Podcast: Play in new window
- Hedge Funds, Highly Leveraged, Own More Treasuries Than China or Japan
- AI Narrative Dangerously Fading
- The Cayman Islands Are Our Number One Creditor!
“It just suggests to me that we have troubled waters ahead, and the last up-cycle, the last up-cycle in precious metals, 2025, driven by central banks and then some late comers to the market, and frankly, seeking gains, chasing profits. I fear the next metals move will be less driven by greed, which we just finished, and more about fear. The most powerful precious metals moves are driven that way.” —David McAlvany
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Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany.
David, sometimes you have to replace what you are spending. I was thinking about this. I had a hot tub that every time you filled it it would lose about two inches a day, and that means you have a leak. And I think if you take our nation and how much we’re spending in debt, it’s a little bit like that as well. I don’t think we’re bringing in enough water to keep that hot tub full, do you?
David: No. In fact, for every $1 the US collects in taxes and tariffs, it’ll spend a 1.33 this year. And when you look at the US markets, it’s not a loan. Sovereign debt crisis is not a theoretical crisis. It’s an unfolding reality. Whether it comes to a head in the US or Japan first is the question I’m asking.
The numbers I want to share today are an approximate range, just like US debt to GDP. It’s either 102, 102%, or 125% depending on whether you’ve got a gross or net calculation. The gross numbers most recently were calculated by the IMF at 125. So there’s a variety of measures that exist.
Similarly, interest payments are in the range from 970 billion to 1.22 trillion. Again, a range according to the Peterson Institute. And at year-end, we were averaging 92 billion a month in interest payments, not an insignificant sum, gets us over the trillion mark. The Wall Street Journal put it this way, “the US is projected to run a deficit of $1.85 trillion, or 5.8% of GDP, in the year that ends September 30th, and then stay at 5.7% in fiscal 2027.” So that earlier quote was from the Wall Street Journal. For every $1 the US collects in taxes and tariffs, it will spend a $1.33 this year. It’s not if, it’s when we have a debt crisis.
Kevin: Okay. So I think we need to go back and actually look at who is loaning us this money. So if it’s a 1.33 for every dollar, and that’s including tariffs. Years ago we had that symbiotic relationship. The Chinese would just loan us everything that we had in trade deficit to them. They had a surplus. But the Chinese are backing away big time, and the Japanese, I think, also. There’s a reason why the Japanese money may repatriate and stop sending us money.
David: As you have yields on Japanese government bonds, 10-year maturity. They’ve gone from less than 1% as recently as November of 2024 to 2.29%. Maybe that’s not a big deal if you don’t have very much debt, not a big increase, but more than doubling on a very large base of debt is a factor. Your longer term Japanese government bonds, the 30-years, are currently at 3.39, and they haven’t been this high since I was in grade school. So, fortunate there is a growth in GDP in Japan. So Japanese debt to GDP has come down from 250% to only 236%. And estimates are that we get into the 220s next year.
So fiscal stimulus is, under the new administration, to be focused on corporate sectors, recapturing global market share, and as recently elected Prime Minister Sanae Takaichi has announced, I think one can reasonably assume an improvement in that government-stimulated GDP. The fly in the ointment would be if rates increase in Japan in line with market projections. There are some who are estimating that their rates move as high as 4.6%. So it becomes an issue when you’ve got as much as they do.
Kevin: So what you’re saying is, as Japanese rates increase— I mean historically, especially the last few decades, Japanese rates have been so low that it’s created a carry trade where it helps the United States actually. But what you’re saying is, Japan may be paying a reasonable, higher interest rate that would pull money back away from us and over to Japan. Is that what you’re saying?
David: Yeah, exactly. And the interest component, which we’ve often talked about in the US, this is a reality in Japan as well. Interest paid on their national debt as a percentage of GDP has already gone from 1.2 to 4.48. And you’re talking about nearly 10% of tax revenue in Japan going to interest payments, held in check largely by the high percentage holdings of the Bank of Japan of those JGBs. 46% of public debt is held by the Bank of Japan. So even with higher rates, it’s not an endgame scenario because it’s not like you have foreign creditors who are upset, you kind of owe it to yourself.
So in the US, of course, it’s a different matter—interest as a percentage of revenue as well. Yeah, so coming back to Japan, 10% of revenue, that’s well below the level of the US where 23% of tax receipts went to interest in 2025. 1.2 trillion paid. I had originally estimated 5.6% in tax receipts. It came in at 5.2. And so interest as a percentage of GDP in the US, still 5% of GDP, but over 23, over 22-23% of total tax receipts. Clearly it’s more dramatic as a percent of revenue.
Kevin: Well, and I can’t help think, Dave, I remember when I memorized a few lines of Hamlet, the line, “The borrower is servant to the lender.” I would think that Japan may play a key role in the direction of our own bond market.
David: Yeah, I think you’re right. Japan is likely to hold one of the important keys to the direction of the US bond market. We have already lost China as a primary financer of our debt. Treasury holdings in China peaked between 2011 and 2013, and have steadily fallen by nearly 50% since that time. So they’re just not interested. They’re out.
Last week, Bloomberg noted the Chinese government urging state-run commercial banks to limit their holdings of US Treasuries. Japan on the other hand has remained a source of Treasury financing. But with upward pressure on Japanese yields and an improving outlook for the Japanese yen, repatriation of capital and curtailment of yen carry trade dynamics is likely to further pressure US Treasury demand, which, again, is kind of a knock-on effect—pressure yields higher, not exactly what the current administration wants.
Kevin: Now I think about our conversations with people who are planning on retiring, David. One of the first questions that I ask is, what are your sources of income? So what you’re saying the sources of income for the United States, as far as our debt, China, which you said they’ve reduced their purchases of Treasuries by 50%. Japan, who else are we looking at?
David: Yeah, Japan’s not the number one creditor of the US. The Cayman Islands are.
Kevin: The Cayman Islands? Yeah. Wow.
David: And how is that possible, US? It’s the domicile of a huge number of hedge funds. So implicit to the Treasury financing its debt is the leveraged speculative community using vast quantities of US Treasuries to speculate in the basis trade, which Morgan Stanley notes the scale of the basis trade at $1.5 trillion in January.
So Cayman Islands holds the most Treasuries. They are the largest creditor of the United States. In essence, again, it’s hedge funds who have rented, if you will, rented Treasuries to turn around and use as collateral. So these hedge funds use Treasuries as collateral against repo debt. The discrepancy there is between the cash price of Treasuries and the Treasury futures price, which is sufficient in basis points for hedge funds to leverage up and collect the differential, and arbitrage, if you will.
Kevin: Well, and see, that’s the thing that scares me. I mean, those basis points would not provide enough profit for those hedge funds if they just did it straight away, but they leverage those basis differences. And so actually they sort of need a spread, don’t they?
David: Yeah. So you pledge the cash Treasuries as collateral in return for repo market borrowing, and then the juice comes from these trades being leveraged 15 to one, up to actually 100 to one. So they’re taking no duration risk. Hedge funds just want to see volatility. They want to see a narrowing or widening of the spread between cash, Treasuries, and the futures market price. And that’s where they’re making their money on a highly, highly leveraged basis.
Kevin: So when COVID broke out and when everybody started to realize that there was going to be a shutdown, we saw major volatility in those very markets.
David: Yes, in November of 2019, we had disruptions in the repo market. March of 2020 again, and then if you fast-forward to Silicon National Bank, yet another incident where the repo markets came under strain, moving in an unanticipated direction, which is a problem for the levered speculator.
Kevin: So what you’re saying is, it’s not if, but when this thing comes apart. This is supposed to be the safest investment in the world, US Treasuries, but they’re playing the volatility between the spreads.
David: Well, I mean, I guess the basis trade could hold together as long as interest rates remain predictable. But I think you’re right. It’s when not if we see an unwind in the basis trade, bringing cash Treasuries to market in quantity that would overwhelm the capacity of primary dealers responsible for selling new issued Treasury obligations. It’s basically down to supply and demand.
As long as you have those things in balance, then the Treasury market behaves in a normal fashion. But you’ve got leveraged speculators who may, not as a choice of their own, may have to cough up a lot of these cash Treasuries, and that’s when your primary dealers are flooded with oversupply, lack of demand. And that’s where you begin to see interest rates do some things that are, well, shall we say unpleasant.
Kevin: And so this goes back to what are your sources of income? If China has backed away and they’re 50% down on loaning us money, and Japan, you’re talking about the possibility of higher rates and repatriation of those debt dollars or yen. Then Cayman Islands, the holder of last resort—I guess maybe the Federal Reserve would be the holder of last resort—but the Cayman Islands being in a speculative frenzy as long as interest rates are predictable, like you said. It seems to me like this is very, very thin ice.
David: It’s thin ice. You had, last June, the Bank of International Settlements highlighting a growing concern, not with the basis trade, but yet another leveraged trade in Treasuries, where again your leveraged speculative community has found ways to borrow and invest—it’s their own version of a carry trade—and do this on a highly leveraged basis and pick up just a small amount. But that small amount of carry ends up being very impressive in terms of returns on a leveraged basis.
So the one that the BIS was highlighting in June was the swap spread trade, which tallies to a mere 631 billion, or it did at the time. So this trade, it’s also a relative value trade, but instead of using the repo markets, it uses interest rate swaps versus the current Treasury yields. And this trade comes unglued if or when you have an unexpected rise in yields. So Treasury yields need to fall relative to swaps for the trade to work. And if, like in April of last year, yields spike, then the swap spread trade comes under pressure as well.
So you get different versions of leveraged speculation in the Treasury market, with the largest pool of Treasuries held by a single group. I wouldn’t say single entity, but they’re all doing the same thing [unclear]. It works until it doesn’t, and we got to see it in real time. We had a pre-shock last April, yields spike, swap spread trade comes under pressure, and the hedge fund community starts scrambling for liquidity.
Kevin: And again, this is all about leverage. We’re not talking about making the risk that we’re talking about twofold or threefold or fourfold. How much leverage do these guys use?
David: Yeah, it’s fair to say that leverage enhances your returns until it kills them, and when it kills them, it does so very quickly. So you combine the swap trade with the basis trade, and you’re over $2 trillion, and that’s what you can account for. Then you’ve got, depending on the leverage, pick your number—somewhere between 50 and a hundred.
That’s a lot of cash, but just the $2 trillion in leveraged bets within the US Treasury market is equal to 7.5% of all of debt held by the public. It was Jim Grant who commented that the world’s safest and most liquid market depends on the stability of hedge funds levered, say 50 to one, is not exactly what Alexander Hamilton had in mind. It’s an abnormality of the second order, the first being peacetime deficits and the ensuing deluge of issuance.
Kevin: Yeah. And so part of the reason you have these spreads, too, Dave, is because we have an oversupply problem. The markets, even debt markets are driven by supply and demand. And the United States has a lot of supply of Treasuries and not that much demand.
David: It’s fairly in balance today. That’s the question, does it remain in balance? Are we able to maintain the old audiences? We’ve lost the Chinese, the real question now, the reason we bring up Japan in this context of leveraged Treasury holdings, is because we need Japanese capital to stay where it is, and we’ve often discussed the oversupply problem emerging in US Treasuries because there’s a lot of them out there. And yet we’re offering to the market between one and a half and two trillion each year, and expect the market to take that in stride and absorb it.
So again, this is in part due to our deficits increasing, and it’s happening at a time of global de-dollarization. So we’re continuing to push out more IOUs into an arguably saturated market. Chinese government holdings illustrate this, as does the Chinese government mandating a decrease in bank sector holdings of Treasuries. So the outstanding US government IOUs are there at real significant scale, and increased demand is the only way to keep things in balance and continue to soak up the increasing supplies.
Yet the opposite is being set up, and we have this straight from the horse’s mouth. Congressional budget office is looking at debt increasing to north of 52 trillion by 2035. So of course we’re going to have to have a new audience, we’re going to have to have even more appetite for Treasuries, and it’s just not likely in the context of global de-dollarization, I frankly think the CDO’s numbers, that’s conservative. Figure 52 trillion and a conservative time frame, 2035—likely to happen faster than that.
All you need is a recession and all of a sudden government financing needs go through the roof. So as issuance grows and appetite for US Treasuries grows cold the world over, we see the hedge fund linchpin as a very vulnerable part of our financing equation—one that large enough to drive an upward spike in long-term borrowing costs. And of course, there’s dominoes that fall from there. Perhaps that is the key which fells the equity markets here in the US.
Kevin: Okay, so you’re talking about both. You’re talking about the bond market and the equity market, and 99% of the brokers out there, Dave, that are managing people’s portfolios, are still stuck in the 60/40 mode, 60% equities, 40% bonds, but what you’re saying is that’s a dead issue at this point. That’s the wrong strategy.
David: I do this every week. I review prospective clients’ portfolios, look at where things are currently held, how they’re allocated. And this last week I was treated to a portfolio constructed by a CFA, CPA, knows his numbers well, but there was really no surprise. There was a classic 60/40 portfolio. Only the 40% in bonds was high-yield investment-grade corporates, but surprisingly higher risk given the junk status of some of the debt.
And of course it’s just, “Look, let’s maximize income as much as we can, and you’re going to get a few more basis points in yield from the junk category.” Look, April of last year was a pre-shot. The 60/40 portfolio has been dead for some time. And these elements of hedge fund dependence on bond market stability, they’re like the final nail in the coffin. We’ve got the hammer raised and at the ready.
Kevin: Yeah, I wonder, Dave, okay, so we’re going back and we’re saying, “All right, what are your sources of income?” We talked about China. It’s down half of what it used to be. Japan, and that probably is going to diminish. You talked about the Cayman Islands, the hedge funds, which are playing a pretty fast strategy with high leverage. What about Kevin Warsh, though, reducing? Yeah, I mentioned the Fed Reserve might be the buyer of last resort, but what Kevin is basically saying is he wants to reduce, he wants to shrink the Federal Reserve balance sheet. It’s not going to work.
David: That’s a nice idea. In theory, this is what he’s been saying for a number of years. In practice there’s some practical limitations, and that’s what we’re talking about today. So you bring the worst notion of shrinking the Federal Reserve balance sheet and returning more supply of IOUs to the market. Is it reasonable? Yes, it’s reasonable. Is it realistic? No. In fact, the setup is quite the opposite. There is a realistic scenario where the Federal Reserve is the only entity with the capacity to absorb trillions in abandoned US dollar assets, debt instruments.
Would they end up as the backstop for the hedge fund industry? Would they practice the most egregious form of moral hazard in all of history, where it’s not just supporting commercial banks who might’ve gotten frisky with some loans, but you’re talking about rank speculation, the highest leverage imaginable. And if the credit system’s survival depended on it, of course they would backstop the hedge fund community. So while Warsh may wish to shrink the balance sheet at the Fed during his tenure, it’s far more likely to see the balance sheet increased by 50 to 100%.
Kevin: So you’ve talked about the de-dollarization, and our currency at this point is not nearly as treasured as it was in the past, to use a pun, but the Japanese yen, you were talking about Japan probably seeing higher rates. What will that do to the currency?
David: Yeah, well, if we go back to the Japanese, our friend Russell Napier in his most recent issue of The Solid Ground, suggests that the yen is today an attractive asset, it’s an attractive place to keep liquidity. Of course, he’s been bullish on gold for some time, but last week’s 3% gain in the currency, if he’s right, is the beginning of a new trend to watch.
Kevin: Is that also because the Japanese have no problem intervening on the currency?
David: Yeah, I think a part of it is that we’ve seen those interventions by the Bank of Japan that occurred on a routine basis around the 160 level versus the US dollar, but Takaichi’s corporate stimulus plan comes at an opportune time, driving GDP growth in Japan via fiscal stimulus. Number one, that relieves some of the pressure in terms of debt to GDP statistics if they can get GDP to grow. But if you also have rates increasing at the same time, it beckons home some part of the $5 trillion in overseas liquid capital owned by the Japanese public and private sector, including Japanese corporations. So repatriated capital will be further wind in the sail, strengthening the yen. To what degree? How much? We don’t know.
Kevin: Well, and of course we’re talking about strengthening the yen relative to the dollar.
David: Yeah, and there’s ranges, I think 120 to 140 is realistic. The IMF’s measure of purchasing power parity, their calculation, values the yen at 93.67 to the dollar, and Russell in The Solid Ground qualifies that statistic, saying that currencies only trade at a purchasing power parity once in 15 years. So, long shot that we see it go that low, but the trade to purchasing power parity does happen on rare occasions.
Kevin: I have a question, because as we talk to clients, we can go back, I remember decades of talking about the petrodollar and how we protected that militarily, and we were very careful until 2022. And then we weaponized the dollar when Russia invaded Ukraine. That seems to be a mistake, doesn’t it?
David: Well, for sure, and I think this is one of the things that you see reflected in the gold price today. The current softness notwithstanding, you’re seeing a global shift in monetary dynamics, and it is very important to know what the undercurrents are. Yeah, we wonder if in the process of weaponizing the dollar, we haven’t in effect pulled the pin and then forgot to toss the grenade. We were intending to gain an international relations edge and pressure countries into a DC or US MAGA-oriented agenda. We may have motivated one of the great mass exoduses from a currency, again only to discover that we’re dependent on—and this is the irony—dependent on the leveraged speculative community with accounts in the Caymans for maintaining what the world has in past decades referred to as the risk-free rate. The US Treasury was the benchmark for a risk-free return, and of course it’s not really seen that way anymore.
Kevin: We’re not the only ones competing for money to borrow, right? We’ve got Europe. We haven’t even brought up Europe, but they’re very dependent on demand for their own bonds.
David: Yeah. And so that brings into focus not only the dollar at risk, but also euro stability. We may be the greatest debt abuser in recent times, but if you go back to Japan, of course their debt to GDP reaching 250% a few years ago, they have been, if you want to look at that from a more “historical perspective”, the great abuser of debt.
It’s just fascinating that now the interest of its own people, Japanese people, through a combination of GDP growth and currency stabilization, may be the factor which unhinges both the dollar and the euro—I think the dollar to a greater degree. But if the Japanese repatriate, it’s not only the US Treasury market at risk, it’s the European debt markets, particularly the French, which is something that Napier notes in his piece, because there’s a lot of French debt which is owned by Japanese capital.
So if the Chinese can mandate a reduction in Treasury holdings at its banks, what about favoring repatriated capital by Japanese insurers or by the Japanese government pension investment fund? They’re only $1.88 trillion fund, third largest in the world, 42.5% of their holdings are overseas. Well, what if they’re special terms? What if they don’t even need special terms? If it’s just down to, again, GDP growth and an improving currency situation, why wouldn’t you bring that money home?
Kevin: Sometimes I wonder too, Dave. It’s fascinating, you talk about the Treasury’s war and how we have been able to use the strength of the hegemony of the US dollar as a weapon, and we’ve restrained ourselves actually for the most part until recently when we really weaponized the dollar by telling Russia they couldn’t sell their oil in dollars. But the question that I have, then, the negative case for the dollar. We’re talking about a major weapon that helped avoid kinetic warfare—I mean actual military action. And I’m wondering if we should be looking at the dollar and saying maybe the only thing we’re looking at is what’s the value of the dollar relative to other currencies. But what does that do for policies—international policymaking—and how we go forward?
David: I think in the easiest gloss, you could say, we built a negative case for the dollar around measuring money supply growth or rates of inflation, things like that. And today, what you’re pointing to is something that’s a little bit more complex. We’re measuring the impact of policies and political preferences that have, implicit to them, unintended consequences.
It is in witnessing a reappraisal of risk, and this is again back to our debt markets and sustainability in terms of GDP growth and a strong economy relative to payments on national debt, which again, as a percentage of GDP are not particularly concerning, but as a percentage of total revenue, squeezing out things that we have to pay for. We’ve got the three largest line items in the national budget—Social security, Medicare, and now interest on the national debt. Well, there’s more to running a government than these long-term liabilities, and then the current cash flow required to make payments on debt.
So I think our debt markets are incredibly vulnerable. Too much supply, not enough demand. The repricing of rates to reflect a gap in demand is likely what ushers in a reappraisal of asset classes in general, because I think there’s certainly a knock-on effect to real estate, but also a reappraisal of valuation metrics in US equities. And it forces the math—this is math we discussed months ago—where foreign investment in US markets has continued through the end of 2025, even into early 2026, into the unassailable trades, the things that were just guaranteed to make money: AI and the tech trades. So foreign investment in US markets, that’s where it has flowed. And so just as we could imagine a world where there’s an exit from Treasuries, well, it’s not that hard to imagine a world where the unassailable trade moves in reverse.
Kevin: And I’m wondering if that’s not starting to happen, Dave, the momentum that we had in the Mag-7 stocks, the AI and the tech trades, what happens when that flow reverses?
David: Well reverse the flows, money seeks greener pastures because you not only have to make money on the underlying investment, but you can’t lose money in the currency exchange. So if you have a combination of a weak dollar and a weak equity market, now you’ve got a two jab-type scenario. The attempt to sidestep both market and currency exchange losses, that’s a scenario where the trickles of selling become a deluge. No one really has to consider valuation metrics when momentum is running to the upside. That’s kind of a convenient truth that’s set aside. Those metrics remain valuable to the Cassandras and the permabears.
But ultimately they become important again to everyone else when valuations mean revert, which they always do. And I’m traveling, which is why we’re not doing the video today. I’m reading Jeremy Grantham’s latest book, co-authored by one of our prior commentary guests, Edward Chancellor. GMO is the institutional money management firm that Jeremy Grantham has run, going back to, I think it’s the sixties. And GMO from inception to present has focused on mean reversion as a fact, market inefficiency as a fact. And from GMO’s recent report, a record proportion of the US stock market trades at over 10 times sales. Kevin, that’s a problem. That’s something that’s pretty easy to say, okay, if you’ve never been this high, maybe we’ve got mean reversion around the corner.
They also note that the US market capital/GDP ratio, the so-called Buffett indicator, is at all-time highs. And as you know, Kevin, you and I have talked about this repeatedly, all throughout 2025 as it was reaching new heights and then setting new highs every month, this ultimately is unsustainable. It’s one of the reasons why Buffett prefers to sit in cash close to $400 billion. The S&P 500, on a cyclically adjusted basis, trading at 40.3. What shifts these metrics? Frankly, it doesn’t matter. Markets can follow their own way, but there is growing negativity filling the void that the dominant AI narrative and that idea of unbound growth in tech had previously filled. That growing negativity is showing up. We’ve seen in the last week or two a growing pressure on tech, software, on anything AI related.
Kevin: Yeah, and so the cheerleaders that have just been saying that AI is just to the moon forever, at this point, they’re starting to sound a little bit noisy.
David: Yeah, it was only a few weeks ago that if AI was attached to your business plan, you could do no wrong and you didn’t need to have profits. Now, the headlines are very different. These are headlines I will quote. “Wall Street’s new trade is dumping stocks in AI’s crosshairs.” Another reads, “Stocks have few pockets of calm amid AI worries.” Yet another, “Tech rout intensifies as angst over AI deepens,” “US financial shares extend sell-off on continued AI concerns.” “Wealth manager stocks sink as investors flee AI’s next casualty.” And on and on. So sentiment shifts with narrative. Then liquidity dynamics shift. And that’s when you have new price realities emerge.
Kevin: I have a question for you then. If the listener is saying, “All right, well, I’m going to step out of the volatility right now. I’m going to go into US Treasuries.” We’ve talked about the danger in the Treasuries market, but a lot of that has to do with length of maturity. If you go shorter term, that’s still a safe bet, isn’t it?
David: Yeah. I think if you want to sidestep volatility, you can move to Treasuries. You just want to stay in very short term. Treasury bills, avoid the bonds, avoid the notes. So only the shortest of maturities.
I think better yet is the macro advice which was proffered by Mike Wilson at Morgan Stanley. Cut your bond position in half in favor of a better anti-fragile asset, gold. When he’s suggesting this, back in October of last year, he’s not saying that this is the trade for the next 90 days. He’s not saying this is the trade to end 2025 and to begin 2026. This is a shift in thinking which is set for many years to come. Many years to come.
And I think, again, that the wisdom that Wilson is expressing is that there are fundamental shifts in the debt markets, in the global debt markets, and certainly in the US Treasury market. And that has an impact across not only the credit spectrum but the duration spectrum. And you are better positioned, take half of what you would’ve had in fixed income and have it in gold.
I don’t think he’s thinking, “but,” “if,” “here’s the qualifier, if gold goes up a little bit more, then you should reconsider and not own any gold at all.” No, I think this is a macro call which has legs to it, and as many years yet in the making as we are just at the front edge of seeing a change in the bond markets.
The things that we’ve been talking about today, Kevin, this is prospective. This is yet to occur. We see where the fragility lies, that the Cayman Islands and leveraged speculators are the largest holder of Treasury paper in the world is more than a bit concerning, but we have yet to see any real ramifications from that. That is the context. When we see those ramifications, that is the context in which you hold gold and perhaps you say, “And you can pry it from my cold dead hand.”
Kevin: Well, and like you said, we’re on the front edge of this. And Dave, as you know, I mean we lived in a town here in Durango now for 33 years since we moved down from Denver, where a train runs through town, an old narrow gauge railway train runs through town three to six times a day. And we hear the whistle. Anybody in Durango knows when you hear the whistle, get off the track, and what you’re saying, it’s not too late.
David: No, it’s not too late. I go back to the portfolio. I looked at this last week, again with investment grade and high yield bonds, but when I look at the spreads on investment grade and high yield versus Treasuries, they’re about as compressed as they’ve been in multiple decades. Really, the appetite for those bonds is still strong. And so I think it’s not too late. It’s not too late. You can still avoid the spread expansion where all of a sudden those things trade at much lower prices and much higher yields. You can still avoid the increase in yields, which is likely the defining factor to markets in the years ahead.
And again, this is really with a focus on duration and credit quality. We’re already seeing the stress in the leveraged loan market. We’re already seeing the stress in the private credit markets. And I think what we’ve talked about here just a moment ago in terms of AI and tech, the leaders, the generals which have defined the bullish sentiment in 2025, they’re being taken out. The troops do scatter thereafter. So I think volatility like April of 2025 around liberation day, it’s just beginning to return.
Kevin: So you’re not saying higher interest rates right away because if that volatility affects the equities market, money’s going to come out and go somewhere. Like you said, some of it’s going to go to gold, some will go into short term Treasuries, but will some of that go into long-term Treasuries and possibly push rates down initially?
David: That’s a healthy caveat. I mean, if equity market volatility increases in the short term, could we see a global risk off dynamic which brings interest rates lower in the short run? Yeah. I mean, that’s a 2008, 2009 dynamic. And I think the difference between then and now, at least in terms of pressure in the precious metals space is that you have a growing desire to dedollarize. And you’ve got a growing number of central banks that are trying to get away from paper assets to something that they can hold onto.
In recent interviews and samplings of interest from high net worth individuals, investors, family offices, they want to be in an inert asset class. They want to be in something that represents true safety. The demand cycle for the metals is, I think, very different than ’08, ’09. Even past the 2008, 2009 period, we did see resurgence in interest as people started to question the solvency of the institutions that they had capital with, whether you’re in stocks or bonds or annuities or mutual funds or exchange traded funds.
However you’ve allocated your portfolio, first is liquidity drying up and there being a significant price correction in those assets. Then comes the realization that you’ve got institutions which are under real strain, and in those moments you have a scramble for things that are financial assets, but they are outside of the financial system.
This Treasury market dynamic where pressure in rates to the upside, a real mismatch between supply and demand, forced liquidations from leveraged Treasury holdings in the Caymans. This kind of a setup is like what we saw in March, April, May, June, July of 2009, where all of a sudden individuals and institutions are scrambling to own gold because the institutions themselves don’t trust each other. When you’re worried about counterparty risk, there is one place to go. One place to go.
So I appreciate that momentum runs both ways, and the more I think about our debt markets— Certainly we can see further weakness in metals, but the more I think about our debt markets, the more bullish I am, which again is not to say that consolidation can’t or won’t retest breakout levels. From a technical perspective, that would be the best thing to happen to the precious metals, setting the stage for a longer term move to much higher levels. I see the counterparty risk growing and the only backstop for the hedge fund community, the largest holder of Treasuries, being the Federal Reserve.
So we’ve kind of seen this play before, whether it’s 2022 or when we’ve had to have significant interventions, March 2020, when the Fed reversed its course of tightening and went back to easing policies in the fourth quarter of 2019. Or you can roll the clock back even further, necessary interventions to the tune of $1 trillion back in ’08 and ’09, the beginnings, the initial expansion of the Fed balance sheet. Now it’s time, I think, to anticipate a doubling of the balance sheet, even as Warsh is talking about shrinking it.
Kevin: What we’ve talked about with our clients, many times with precious metals, because we do have volatility in the metals market right now, but there’s sort of two tranches that you own. There’s the portion that you own outright on a one-to-one basis for preservation, and you just ignore it. You don’t try to time the market. And then the second tranche would be the portion of your assets where you’re actually trying to time it and make it grow. So the momentum right now, I mean high volatility, there’s a lot of pressure on the leveraged guys even in the metals markets, the guys who aren’t owning it on a one-to-one basis, but maybe many multiples to one.
David: Yeah. And that’s what you see expressed in the futures market where the greatest volatility in metals comes from, five to one leverage in the futures market all too common, and that’s where the vulnerability, the higher volatility gets expressed. But just as a reminder, volatility is your friend. Volatility, if you’re interested in compounding ounces, if you’re looking at a portfolio and wanting to use the gold/silver ratio just as one expression of that kind of intra market arbitrage, without the volatility, there is no opportunity.
Kevin: Right.
David: And so we went from 80 last year down to 43, back to 70. That’s not disconcerting. That’s the smell of money. Higher volatility is where the opportunity is embedded, and what is uncomfortable is if somebody steps into the metals market for the first time, higher volatility, increased pressure on those levered speculators in the futures market, ends up taking any asset class to the woodshed. Metals aren’t exempt from that, but the bigger picture is too important to ignore. The Caymans, the combined spread and basis trades, the unwind of the yen carry trade, which is just a massive trade. I don’t think there’s even— Nobody has their arms around just what the yen carry trade is.
Bloomberg notes that the trade unravels if the riskier assets tumble or the yen rallies. And in that same Bloomberg article, they quoted bank credit analysts commenting that our hunch is that the next unwinding case will also be triggered by a combination of a drop in carry assets and/or a rebound in the yen.
So are the carry assets tied to the AI narrative? We certainly have the fading of the AI narrative. It just suggests to me that we have troubled waters ahead, and the last upcycle, the last upcycle in precious metals, 2025, driven by central banks and then some late comers to the market, and frankly seeking gains, chasing profits. I fear the next metals move will be less driven by greed, which we just finished, and more by fear. The most powerful precious metals moves are driven that way, which is uncomfortable to say because the best is ahead, but from a macro stability standpoint, still is the worst.
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Well, you’ve been listening to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany. You can find us at mcalvany.com and you can call us at (800) 525-9556.
This has been the McAlvany Weekly Commentary. The views expressed should not be considered to be a solicitation or a recommendation for your investment portfolio. You should consult a professional financial advisor to assess your suitability for risk and investment. Join us again next week for a new edition of the McAlvany Weekly Commentary.
