Podcast: Play in new window
- IMF warns “normalization of rates may be more difficult than previously envisioned”
- “Not QE” is in high gear, $7.5 billion in one day
- Elizabeth Warren promises to tax wealth
The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick
“The Fed Is In Some State Of Panic Over Something
That Is Not Entirely Clear” – Bill King
October 23, 2019
“You can see why wealthy families have a little bit of money in art, a little bit of money in gold, a little bit of money in international real estate. These are forms of wealth storage that are either quiet, or they are beyond the arm of whatever treasury you might be concerned about. Come back to this issue of building tax capacity in the IMF paper. Building tax capacity – maybe Elizabeth Warren is just what the IMF doctor ordered.”
David McAlvany
Kevin: David, something is not right. It just doesn’t feel right. Our friend, Bill King, said just recently, “The Fed is in some stage of panic over something that is not entirely clear.” When you know something is not quite right – have you ever met a person and they seem very, very genuine, and you think, “This guy, boy, he would be a good hire.” And then as you call references and look around and get context for him, you start to realize that not only is this a person who can’t keep a job, but he leaves disaster in his path.
David: Oh, like he’s been fired from every previous job he has had? That’s an interesting thing.
Kevin: Well, you need context and you need references, because people can put on a face, and what I’m saying is the Fed is putting a face on right now.
David: (laughs)
Kevin: And that’s probably not what is actually happening.
David: When my wife came to visit me, before we were married, about 20 years ago, she watched my family, she watched friends, and she was curious about how they reacted to me when we were all together. Was this the genuine Dave, was I acting strangely? Were there clues from my sister, my brother-in-law, from my friends?
Kevin: She was getting references. That’s what she was doing.
David: What did my actions say? And a part of this was she was unable to judge the context from afar. We were living 2000 miles apart. What did my actions, what did the actions of others tell her about sincerity, or about the reality of the man that I was presenting myself to be, the reality of our circumstance, the future, maybe potentially, our future together?
Kevin: Fortunately for you, you turned out to be genuine, but what if we were behind the doors of the Fed – I’m not talking about the Wednesday announcements when the Fed comes out and actually does the pre-prepared announcement, but when the doors are closed, and behind the doors, what is the context going on there?
David: In a similar way we observe the Federal Reserve and we’re trying to judge the context. We know that one major transition occurred from Greenspan to Bernanke where Greenspan was intentionally opaque, he was guarded, and he riddled his words, so much so, that in that era when we spoke about what he was saying it was referenced as Greenspeak. I think it was only intelligible to him. But Greenspeak was how we described his language. And there was a cultural shift during the Bernanke era which included telegraphing in advance what moves you were considering and communicating.
Kevin: “Tell them what I’m going to tell them, tell them, and then tell them what I just told them.” And that controlled the market.
David: We call that forward guidance, and it hasn’t been that long since this new strategy of “transparency” has come into vogue, and it serves a purpose, not always to telegraph what will happen, but perhaps to direct the flow of decisions toward desired outcomes on the basis of judgments that are being made by market participants and you feel like you are a well-informed market participant because of this forward guidance. And it seems to have coincided with the Fed wanting to make market participants absorb these shifts in policy on a forward-looking basis, instead of being these future shocks. No surprises.
Kevin: Speaking of surprises, remember a few years ago, the taper tantrum? I don’t think the Fed thought that they were surprising the market, but certainly when they started tapering, it had a tantrum.
David: (laughs) That’s right. Well, we go back to the idea of the end of theory which Richard Bookstaber discussed with us and explored in his book where outcomes are guided and the market is led like a bull with a ring in its nose. So you’re using data, you’re using the ability to communicate and using perception management to move beyond these economic theories of cause and effect and really sort of guide or determine a future outcome. It may be that that is what is being experimented with.
Kevin: Do you think that’s what the Fed is doing right now? They seem to be in a private panic with what we talked about last week as far as the repos, the monetization, the QE.
David: And that is what Bill King has repeatedly told us. The Fed is in some stage of panic over something that is not entirely clear. And we know this, not from their words, but from the weirdness of their behavior over the last three to four weeks, a game of talking up the economy, that’s a fine reason to do that, suggesting that markets are, in most cases, reasonably valued – eh, that’s questionable. You know, you can pick and choose.
Kevin: No bubble.
David: That’s right, no bubbles in their line of sight. But you watch around them. You judge, not just them, you can see that something is off, something about the repo markets and the recent QE which shall not be permitted to be called QE.
Kevin: Right, we don’t call it QE.
David: It suggests that there is an undetected, or an undisclosed fissure in the financial markets, which they would like to fill and stabilize as quickly as possible.
Kevin: And I’m wondering, it’s a black hole type of thing, Dave. Black holes can’t be seen because the light doesn’t come back out of them. There seems to be a black hole sucking up liquidity right now because the Fed has not been able to keep up, using repos and QE, everything else. They’re still not keeping up.
David: So what is the something that has the Fed’s full attention and has them with hundreds of billions of firepower at the ready? I think there are a few clues to this from the recent IMF global financial stability report dated October 2019. I was going through that this weekend and it reads like Doug Noland’s Credit Bubble Bulletin, affectionately in-house known as the CBB. Both, I would add, are worth a read. If you have the time, the IMF piece will cost you a few hours, it is about 109 pages. Noland’s, 15 -20 minutes. Read Doug’s if you’re time crunched.
Kevin: Well, and you know what? I made fun of you last April when you said you sat and read the 83-page IMF report on negative interest rates, and since then I have sent it to clients, I have read it. I will not make fun of you anymore because when the IMF puts it on paper, a lot of times it is shocking to the person when they hear it, but the IMF is actually telegraphing things that you may not want to hear.
David: I also worked through the Bank of International Settlements paper, one of them recently released, and it is fascinating. Claudio Borio ran the numbers and concluded that monetary policy – this will be a shock to our listeners – may be one of those endogenous problems that causes future financial chaos. So what we are doing today, rather than looking at these outside influences that can cause market panic and financial collapse (laughs), he is basically saying, “No, we could, through monetary policy, actually seed future financial issues by what we are doing.” Of course, he is being critical of the low interest rate environment and that being an endogenous and internal cause for financial market panic.
Kevin: It reminds me of this person that we are talking about that you needed reference on because they may look at you and say, “Don’t make me do something that I don’t want to do.” Wait a second, I thought you were here to help. This is where reference, and actually getting some context helps.
David: My wife and I have been discussing Malcolm Gladwell’s book Talking To Strangers, which in a nutshell is a look at social epistemology. How do we know what we know about someone, and is that perception right? Is it wrong? That is basically what she was doing when she came out and visited me in Idaho before we were married. She was trying to get an idea of who I was. Again, Gladwell’s idea is that sometimes we don’t get those judgments right. And so he explores a number of things. Does the quality of analysis change with education? Does it improve with professional insight?
And again, here we’re trying to discern the level of panic and the point of concern at the Fed based on actions, not on words. Can we possibly get that right? On the Commentary, obviously, we certainly try anyway. Gladwell argues, we get the easy calls right most of the time. Everybody does. Law enforcement gets the easy calls right, the average guy on the street gets the average calls right – is this a good person, is this a bad person? Well, if you’ve got the obvious indicators, you’re going to get it right.
Kevin: Yes, but what if somebody is hiding some of the less obvious?
David: Yes, so where it matters most, the difficult calls, when you are dealing with either criminals or sociopaths, real threats, or even hidden agendas, the less obvious sort of being led to water that you are intended to drink from – not the obvious, but more of the insidious ones – he says that even the pros get it wrong, more often than right. So it doesn’t matter if you’re a detective, if you’re a secret service agent or a judge, he documents that we’re not good judges of the “other.”
He argues that even where you have eyewitnesses, this is a terrible source of information when coming to critical judgment. And his evidence for this is that multiple eyewitnesses to an event recall radically different details and in many instances completely contradictory details, and these are the things that we hang judgments on, and in fact, sometimes hang people on.
Kevin: Have you ever been involved in an automobile accident that makes the paper, or some other event that makes the paper? And you read it. You were the one who was there, you actually experienced it, and you read about it and you can hardly recognize it. That’s what you are talking about. You really cannot trust, necessarily, multiple witnesses.
David: After reading the book, it made me think twice about taking the news media seriously. Maybe I had reasons to do that previously anyway, but when you are judging events or when you are judging people, how do you account for bias? How do you account for spin, and either the external or internal influences when judging events and people?
Kevin: Well, we have a preferential filter. What do we prefer?
David: Right. So this is not an easy process, but lawyers, judges, doctors, see what they want to see, concludes Gladwell. Even if they wanted to be objective, odds are the news media blindness would remain as much as it does in a clinical trial or in a court case, which to me, frankly, is chilling. But my personal conclusion as it relates to strangers and as it relates to how things are recorded by the news media, we should give people the benefit of the doubt, we should be incredibly generous and kind, we should assume the best, and assume that if there is an error in interpretation that it is yours, or I should say, it is mine. And in that sense, you will be statistically right.
And the bottom line is, we live in this age of snap judgments and social media witchhunts. You can even reference Gladwell’s other book, Blink, where he is talking about the speed of decisions and the accuracy of those decisions. Here he is almost creating a foil in this new book. You should be careful in your dogmatism, because again, the dogmatic views of things which sort of totalize and give you a perception of, “This is the way it is,” he is saying, “Odds are you don’t have it right.”
Kevin: It makes me think of the China deal.
David: And of course he is talking about people you don’t know, he is talking about people that are unfamiliar to you – this could be foreigners or people from another culture.
Kevin: That’s what I was saying about the China deal. We have been set up now for a year-and-a-half for when the China deals starts coming together. In phase one they announced that the China deal is now coming, and it has really turned out to be a non-event.
David: We were told it is a big deal. In the phase one, obviously the market was not impressed. You had Monday and Tuesday where market participants had the opportunity to move markets, and nothing really happened. And I think everyone gets it. Part of this is, just because Trump says something is huge, it doesn’t mean it is huge.
Kevin: “Yuge.” Yes.
David: And I try to teach my kids that hyperbole, while it is a useful and a very strong literary device, it can be detrimental when it is used in relationships, and it can cause credibility issues when everything is always off the charts.
Kevin: Yes, but is China even playing? They are really waiting for us to pull the tariffs back before they do anything.
David: Yes, the deal was announced, here was the big win, then China mentions, “Yes, we’ll get started. We’ll do everything we said we were going to do. We’ll buy all the agricultural products once tariffs are removed.” So yes, we have a deal, but if we are also waiting for the U.S to comply with the Chinese quid pro quo first, we do not have a deal. That much is reflected in the market action following the announcement. It just didn’t mean anything.
Kevin: But you’re also not saying, necessarily, that the stock market won’t continue to move up. Technically, there are reasons why it could, actually, proceed north for a while.
David: Yes. One particular technical view of stocks today is the S&P moves well above 3100 before a major correction, and of course, looking at how that view would be negated, it is negated if prices move below 2820. So again, taking out fundamental factors, just looking at technical factors, 3000 is a somewhat critical hurdle for the S&P. Break above 3000, that opens the door for a push higher. And we generally disregard an intra-day move and look for a multi-day close above or below a critical number. That is what we borrow from Dow theory and stuff that was popularized not only by Richard Russell, but if you go back to Hamilton and Rhea and that legacy, you want to see a multi-day close above a critical level.
So last week was fascinating because even with options expiration there was very little appetite to push the S&P above 3000, couldn’t hold the number. And that is with the Fed being incredibly active.
Kevin: Speaking of an active Fed, yes, the Fed is nudging everything the direction that they need, but actually, like you said, they are strangely panicking, too. We don’t really know what is going on, but the repo markets are rearing their ugly heads again.
David: Mid-week last week we had the repo markets under pressure, overnight collateral rates moved outside of the desired and managed range. Of course that raises the question, who really is in control? And as we have always said, the market is in control. There is continuing to be more desire for overnight liquidity than the Fed is currently offering. And that is what is wild, they are offering a lot.
Kevin: And you have been mentioning that the Federal Reserve is acting more like they are trying to save the world than the nation, or the nation’s economy or finance, so I wonder how much overlap there is where they are actually reacting to things maybe in Europe or in Asia.
David: And from a pragmatic standpoint that makes sense because the world of finance is very interconnected and these linkages are important to appreciate. Problems elsewhere do become our problems at some point. But I wonder how foreign banks with U.S. subsidiaries, and how foreign banks with U.S. branches, are managing a collective balance sheet. They have these geographic exposures and even if their headquarters are, say, in Germany – maybe I’m thinking Deutsche Bank – would they also have a footprint here in the U.S.?
I wonder if, to some degree or another, we’re not providing liquidity to the globe. I know there are regulatory lines in place here, I just don’t know if those lines are well-managed, well-maintained, well-monitored, well-supervised. Are we accommodating the global financial market liquidity need? In the past we have had the swap lines but we’re not in that context where the Fed is announcing swap lines and is telling the world we are the global financial market’s liquidity provider. But are we, by default, becoming that?
Kevin: And I’m wondering, you read that 103-page IMF report. What did they have to say? Because it is about global stability. I would imagine that would show up there.
David: Yes, the IMF’s global financial stability report for October was fascinating. It covered the 2019 bank interventions in China, for them considered a very significant issue. The Chinese credit markets hold the highest probability of issues, of defaults and future crisis dynamics. And they are confirming what Doug Noland, through the CBB has been writing all year. They discussed in the IMF paper the end of LIBOR. They have discussed that at length.
Kevin: Let’s talk about that. What is LIBOR and why should that matter?
David: The London Interbank Offer Rate. We are transitioning away from that number. The deadline is end of year 2021.
Kevin: And that is just a stabilization mechanism, right? That is sort of a number that everyone agrees to as far as keeping interest rates stable worldwide?
David: I would say it is a number that has been fairly stable and it is a reference rate for lending internationally. Think of it like this. If you’ve done a private personal loan with a bank, they might reference prime, so your loan will be at prime plus 1, or prime plus 2.
Kevin: They will do that with mortgages, as well.
David: And so you have this sort of reference rate which all of these other loans key off of. Maybe another way of thinking about this transition away from LIBOR to SOFR, is the new rate, or the most commonly accepted rate so far – did I say that? (laughs)
Kevin: It’s so good. There you go.
David: To think of a very stable rate, LIBOR has been stable for a long time, and the SOFR really is not tried, true, developed, and at this point is far more volatile than LIBOR has been. And so again, this represents a major issue. We are transitioning the remaining 267 trillion dollars…
Kevin: That’s with a “t.” This is derivatives.
David: Yes, these are derivative contracts. I think 67 of that is international, 200 trillion is domestic here in the U.S. We’re transitioning this 267 trillion in derivatives contracts away from referencing LIBOR to referencing a new number. And thus far I think it is intriguing that the new substitute, again SOFR, is trading in the tens of billions, will ultimately have to trade hundreds of trillions, and the gap between those numbers is a real one. The timeframe to transition is not that far off, year-end 2021, and thus in the paper you have this concern expressed. I want to come back to LIBOR and the derivatives market perhaps in future podcasts.
Kevin: Well, before we move off of that, for the person who doesn’t really watch that type of thing, you likened it to me, earlier before we started recording, to your mortgage rate. Let’s say your mortgage rate, you pretty much could consistently know what the interest was. That would be like the LIBOR. That was something stable. But moving to something that hasn’t been tested before could create quite a bit of volatility, and you asked me, “Kevin, what if your payment fluctuated dramatically every month depending on what the interest rate was? You really couldn’t make plans ahead.”
David: To be clear, it’s not a perfect analogy, but I think it is helpful because LIBOR has been so stable, you can almost think of it like a 30-year fixed rate mortgage. It doesn’t really move, and from one month to the next you kind of know what the damage is going to be. But so far, it has been more volatile and it does introduce into the overnight lending markets a certain degree of instability that hasn’t existed for decades. So I do wonder, is there something going on in the current overnight lending rate? We talk about the repo market, and as we did last week, sort of highlight some of the issues there, is that what we are dealing with, this transition from a stable rate to an unstable rate?
Kevin: I have conversations with a client of ours – you and I both talk to him on a regular basis. He has one of the best insurance companies in America. He has a very large policy with them. But he understands that all of this “stability,” this artificial low interest rates, the stability that has been built into the system, has forced a degree of risk, like with insurance companies where they say, “Yes, we’re going to still pay you your interest, but under the surface they are having to take much higher risk because they can’t actually, in a stable way, earn the kind of rates that they are guaranteeing to subscribers.
David: Yes, so there is a series of things that get assumed in derivatives contracts, whether it is a credit default swap, or if you’re thinking of a collateralized debt obligation, or even the creative stuff that was made back in 2005, 2006 and 2007, the CDO squares where you are basically repackaging garbage three different ways and selling it three different times.
Kevin: Taking high risk, but calling it triple A.
David: Yes, and there are assumptions embedded in these contracts about interest rates, about market volatility and about pricing, and again, we’re beginning to play with some of the underlying assumptions that go into these contracts. I don’t want to connect dots that shouldn’t be here, but the LIBOR issue coinciding with the massive ramp-up in dollar-funded debt in recent years, you have balance sheet vulnerability in the emerging markets, growing balance sheet vulnerability in the corporate sector – that was a big part of the IMF paper – and the IMF was screaming in this paper that there is inappropriate risk being taken by pensions and insurance companies in response to the lower-for-longer interest rate environment that we are in. So, it doesn’t suggest a picnic in the years ahead, and it is one of the reasons I thought the Bank of International Settlements paper was kind of a good weekend complement.
I wanted a strong whiskey after reading it because basically what they are coming to is a reasonable conclusion – the lower for longer is the monetary policy that we have put in place and the IMF is saying, “Yes, and this is a problem because it’s changing the behavior and it is becoming the fact that we have inappropriate risk being taken by pensioners, insurance companies and institutional money-managers.”
Kevin: Yes, so it’s not just the banks that we’re talking about. Even though the IMF talks mainly to the banks, it’s not just the banks.
David: That’s right. And one last major theme from the IMF paper was that non-bank financial firms are playing a larger and larger role in the credit markets, and they don’t have the same restrictions. They don’t have the same capital requirements you have at banks, which, roughly, if you want to interpret that, is to say that we have higher and higher risks, we have less and less ability to strategically intervene if, for instance, you begin to see failures. It is no longer with a particular institution that you step in and bail out or have a shotgun wedding.
It is obscure little financial products, and obviously this is done here in the United States. We have some of the best and brightest at J.P. Morgan and City Group and Goldman-Sachs creating these creative financial structured products, but the Chinese have been doing it, too. They have learned from us that you can create wealth management products that have all kinds of interest rate mismatches and problems that are actually baked into the cake.
Kevin: Something that you have mentioned here over the last few months is corporate debt, something that is also probably at high risk if we have any major change.
David: Let me give you a quote or two that kinds of gives you a flavor, again from the IMF paper. They say, “In a material economic slowdown scenario, corporate debt at risk, that is, debt owed by firms that are unable to cover their interest expense with their earnings, could rise to 19 trillion dollars, or nearly 40% of total corporate debt in major economies, above crisis levels.” So they’re looking at the implication here of, you continue to see a slowdown and you are going to have a major issue in the debt markets. The debt markets aren’t really giving you any indication of that. The math would suggest that is going to be the case, but the market participants today are not particularly concerned. So they circle back around and say, “Well, if the market participants aren’t going to be concerned, we should be, and policymakers are urged to tackle these three critical risks: One, rising corporate debt burdens. We should be doing something.”
Kevin: Well, 19 trillion dollars, that is almost the size of the U.S. deficit. That’s what they’re saying could be at risk.
David: Right, exactly, and they are basically saying, we need to stop, and policy-makers can impact this by doing things like, don’t allow writing off debt in favor to equity. So you’ve actually created an incentive structure for corporations to increase the amount of debt that they have through the tax code. So they are saying policy-makers should scrap that.
Secondly, they say that increasing holdings of riskier and more illiquid securities by institutional investors has to be tackled. Again, they are seeing this migration and the Bank of International Settlements connects the dots and says, “Oh by the way, the problems of tomorrow are because of the monetary policies of today.” Is it a surprise that you have institutional investors buying riskier and less liquid securities in a low interest rate environment?
Kevin: And we talked about a black hole, Dave. If we have a liquidity crisis going on, a secret liquidity crisis, which is very obvious the way the Fed is responding, what that actually means is, somebody is holding illiquid securities. They are holding something they can’t sell, so they have to borrow money.
David: And that’s where the paper points to cross-border interconnectivity where, again, you have an increased reliance on external borrowing by emerging and frontier market economies. They are borrowing in U.S. dollar terms, so you have the currency mismatch – we’ve talked about that in previous shows – where the burden of debt, if you have any devaluation at all, ends up ratcheting higher.
Kevin: And if you are growing, if we have a growing economy, this is usually not a problem. What does the IMF see for growth?
David: That’s the issue. Global growth in 2019 will be the slowest since the global financial crisis. So the assumption is that to keep the growth numbers marginally positive in future years, it is going to require a significant fiscal boost, and that is one of the things the paper addresses, this fiscal boost which is going to be required. So they don’t address what the BIS paper does in terms of monetary policy being a part of the problem. They’re just saying, that is, the IMF is saying, the next step is to step in with a fiscal boost. And they also suggest that it is going to require building tax capacity.
Kevin: Oh, that sounds bad.
David: Well, put that in quotes – “building tax capacity.” It is ominous. Euphemistically, that says to me that the IMF knows that a major redistribution of wealth is on the horizon and maybe on a global basis, which would mean that the coordination of tax authorities working as one team is also kind of a working assumption.
Kevin: Okay, but we talked about this liquidity problem. They don’t want to really call it a problem. In fact, we titled last week’s program, “Not QE,” the new 60 billion dollars of not-QE. 60 billion dollars in a month is a lot of money, but how about last Wednesday?
David: I know. Even as we were talking about it, Wednesday of last week the Fed monetized 7.5 billion dollars in T-bills in a day – 7.5 billion T-bills in a day – and that was not QE.
Kevin: Not QE, not at all.
David: And certainly it was not monetization.
Kevin: Not monetization.
David: Just as the Fed’s balance sheet was not expanded by 200 billion dollars in a month. That’s in one month!
Kevin: Wow.
David: Kevin’s that’s the greatest increase in the Fed’s balance sheet since the global financial crisis.
Kevin: There is nothing in the news that it is a crisis. Back ten years ago that was a crisis. That’s how they justified it.
David: Right. So we mentioned last week these purchases end up pressing the short end of the curve lower last Wednesday, using these T-bill purchases to do that. You know what is fascinating to me is, in spite of the Fed stepping in, this week guess what we have? Rising interest rates in the treasury market, so if there is not a lot of cooperation here, and yet, we were talking about this last Wednesday. It was happening last Wednesday.
Kevin: But they still want to erase the signal.
David: I think that is a part of the motivation is removing the signal of the inverted yield curve, reducing the shorter-term borrowing costs. And I note one of the funnier reflections in the IMF paper is discussing this fresh accommodation from the Fed, and here is what they say: “A sustained normalization of rates and central bank balance sheets may be more difficult than previously envisioned, especially in the context of weaker global growth and when other central banks continue to pursue QE. That’s right, the IMF is not afraid to call QE, QE.
Kevin: Yesterday my son needed a tool that was at our house, not at his, and so he came over and got my toolkit. I told him, “You know, son, at this point you really need to have a toolbox of your own that has some basic tools in it.”
David: (laughs)
Kevin: But basic tools of the Federal Reserve and central banks, let’s say we are going into a crisis, ten years ago the basic tools were, “Look, we can lower interest rates, we can monetize.” Well, they are monetizing already. We’re not in “a crisis” but they are monetizing. Call it QE, or whatever you want. But we’re at near zero interest rates, Dave, so that tool is not in the box anymore unless we go deeply negative like the IMF paper said in April.
David: Yes, and a part of what they did creatively back in 2008 and 2009 was swap garbage paper for liquid paper, so TARP, TALF, and a whole host of acronyms gave some sort of explanation of what they were doing. At the end of the day, what was it? It was substituting bad assets for good and reliquefying the system. And here we are, really in remarkable times. Rate reduction is typically one of those tools. But it is one of those tools from the triage kit.
Kevin: Yes. That’s for emergencies.
David: And we are less than two weeks away from a probable interest rate cut. It might be understandable for accommodative monetary policies to be at work in other geographies, and we already see that. There is policy easing in economies representing 70% of world GDP. That’s at present. So yes, we have accommodative policies across most of the world. But here in the U.S. we have unemployment at a 50-year low, we have economic expansion which is now at 123 months.
Kevin: That’s a record.
David: The longest in history. 108 straight months of job growth, also the longest in history. The most recent numbers for the Consumer Price Index, core CPI is at 2.4%. That is at an 11-year high. 2% was the objective. So why introduce a triage tool?
Kevin: That’s the thing, we just continue with the theme of the show last week and this week. There is something going on. We have a crisis of some sort.
David: As of last week, QE has begun.
Kevin: Not QE, David. Not QE!
David: I apologize. With all respect to Jerome, what is the Fed afraid of? Are they afraid of mean reversions? Are they afraid of the end of a business cycle? Are they afraid of being wrong about having the power to suspend that downside?
Kevin: Yes, but the investor believes that they have the power to do that.
David: That is the irony, that traders and investors are all in. Very little money has hit the sidelines. So this is it. This is the key. The mass psychology in the market has been captured, and very few investors are mitigating risk.
Kevin: Even though we are 123 months into recovery.
David: Capturing popular psychology is what it takes for the Fed to press the game into the 27th inning. You realize the record major league baseball game in the 1920s went to 26 innings. We’re not trying to press the envelope and say, “No, no, we can go to 27 innings.” You capture the popular psychology, and God forbid they lose control of it.
Kevin: But we are totally ignoring so far politics, which I actually prefer. To be honest with you, prefer that we ignore politics, I hate politics, but politics is probably going to play a role in public psychology.
David: I’ll never forget when Ian McAvity was on the program and he said, “You know what politics is? Poly-ticks – many blood-sucking creatures.
Kevin: (laughs) And I have to jump in real quick because we do have some listeners that are politicians that are good guys.
David: God bless both of you.
Kevin: (laughs) That’s right, all two. You know who you are.
David: Remember a few weeks ago we were talking about Elizabeth Warren, and we talked about Wall Street and the banking crowd not being keen on her election. Well, this last week, from the New York Times, Elizabeth Warren is defending her proposed wealth tax, and she says that billionaires make their money off of accumulated wealth. The quote was, “Taxing income is not going to get you where you need to be the way taxing wealth does.” The rich are not like you and me.
Kevin: “Look what I found. I found the treasure trove.”
David: This is fascinating at so many levels. Could her nomination be a sufficient trigger to get the stock market to roll over? And I wonder if that move lower in the stock market, hypothetically of course, wouldn’t draw someone like Michael Bloomberg off the sidelines and into the race? That could be a serious race, Bloomberg and Trump.
It was fascinating, I was at a board meeting a few weeks ago, 90% Democratic leaning, and as a fairly well-to-do crowed, they were all nervous about Warren, not just getting elected, but even the implications of her nomination.
Kevin: So they are left-leaning, but they want to keep their money.
David: (laughs) Exactly right. So you have Biden fading. Warren is more and more the contender for the nomination. Each debate confirms the Biden fade. Even CNN was tweeting that Sanders looked great compared to Biden and he had just come out of a heart attack.
Kevin: (laughs)
David: I mean, it was like, “Ouch! Ouch!”
Kevin: Sanders looked really good. Is he in a hospital bed?”
David: And you can see it, too, with the money being raised in the Biden camp, it suggests that the Democratic donors already know that he’s done. So let’s assume a Warren nomination. There is a potential for a serious shock for anyone with accumulated wealth. The vast majority of accumulated wealth is from appreciated ownership in an operating company. There is a lot of capital, a lot of wealth, in the form of stock. Be that privately held or publicly traded, that wealth would go very quiet for four years.
Kevin: And that is not historically without precedent.
David: The interwar period, you go back to the post-war period where the U.S. government was organizing all resources for the war effort, setting prices, taxing the heck out of everything. That bear market in stocks didn’t end until 1949, well after the war had. And this is where the owners of capital were trying to discern if the coast was clear, if there was going to be sufficient reward back on the table to justify putting at risk. So the banter back and forth between Warren and Sanders about who is the greatest socialist, or who is clearly not a capitalist – understand that the capital markets are ruled, and the allocation of capital depends on whether or not there is adequate reward on the table.
Kevin: What was the name of Barton Biggs’ book where he talked about that, where wealth went quite whenever it needed to or it got confiscated during the wars.
David: Wealth, War and Wisdom.
Kevin: That’s a great book. Barton Biggs, before he passed away, he was with Morgan Stanley when you were there. Wasn’t he sort of the old sage of Morgan Stanley?
David: Well, yes, he was one of the economists who was there.
Kevin: He wasn’t well liked by all the younger Wall Street crowd, though, right?
David: My preference was for Stephen Roach.
Kevin: Okay.
David: Biggs was typically a perma-bull, and when he came out with Wealth, War and Wisdom in 2008 I thought it was fascinating. It was early 2008, which means he was writing it in 2006 and 2007.
Kevin: He was saying run for cover, something is about to happen.
David: Exactly. And so for the perma-bull to be forecasting that there is a time to grab your cases of Château Pétrus and a shotgun and just kind of sit this one out, it sent a signal. It definitely sent a signal. But here we are, redistribution of wealth on a grand scale – it has been threatened before here in the United States. If you recall just a few years ago it was threatened in France, and what happened is that money and people simply moved.
Kevin: Right.
David: You can see why wealthy families have a little bit of money in art, a little bit of money in gold, a little bit of money in international real estate. These are forms of wealth storage that are either quiet or they are beyond the arm of whatever treasury you might be concerned about. So to come back to this issue of building tax capacity in the IMF paper. Building tax capacity – maybe Elizabeth Warren is just what the IMF doctor ordered.
Kevin: All we have to do is look at China, and as they tighten things up, where does the money flee to? Well, it certainly doesn’t stay in China.
David: Exactly. So since the Xi Jinping election, you have seen real estate aggressively bought up in Manhattan, in Vancouver. There are a few other U.S. real estate enclaves. But the geographic migration of capital in that case signals concerns. It signals political concerns. And I think this is where prudence requires moving money to a safer place.
Kevin: Quieter and safer. Yes.
David: And this is in the event that, in the case of the Chinese, the quasi-capitalism of the past two to three decades reverts back to quasi- or not so quasi-communism.
Kevin: And you’re saying a Warren presidency could also be very similar to what happened in China when Xi got in.
David: It represents a form of political risk, and so in that sense it is not unlike the election of Xi in China. Political risk – frankly, the markets haven’t had to consider since before Ronald Reagan, the confiscatory political risk. If you look at the tax policy center, they track the top marginal rates here in the United States going back to when they were first introduced. Believe it or not, we didn’t have an income tax prior to the creation of the Federal Reserve. I guess that is no irony and no surprise for those of you who understand the structure of the Federal Reserve.
Kevin: 1913 was an interesting year, Dave.
David: That’s right. I think we started at 7%, and then it popped to 25%. And then again, according to the tax policy center, rates rose in 1932 from 25% to 63%, and that was the top marginal rate here in the U.S. And then it averaged over 80% all the way through the 1970s.
Kevin: People used lots of loopholes. They had to, just to survive.
David: And money looked for and found every legal loophole allowed, some not so legal. But they were, again, trying to dodge the income tax, again legally so finding those loopholes. Promote a wealth tax instead of an income tax and money will simply disappear, not from the country, but off the map.
Kevin: This would be cutting my nose off to spite my face, but actually, in a way, as a gold broker for the last 32 years, I have thought, “You know, we ought to just really elect one of these people. Look what gold would do.”
David: (laughs) In a self-interested way, Warren would be great for the gold business.
Think about this. Try to move a trillion dollars. You might think that is an absurd amount of money. Well, that is less than 1% of the accumulated household net worth of the United States. As of June 2019 it is 113.5 trillion dollars. Try moving 1 trillion dollars into gold. The price would be multiples of the current level, 5-10 times the current price. I know of one natural gas trader who is in possession of, took physical delivery of, 400 million dollars in gold. That is a part of personal net worth now off the radar, off the map.
And I will try to keep my self-interest contained. No, I will be not be voting my self-interest.
