender or regime capitulation. And all of a sudden those things are not on the radar for Trump. What is on the radar is the November election.
Kevin: Well, and I heard an interview this morning, my wife had Glenn Beck on, and Vance was on, and Vance has always been against any kind of use of military. So they’re obviously, they’ve got to be happy.
David: Yeah. It’s Vance, it’s Kushner, it’s Witkoff that are advocating for a deal, and Trump is going for the deal. November is getting closer. The midterms in the US are more of a priority than a durable settlement with Iran. And again, it’s not even clear what that settlement will be. It will be determined over a 60-day period in the context of a ceasefire.
Kevin: There was a movie that I remember watching years ago called “Vantage Point.” I don’t know if you remember that, but it was the same story told from seven—I think it was seven—different directions. And the story was quite different each time you looked at the different— I’m wondering if the story that Iran is seeing right now unfold versus the story the US is seeing unfold, and then how about Israel? We’ve got a lot of different lenses going on right now, don’t we?
David: Yeah. And I mean, seen through the lens of the Iranian regime, they have survived an assault from the world’s greatest military power and are forcing the terms of this negotiation. The things that were originally priorities for Trump are now no longer priorities.
Kevin: How does that not strengthen their resolve going forward?
David: Yeah. So in summary, Trump sees the negotiation through one lens. Iran sees it through another. Israel, yet another lens, and none of them are operating with the same assumptions. So be aware that headlines will continue to change, very much like the weather, and certainly that has implications in terms of volatility within the markets.
Kevin: Dave, you own multiple businesses, and what that means is there are times when you have to sit down and you negotiate with various parties. When you do that, don’t you lay out something where everybody sees the negotiation somewhat the same so that you understand what you’re agreeing to?
David: Yeah. And so, you lay it out very clearly, “This is what we want.” And then, the other party says, “All right, well, this is what we want.” And then, you begin to figure out what you can actually agree to. So in a negotiation, it’s important to be working off the same term sheet. It’s very important to get clear on definitions and assumptions and meaning. If anything is clear in this situation, it’s that no one has agreed to terms, and no one is operating on the same assumptions.
So that seems to me to be a setup for headlines that quickly reverse. If you’ve got Pakistan’s interpretation of what we have this week and what will be signed Friday as a permanent termination of military operations, I think it would be a better description of what they want, versus what is actually in play—no more than a period of temporary restraint. Is this anything more than a temporary pause where everybody gets to reload, regroup, re-arm? That’s what it seems to me.
Kevin: Well, and what could trigger something even worse? I mean, let’s say Israel does strike back in self-defense. Would that be seen as a violation of the agreement?
David: Well, again, Israel’s view is that the US can do what it wants with Iran, but we’re going to do what we need to do in Lebanon, and this is a separate issue altogether. Iran will view any Israeli action as a violation of the ceasefire. While Iran has made it clear that the US is not negotiating on its behalf, and if necessary it’ll address all relevant threats from wherever they come.
Kevin: It seems like Trump is the one who really needs the deal. I mean, we’ve got an election year coming over the next few months.
David: Yeah. And I think negotiating from a position of strength is where you don’t need a deal. But if you do need a deal, that means that you maybe want something more than the other party does.
Kevin: And they sense that.
David: That’s right. That’s right.
Kevin: Yeah.
David: So that’s clear to me that Trump needs the deal, and the desire is to ease inflationary pressures from global energy shock. So setting the time frames in this negotiation, he’s put himself in a position of weakness as far as negotiations are concerned. Trump wants peace on a time frame that gives Iran a strategic advantage in that peace process. Trump needs resolution, frankly, more than Iran does.
Kevin: Okay. So I brought up 2015 when Obama was “negotiating” with Iran, and Iran came out just shining like a rose. It was amazing what they came away with, and then they applied that toward what we’ve been fighting against since then. What are your thoughts?
David: There was criticism of the Obama administration being too eager to complete a deal back in 2015.
Kevin: And they were.
David: And the current negotiations are setting up to be similar. From Trump’s own lips, if you go back to 2020 and play the reel, this is January 3rd of 2020, “Iran never won a war, but never lost a negotiation.”
Kevin: Now that’s Trump saying that. “Iran never won a war, but they never lost a negotiation.”
David: And I wonder if he remembers saying that because that’s precisely what’s unfolding.
Kevin: Wow. Okay. So this is not some sort of resolution. This is a memorandum of agreement.
David: This week’s events, an MOU, a memorandum of understanding, is a framework for negotiations.
Kevin: Memorandum of understanding. Okay, MOU.
David: It’s not a deal. It is the framework for getting to a deal.
Kevin: There was a house in our neighborhood that was for sale, and I asked the realtor, because we had heard that someone had bought the house, and I asked the realtor and she looked at me and she said, “Oh, it ain’t done yet. It ain’t done yet, hon.”
David: Well, so that might be, somebody’s made an offer.
Kevin: That’s right.
David: Doesn’t mean the offer has been accepted—
Kevin: And the sign didn’t come off the yard.
David: Yeah. Well, as of Friday, nothing is finalized, and we are extending negotiations for a deal. Markets seem not to care about the difference. As far as they’re concerned, we already have—
Kevin: It’s done.
David: Yeah, it’s done. So Israel has emphatically and explicitly made clear it is not a party to any agreement with Iran arranged by the US, and at best we get 60 days of a ceasefire. So in that time frame oil will flow through the Strait of Hormuz, and the agreement, as we understand it, there’ll be no tolls charged during that time frame, which is interesting to think about because essentially the choke point still exists and the pressure that Iran has over the global economy and over inflationary dynamics, that doesn’t go away.
Kevin: It’s just for this period of time.
David: For this period of time.
Kevin: Okay. But oil has stopped now for how long? I mean, inflation, if inflation is the big issue that’s pushing this, that inflation isn’t going to go away for a long time.
David: No, it doesn’t go away and what is more durable than the MOU or the ceasefire is the inflationary impact of losing millions of barrels a day in oil supplies for over 100 days.
Kevin: Yeah.
David: So we’ve got CPI at 4.2%. Last week, we mentioned 3.8 just on the eve of the new inflation stat. Later in the week, we got the producer price index at 6.5%. That makes the policy rate of the Fed between three and a half and three and three quarters percent, maybe the second paper tiger.
Kevin: You think Warsh is going to address that?
David: Rates have not been set to address the price stability mandate in over five years.
Kevin: Right.
David: So they’ve done a better job at managing towards full employment, but if you looked at the rates that are set, interest rates compared to the inflation rate, they’re not winning. And so Warsh makes his debut Wednesday of this week, and the bond market would like to see a little discipline. They’re pricing in rate increases. Question will be, does Warsh satisfy the bond market or does he satisfy the president’s expectations for a rate cut?
Trump’s credibility is shot through with holes. The question, will the Treasury market and the Fed as an institution, will its credibility follow in the same vein, will it follow suit?
Kevin: There was a book that you had me read, and you read, that was fabulous, called Treasury’s War, and it talked about how a lot of our hegemony worldwide is actually managed by how we let people use the US dollar. But what actually gives it the power underneath is our military. The hegemony militarily worldwide, it allows us to set the terms of how people use the US dollar. Do you see what’s going on right now with Iran and this rushing to “an agreement” as a possible loss of credibility for the hegemony?
David: Yeah. From a military standpoint, if the US loss of military hegemony is in play, which I think it is, what does that mean for asset prices? What does it mean for Treasuries? What does it mean for the dollar, for gold? We’ve talked about how important the military is for that hegemony. We’ve also talked about how important currency credibility, Treasury market credibility, is.
Kevin: That’s the Treasury side of it.
David: And that’s the other part of our global monetary hegemony. To some degree, there’s been no alternatives. We’ve talked about the CIPS program where China is seeking to displace the capital flows and the control that we have over the currency pipes, so to say, in the financial markets. The US controls that via the SWIFT system. At the same time, we have Beijing launching mBridge, which is a cross-border currency platform backed not only by, of course, the People’s Bank of China, but by Hong Kong, Thailand, the United Arab Emirates, and Saudi Arabia as well.
Kevin: They’ve been working towards that for the last 10 or 12 years, haven’t they?
David: Yeah. And this is the digital currency platform, which is designed really to also compete with the dollar’s role as a trade settlement vehicle. And so, we’ve got trade settlement which is being undercut. We’ve got reserve management where central banks are moving out of Treasuries and towards gold. We’ve got military hegemony which is very much in play. Again, in the same week, we’ve got the Fed making decisions that are equally relevant to the dollar’s role as a currency hegemon.
What does that mean for asset prices? If some of the sheen is taken off of the dollar, does that impact the way people view Treasuries? Does it impact the stock market? Does it impact gold? I think the answer is yes, it impacts all of those assets.
Kevin: Well, I was talking to a client yesterday who has banking experience. In fact, they own a bank. And we were talking about how in a strange way the balance of payment system is returning worldwide. You’re seeing that with the Central Bank’s stocking up on gold and owning more gold than they own Treasuries. The old balance of payment system back from the 1800s up until 1914, when a country had a deficit, they had to ultimately satisfy it in something that was real, and that was a beautiful period of time.
That was the industrial revolution. Then of course we broke that and we tried to make the dollar the replacement for that. How much, right now, Dave— From a foreign standpoint, how much are we really needing the foreigners to hold Treasuries?
David: All of this takes place in the context of deglobalization. We’ve answered the question, what do central banks want to hold? And the math would suggest that it’s gold. The second part of that—not only what, but where—is also in play. We talked about that last week, and having it on hand where it cannot be absconded with, it cannot be taken from you. That’s also a reason why gold as a physical asset is more and more important.
Kevin: Close to home.
David: Yeah. You look at the rest of world holdings of US financial assets. Some of this is central bank, some of this is investor capital, but if you add up both the equity holdings, their investment in US stocks as well as US debt instruments, it sums to 65 trillion dollars, 65.18 trillion. Debt holdings are—
Kevin: Foreign money in.
David: Yeah. And that’s 15.92 trillion in a combination of corporate debt agencies, Treasury securities, probably nine, just shy of 10 trillion in Treasuries. A Federal Reserve—and I think this is why this week is so important—a federal serve that ignores inflation takes for granted the stability of that investor base.
A foreign investor in US assets is looking at a variety of things. One, what is the return on capital? Maybe that’s a less important concern for central banks, but certainly from an investor standpoint you’d like to know what interest rates, what the compensation is for loaning money to, again, corporates, agencies, the Treasury itself.
Kevin: Plus they need the currency that it’s invested in to stay somewhat strong.
David: That’s the other piece is that weakness in the dollar is sort of the double whammy. Rates that aren’t sufficient to justify the allocation, and a currency that is in question, it’s very, very relevant. The Federal Reserve has a lot at stake if they choose to ignore inflation. They were late to address their inflation concerns. They considered them to be a transitory—the word that got used over, and over, and over, and over again. And is this another version of transitory?
Well, again, judging by where the target rate is, three and a half to three and three quarters percent, and where the inflation rate is, not only is it transitory, but they’re not doing enough to get it in line. They have not tamed it in five years. So that in itself is a credibility issue in terms of the decisions they’re making, the policy choices.
Yes, it’s been favorable for employment. No, it has not been favorable towards those who may still be employed but are having a hard time paying their bills, running out of money before they run out of month.
Kevin: So there’s an expectation this week with Warsh.
David: Yeah. A bond investor cares about income, cares about currency stability. The Fed’s recent record has been to do too little, too late in the fight against inflation, and Warsh can change that record. But the cost, the cost for Warsh will be either an angry equity investor base—you start to shift rates higher and there’s a real implication for the stability within the equity markets.
Kevin: And watch Trump react, too.
David: And that’s the other thing is that if it’s not an angry investor base, equity investor base, you may have a very angry president. Recall his comments in the Financial Times about Netanyahu. “I call the shots. I call all the shots.” Well, the bond market wants confirmation that the Federal Reserve is not a shadow White House operator. They want to know that the institution has independence. And if it doesn’t, there’s massive implications in terms of higher rates priced into long end of the curve. Warsh has to choose this week, and of course in future months, who he wants to be reviled by. He is not in an enviable position. This is not a great role. Popularity, you got to kind of check that at the door. So Trump plus the stock market, do you want them to be on your side, or the bond market, which would include the nearly 16 trillion in foreign capital sitting in US fixed income assets?
Kevin: The game seems to have been, for many years, this financial repression is to have negative real rates of return so that you can work your debt off. You can inflate your way basically out of a situation. But it reminds me of sleight of hand, Dave. When somebody is really good at sleight of hand, what they get you doing is always looking at the wrong hand. But there’s a point when you know the trick and you can just watch the hand and go, wait a second. This is repression. This is negative real rates of return. I’m losing money. Could this be a shifting, a turning point right now with a new Fed chairman?
David: It seems like yesterday and yet it was almost two decades ago that we were talking with Carmen Reinhart on this program, and she was describing how, from a policy perspective, it was necessary to corral investors. And the process of financial repression was one of choosing winners and losers.
Kevin: She called it a captive audience. Create a captive audience.
David: That’s right. And it was interesting that after that conversation, I think it was actually after the recorded comments, we were talking about, what do you do personally? She’s paying down debt, making sure their real estate had no debt associated with it.
Kevin: Buying some gold.
David: Owning hard assets, maybe even own some gold was her comment. Well, negative real yields may serve the interest of the Treasury department. Again, that would be where you’ve got inflation above the target rate.
Kevin: Watch this hand.
David: That’s financial repression. It’s a policy tool used to alleviate the pressure on US debt and from US deficits. But bond investors, I think they remain uninspired by being that captive audience, by being treated as grist for the mill. So how you keep them happy is going to be a real trick for Warsh. And that sleight of hand, it’ll be interesting to see what he focuses on.
Just to reiterate, inflation has been allowed to run hot. If it increases, and inflation rates run higher than the current yields across the yield curve, effectively investors are losing money, and the disincentive to hold fixed income assets becomes more apparent. I think this is the setup which Mike Wilson from Morgan Stanley was getting at. Why is the 60/40 portfolio broken?
And again, this is a part of our conversation when old assumptions fray, what we’ll be talking about later on Wednesday. There are a whole set of assumptions which are shifting. And some on Wall Street have seen that structural shifts are afoot, Mike Wilson being one of them.
Kevin: And maybe Warsh as well. I mean, to be honest with you, you said he’s a very capable guy. He’s not missing it.
David: No, absolutely. But when a country is drowning in debt, there is a strategic advantage to running inflation hot and suppressing interest rates, either by keeping the policy rate low or by buying down the yield curve, which you can do through what we’ve called yield curve control.
Kevin: Which is inflationary, ultimately.
David: Should be. Yeah. But repression is essentially choosing the winners and losers in the marketplace. In this case, it’s the saver. It’s the investor. It’s the person with the 60/40 portfolio, or as somebody’s getting closer to retirement who has actually even more than the 40% allocated to bonds. Who’s the winner? The net winner’s the Treasury, who gets to pay off debt with cheaper currency units and is managing, with the help of the Fed, managing those interest payments to a lower level.
Kevin: So we’ve rolled back the time scale sometimes back to Volcker because just about everybody has heard Volcker’s name because he did something that was very unpopular. He raised rates. And Volcker was the Fed chairman. It was his last year as Fed chairman when I first started with this company. He was considered tough, but he had a different environment. If Warsh raises rates, what does that look like?
David: Well, some experts would see that the fiscal position of the US is already too far gone, even if you’re raising rates to battle inflation. Charles Goodhart was quoted in last week’s Hard Asset Insights, and this came from the Financial Times, stating that, “fiscal policy has become so unsustainable and so precarious that monetary policy cannot easily work.”
Kevin: Right. So what Volcker did, that was monetary policy. It doesn’t work like it does now.
David: Yeah. Particularly not in its regular form of raising interest rates. This is what Goodhart said, “Central banks are going to be subject to much greater pressure. Their freedom to use interest rates as they might want, to bring inflation back to target, is not going to be the same as it was earlier.”
So again, whether it’s Goodhart or Mike Wilson at Morgan Stanley, these are structural shifts. And I can only speculate what Goodhart was thinking as the element that restricts the central bank’s freedom. It seems that interest expense could fit near the top of the list. You raise rates, and your interest expense compounds negatively against you. It moves higher and further raises the bar you must reach fiscally.
Kevin: I think it was two or three years ago. Didn’t you actually have dinner with Goodhart, in England, right?
David: Yeah. Yeah. Over dinner, Charles and I had a fabulous conversation about the Suez Canal and his time in the service. So he was in the military in ’56. And near the end of the dinner, he commented that it seemed like gold was a great place to allocate savings. His comment was, “It must be a great time to be in the business you’re in.”
Kevin: And guy was a central banker and he was London School of Economics. You would not expect that from those guys.
David: Right. Coming from one of the more tenured central bankers in London, ever, and I think he ran the finance department at the London School of Economics for 20-plus years. It was a bit surprising, and he had sort of this wry smile on his face.
Kevin: Probably winked.
David: Probably a good business to be in. I think people should own some gold.
Kevin: That sort of turned out, didn’t it? I mean, that was a couple of years ago.
David: Well, I hope he was personally allocating at the time. I don’t know if he was or not, but it is interesting to reflect back on the conversations with Carmen Reinhart—for the Commentary—and that dinner conversation with Charles Goodhart. There’s a recognition that things are different and there’s other constraints in play.
And so I don’t envy Warsh and the calls that he has to make in leadership. Of course, he’s not making them alone, but the markets are going to have to adjust to a new style of leadership, and a part of that is that he’s not interested in forward guidance. He doesn’t like the dot plots. He doesn’t want to tell the financial markets what the next moves are going to be by the central bank.
And I think some of that comes from his direct experience in the financial markets. He made a good bit of money working as, I guess you could call him protege, Stanley Druckenmiller at Duquesne Capital, one of the finest investors of our lifetime, and kind of made a name for himself originally as one of the chief traders for Soros’s Quantum Fund. And then running his own family office, Duquesne Capital. That’s where he and Warsh overlapped for a good many years.
So the desire to move away from telling the market what you’re going to do is with an awareness that the markets will use that information to their advantage. And it makes it even more difficult to accomplish what you want from a monetary policy standpoint if you’re just feeding the financial market beast.
Kevin: And that was an older policy. I remember when I was taking economics in college, my professor, Dr. Cochran, he would say, “Read the Wall Street Journal. Anything that a Fed chairman says, write it out word for word opposite,” because that was back in the day when the Fed didn’t tell you what they were going to do. He said, “Just make sure that you don’t get caught thinking that they’re telling you the truth. They’ve got their own game to play.” Doesn’t that give credibility to the Fed if they do things more that way than telling the markets what you’re going to do and then letting the market discount it?
David: I think it’s credibility, yes, but it’s also volatility for many market participants because you have the element of surprise. If you don’t know what’s coming, then you have to make a mid-course correction for the bets, and particularly the leveraged bets, that you’ve put in play. And so fast, quick, violent reversals within the marketplace come with the diminishment of forward guidance, which is one of the reasons why people have said that the Fed has adopted a third closet mandate or silent mandate, which is sort of managing the financial markets, and forward guidance allows you to do that by guiding expectations.
Kevin: So they won’t have as much control over the market based on what they do because they’re doing it for a different reason.
David: Right. Effective monetary policy implementation, I think, is a part of the scheme that he wants to harken back to, maybe more in line with the Volcker era or the Greenspan era.
Kevin: So let’s go back to Goodhart for a moment because it is interesting that he told you that gold was a good thing to be buying.
David: No, it was a couple of years ago. I think that common has aged well. And gold, for central banks, of course, has captured the limelight. They’re very interested. They’re allocating, they’re spending their money accordingly. And I think investors, too, will move gold from the shadows, maybe not even allocating anything to the asset class, very much into a prominent place within their portfolios as they realize what we have for a number of years now, that the Fed is trapped. The Fed is trapped.
Central banks more generally face the same constraints. It’s not just the Federal Reserve, but it’s other central banks that are in a similar position with rising inflation and the classic tools of raising interest rates to battle inflation being less effective or more consequential for the Treasury. Those tools may not be implemented, certainly not to the degree that they were under Volcker. So as inflation enters its second wave, policymakers have both a more limited set of options, and those options are in the current environment less effective, as Goodhart was commenting.
Kevin: Okay. So for shorter term, we’ve had somewhat of a correction in gold here over the last few months. Do you think that some of the events that are coming up right now, do you think we’re turning, in the metals? Maybe not quite the bottom, but do you think we’re close?
David: Closer.
Kevin: Closer.
David: Yeah. So have we made the turn in metals? Last week we suggested that there were several sentiment measures that had reached levels sufficient to signal a turn, or at least satisfy criteria that have been a part of past positive reversals. So we’ve met those criteria.
Kevin: It’s the Hey Mikey criteria. Do you remember Life Cereal had that? It was like, “Oh, Mikey won’t like it. He hates everything.” And then Mikey likes it. They hate gold right now. It’s the Mikey criteria.
David: Yeah.
Kevin: But that’s the sentiment that you want, to be buying gold.
David: From a contrarian perspective, yes. So it doesn’t mean that we have turned, but it does suggest that the process of putting in a bottom on the precious metals in this precious metals market correction is well underway. I think that caution is warranted with headlines continuing to shift from one day to the next, and traders on again, off again with their bets. Certainly volatility is not behind us.
But I also suggested last week that with some follow through to the upside, momentum would create a more sustainable uptrend, and I think we’ll know that by the end of the month, and maybe the end of this week, but I think certainly by the end of the month. So if metals prices are finding their feet here in June, gather some momentum in July, the year-end finish may well take out the previous highs that we set in January.
Kevin: Wow. So it could really come back. Okay, but this week let’s just focus on today, first of all, because you guys have this webinar that everyone should watch if you can, and you can ask questions on this webinar too. So sign up for that.
David: Yeah. I mean, we’ve got over 500 people registered for the call. I think we’ve got 50 questions in play and about 40 minutes allocated for those questions. So submit your questions, realize that we may run out of time and we’re happy to address those questions one-on-one in a personalized format. But this week we look at the, if you want to call it the washing machine to see if monetary policy impacts market expectations and what are those expectations going to lead to? Is it a market melt up? Is it a market meltdown? Or do his policy suggestions create a real crack in the bond market?
Again, expectations are so much a part of this, where the bond market has already said rates should be moving in the direction of 25, even 50 basis points higher by the end of the year. The bond market doesn’t get what it wants. Again, it’s a question of who will revile the new Fed chair, and who is he more concerned with? The approbation and praise of the president, or affirmation of the bond market that, yes, the Federal Reserve is a legitimate organization and is bringing some discipline to this problem?
Kevin: And willing to fight inflation.
David: What will he do in real terms to fight inflation? Andy Haldane was writing in the Financial Times this last week and he said, “Please don’t make the mistake that was made prior to 2008. Please don’t make the mistake that was made prior to the run-up inflation in 2022. If you underestimate inflation, you will pay a greater price. And actually the people who pay the greatest price are the people that cannot afford it at all. That is Joe and Susie Lunchbox. That’s the average American, the average voter all around the world who is faced with, whether it’s food inflation or fuel inflation, or inflation creeping into other areas as well, that’s already a price that they can’t afford to pay.”
Kevin: When the question’s no longer, can we eat out, but can we eat?
David: Exactly. So we may have metals responding in a volatile fashion, one direction or the other. Is it because the MOU really means nothing and this is not peace? This is a ceasefire, and anything can happen in the context of negotiating a lasting peace. Those headlines can shift moment by moment, but Warsh and new style and new tone, a new tenor, from the Fed can also have a similar impact, a dramatic impact, and the direction is not clear.
Kevin: So don’t place a leveraged bet anytime in the next few days.
David: I would say that’s a good call.
Kevin: Either direction.
David: That’s a good call. So we have an overloved and overowned US equity market. Valuation suggests that this is an unreasonable time to be very, very, very long, and particularly leveraged, in the stock market. I sat with a gal yesterday and we talked about, what does it mean to be between two and a half and three standard deviations from the mean in terms of stock market valuation? It means that less than three tenths of a percent of all stock market history have you found the stock market more expensive than it is today. So 99.97. 99.97% of the time—
Kevin: That’s amazing.
David: —the stock market is cheaper. There’s still this rarefied air where yes, it has been more expensive, but it’s very, very rarefied. And in terms of statistics, you should pay attention to the greater likelihood of mean reversion. Is there a catalyst? Do we need a catalyst? Actually, we don’t need a catalyst. But what I’m saying is that headlines could provide one, and they won’t be the cause. The cause is overvaluation. The cause is overindebtedness. The cause is the trigger. These are all the structural things that exist. We just need an excuse to sell or an excuse to buy. So contrast the overloved and overowned US equity market with an underloved, underowned precious metals complex.
I think money allocated now with a two to three year time horizon faces a very different path, whether you’re going equities or going towards metals. There is a carve-out within the hard asset space, which we’re going to be talking about on the call, where yes, with a surgical precision allocations within the equity market can make sense because there are still pockets of undervaluation, pockets where there’s been less investment and less capital flowing for better than a decade, decade and a half. And we’ll try to unearth some of those value opportunities as well.
Kevin: You’d better have a steady hand.
David: Yeah. But I’m still betting on the metals coming out on top. If you say, two to three years out, do you want to be invested in the NASDAQ and the S&P or gold?, I’ll take the gold, thank you very much.
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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.
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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.
