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When The Carry Trade Becomes The Buried Trade
August 2, 2023
“Six months of higher rates is no big deal. One year? For most entities, it’s no big deal. Limited lag effects. But as you extend to two or three years, the cumulative effect becomes paralyzing. So financial markets freeze up if rates are high for a longer period. This is one of the reasons why we come back to China, commodities inflation, and the fact that interest rates are likely to be here longer because the factors driving inflation simply are not going away. It’s not merely a function of monetary policy. At this point, it’s fiscal policy, it’s wages, it’s commodities, it’s the governments which over the next 12 to 24 months are really under the gun.” —David McAlvany
Kevin Orrick: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany.
Well, Aloha. You sent your daughter to spend some time with your parents over in the Philippines at the orphanage, and you just got back from meeting your dad and your daughter in Oahu. You went to Hawaii to pick her up.
David McAlvany: That’s right. The most populated of the islands. It’s been about four or five years since I met my dad there for a couple of days. The last time I was there, I got stung by a box jellyfish, so—
Kevin Orrick: I still remember. We talked about that last week.
David McAlvany: My dad was encouraging me to go swimming, but maybe respect red flags, and I did. I looked everywhere for them.
Kevin Orrick: Yeah, I got to see the surf videos, though. Your daughter did a great job on a surfboard. Now you have a little experience with it, but I don’t think she did. And I saw the GoPro, and it looked like she was doing quite well.
David McAlvany: It was really fun. So we went from last week at an economics conference—267 attendees, 190 white papers; I contributed one on the dollar, and then my wife and I co-wrote one on immigration.
Kevin Orrick: That was in California.
David McAlvany: That was in California, San Diego. And then moved over to Hawaii to pick up my daughter and now we’re back.
Kevin Orrick: How was that? Her spending time in the Philippines? She was over there about three weeks with your parents at the orphanage.
David McAlvany: Yeah, such a radically different experience. Got to spend some time with 12-, 13-, 14-year-old girls whose life looks different—educational aspirations, the background, and the future. It’s radically different. She told my wife a week ago, this has changed her life.
Kevin Orrick: Really?
David McAlvany: And I don’t know what she means by that or how that gets translated.
Kevin Orrick: Well, I saw how it changed your parents’ life when they went over. Yeah.
David McAlvany: Yep. No, there’s something about cultivating compassion that’s good for all of us. And regardless of the stage in life you’re at, if your life is lived exclusively for yourself, it’s a high form of poverty. And if there are ways in your local community or other places in the world where you can invest your time and your energy and your fortune, it’s good for you just as much as it is good for them. Probably even better for you.
Kevin Orrick: Dave, on that subject, because we talk about money, we talk about politics, we talk about just social issues here, but it’s not all about getting rich, it’s not all about building a fortune. What it really is, it is about other people. I talked to a family yesterday. They called in, we needed to talk about some financial issues, but I realized that just about everything that they had was going toward adopting the next child. They had six children that they had adopted, and some of them were problem children where they knew that there were—
David McAlvany: Health considerations.
Kevin Orrick: Yeah, health and mental. But it was amazing. As I was giving bank ratings and we were talking about the finances, their goal was exactly what you’re talking about. It was about compassion for others. So as we do these programs, Dave, even as we talk this week about the upcoming call with the Tactical Short fund, we’re keeping in mind that it’s not all about money. It’s about people.
David McAlvany: Yeah. Thank you for the reminder. This week Thursday, Doug Noland leads our Tactical Short quarterly call for Q2. As liquidity has defined asset pricing, so we find again in this period an increase in liquidity to resolve banking sector pressures—most recently translated nicely into a powerful financial market price increase. So we’ll look at the foundations for recent price appreciation and whether they’re solid like a rock or more like shifting sand—bank bailouts, spurs, bubble revival. That’s August the third, 4:00 PM Eastern, 2:00 PM Mountain, followed by Q&A. So please join us and submit your questions in advance.
Kevin Orrick: Well, and those are always nice to listen to. Whether a person is invested in the Tactical Short or not, they get a chance to listen to somebody that we’ve listened to for decades and now works for you, Dave, Doug Noland.
David McAlvany: There’s not a week that goes by that I don’t read the Credit Bubble Bulletin a day, doesn’t go by that I don’t look at the curated news feeds on our website that Doug puts together for us. It’s of incredibly high value. If you go to mcalvany.com and look in the informational section, there you’ll see the Credit Bubble Daily. And again, you get a curated newsfeed of the most important articles of the day relating to the financial markets. And so, to me, to be able to access his framework of thinking and credit analysis, it really is invaluable. Whether you’re invested in Tactical Short or not—I’d encourage you to consider it, but to be a beneficiary of his insight and of the parsing of market nuance, I wouldn’t want to do without it myself.
Kevin Orrick: Well, and he puts so much energy and time in, I don’t have the time to put in, but I certainly do appreciate it. It’s like somebody who really appreciates good wine. I like to drink a glass of good wine, but I don’t have the time to become a sommelier. And so I do appreciate those who do.
Last week we talked about Chinese stimulus and how that would affect the commodities market. I want to go there right now because there have been some changes in China, especially on the central banking side, that we need to talk about today.
David McAlvany: Well, and I think it’s worth keeping in mind that over the last six weeks we’ve gone from oil at $68, $69 to $81. It’s happening. So we discussed the impact of Chinese stimulus on commodities. Downstream from commodities you’ve got global inflation, and then further downstream still, you’ve got the persistence of higher rates for longer with the consequence of true tightening financial conditions throughout the global economy emerging. And this comes from the present tense monetary policy tightening. So this has been in place, but again on the lagging effect. So, China, I argue, in the centrally planned targeted GDP figure, these are the linchpins in the global commodity markets going forward. Will they sufficiently stimulate growth in the number two economy to revive the prior growth trajectory? And to what degree does that drive energy prices, other commodities back to a strong growth trend? And in brief, I think the answer’s yes, strong growth.
Kevin Orrick: And sometimes— You talked about centrally planned targeted GDP—we talked about this a couple of weeks ago. You will make GDP. You will hit the number because you are a centrally planned economy. But the illusion the central bankers like to have worldwide is that they’re not connected to their politics. Central bankers like to think that they’re autonomous, especially in China. That’s not the case. And now we have a new head of the People’s Bank of China.
David: Right. So who’s going to get the job done? Who’s the man with the plan? Pan. Pan Gongsheng. Perhaps not the modern era’s sort of rock star persona.
Kevin: The Pan plan.
David: Yeah. Think about the role that central bankers play today. They used to live in obscurity. Now, everyone knows them by a first name, affectionately. It’s Jay Powell, not Jerome. We’re comfortable with him, and he is a bit of a rock star as have been his predecessors.
Kevin: You can hear the drum roll, yeah.
David: But Gongsheng is both the newly appointed governor at the PBOC, but also that body’s Communist Party secretary. And both roles have not previously been held by one person. The objectives of the party, combined with the tools of the central bank, they’re not connected, right? So this time through one officer, you’ve got a different kind of management in play. Most central banks, as you mentioned a minute ago, maintain some degree of political autonomy. That’s not the case in China.
And so you have a veteran central banker deeply tied to the party taking the helm, navigating a variety of cross currents—property market malaise, post-COVID consumer caution, financial market frailties, which you would expect to exist when you’ve got massive debts accrued in a very short period of time. And so far, those increases in credit have not been sufficient to move the economic growth needle, and could be destabilizing factors going forward. But what he’s there to do is stimulate growth in line with the GDP target, with all those other factors still in mind. And I think he’s appropriately named for the position. He’s connected to everything. He’s Pan Chinese.
Kevin: Pan Chinese, that’s right.
David: Central planning and stimulus management from Mr. Gongsheng.
Kevin: Well, and the old joke about how the husband may be the head, but the wife is the neck. And if you think about it, in a central banking situation in China, it’s the head of the PBOC may be the head, but the neck is definitely Xi and what his expectations are.
David: Sure. So on Thursday, Doug Noland will explore the loosening effects, the loosening effects of the current financial market environment, and that’s in contrast to the intended tightening effects as a result of higher rates. I thought it was interesting, the Financial Times ran an article on the 27th of July quoting the Chief Investment Officer for Franklin Templeton Fixed Income, and he points out the current Chicago Federal Reserve’s Financial Conditions Index. It’s touched the lowest point in 16 months. And to quote him, “The reality is that financial conditions have loosened. We’ve effectively unwound roughly 450 basis points of rate hikes.”
Kevin: It’s as if it never happened.
David: Yeah. He says, “Financial conditions are enough to take us back to March of last year.” So Kevin, that’s to say, it’s as if the Fed never hiked rates.
Kevin: You’re right.
David: So we have this contention that we’ve raised rates, financial conditions have tightened, and yet that’s not really the case, not in the real world. Fixed income spreads to Treasurys are at 15 to 17 month lows—just another measure of loose financial conditions, which, sitting alongside the march to new highs in the equity markets, should be concerning to Jerome Powell. But nothing along those lines was insinuated in last week’s rate increase or his discussion of such, taking us to the 5¼–5½ range. You’ve got equity exuberance on the loose, and this belief by our central bank that conditions have tightened when practitioners in the marketplace would say, “There’s so much looseness here. It’s as if nothing were done.” Well, at least most—450 basis points of loosening, unwinding what was done, basically going back to March of last year.
Kevin: We just came out of the 4th of July, and it’s usually too dry in Colorado these days for us to have fireworks anymore. They usually ban them. But remember when you were a kid and you’d light a Black Cat and the fuse would go out—or you’d think the fuse would go out, and you’d think, “Okay, no more fire in the hole.” And then—boom—it would just start right back up. I’m thinking, look at the Nasdaq this year. We thought that we were going to go into a recession. You and I even talked about that. And yet the financial markets are acting as if there’s nothing but blue sky above us.
David: Yeah. And long discussed are these lagging effects from monetary policies where it may take 18 to 24 months before you see an impact from an increase in rates.
Kevin: That’s that delayed pop.
David: Yeah. And today you’d say, “No, it’s not going to happen.” Nasdaq year-to-date gains are 44.6%. Semiconductors as a segment of technology, up 53%. And as we noted in previous shows, at the same time we have 50% increase in semiconductors, sales for semiconductor companies are in steep decline.
Kevin: Yeah. Nobody’s buying them, it’s just the stocks are going up.
David: Right. So the difference between fundamental reality and the performance of those shares, it’s significant, it’s amazing. The S&P 500 is up 19.3% with help of the magnificent seven or five or whatever. It was interesting, Ned Davis Research captures the rarity of that kind of concentration in a study that goes back to 1972. Only a few times since the ’70s has this happened where you have such a high concentration of performance based on just a few names, where the capitalization of the whole index is made up by just a few names.
1972, just before we head into recession, we got above 30%—and I think they were looking at the top 10 names. Top 10 names equaling a certain amount of capitalization, total capitalization. 1972, then we headed into recession. 2000, so just before the tech-centric blowup. 2021, in the midst of the COVID-stimulated Everything Bubble and the 2023 Echo Bubble—echo of 2021. These are instances in which the top 10 names from the index exceeded 30% of the total value.
Kevin: Wow.
David: Underperformance in those same names is what follows. And they drop back to less than 20% each time. So when concentrations increase as they have, it’s an end-of-cycle dynamic. Those tech names will not lead the next several years of outperformance. Quite the opposite, expect a rotation to value. Expect a rotation to underperforming sectors and a further rotation to money market funds paying over 5%, but don’t expect a replay of what you’ve had in 2023 year to date.
Kevin: Well, and you’re talking about rotation. We look at Powell, and Powell right now actually thinks he has restricted lending. He’s talking about restricting the federal funds rate, that it’s at a restricted level, but you know what? He’s not the only guy that loans people money. That money just goes and finds somebody else to loan right now, and that seems to be what’s going on.
David: Yeah. Chief Investment Officer Franklin Templeton running a fixed income desk and looking at financial conditions, saying things are pretty loose. Contrast that with the theoretical. In fact, Powell says this last week at his press conference, “The federal funds rate is at a restrictive level now.”
Kevin: Yeah, so we’ll just go elsewhere.
David: I guess what we’re seeing is that the equity prices bubbling higher along with valuations—both rising with the tide of liquidity—it’s gone underappreciated by Jerome Powell. And so his perspective that the federal funds rate is at a restrictive level, it’s a unique perspective, and it’s not in keeping with those who are practicing within the financial markets. Where, we wonder, has it been particularly restrictive? I mean, what could he be looking at—
Kevin: Maybe the banks.
David: Would be accurate?
Kevin: Maybe the banks.
David: And that may be, bank lending, at least at the margins. We had the July numbers come through for the SLOOS report, the Senior Loan Officer Opinion Survey, lending standards are in fact getting more restrictive, continuing that same theme from the last report. Loan demand is falling in commercial banking, driving, in my opinion, the traffic elsewhere. And I think this is what’s key to recognize is that there’s always innovation and change. There’s always—maybe mutation or evolution would be another way of looking at it.
Kevin: Well, it’s like people who like to carry a mortgage instead of actually having you go to the bank to get the mortgage, there’s private money that’s happy to lend.
David: Well, and so the traffic has gone away from commercial bank lending and more towards the private credit markets. If you think about the increase in regulatory scrutiny following the Silicon Valley Bank debacle and Republic Bank—this goes back to March—the private lending markets are open just not through traditional bank lending channels.
Kevin: And that’s not as regulated, is it?
David: No, it’s not as regulated and there is no such thing as the FDIC. And this is like a secret carve-out, if you will. You’ve got the bond market, you’ve got the commercial lending, and then private credit is somewhere in between. It’s sort of this hybrid, and it’s become very, very popular. And actually some of the big players in that space are private equity players. These are folks who’ve been buying out private companies or taking public companies private, and they introduce a bunch of credit into the balance sheet, extract big dividends on the front end, collect fees as they go. But as interest rates have come up, there’s been a freezing within the private equity space, and they’ve got a lot of money to invest.
Private credit has become an alternative venue for them. Instead of being equity investors, they’re offering loans. Private credit has become an alternative source of funds for the current market borrower. And maybe you have a different credit profile. You’re certainly not going past the same sort of credit committee approvals and the stodgy lending standards that you’d face in a commercial bank. Terms can be whatever you decide on in what is essentially an extension of shadow banking.
So keep in mind that the growth in lending has been away from commercial banks. Again, where I think maybe Powell’s right, that there is a more restrictive level now, but the volume in lending is still fairly robust. But it’s in this area, shadow banking, problems are bound to emerge, in part because it’s less regulated, in part because you’re talking about leveraged loans and you’re talking about highly structured products that don’t have a lot of liquidity. Collateralized loan obligations are great as long as prices are appreciating, but what’s the two-way flow of funds? What’s the liquidity for a CLO in a down market?
Kevin: It goes back to, can you really control these markets from the banking sector? We’ve seen central bankers—at one point, I mean a few years ago, they were almost like demigods. They could just control, they could tighten, they could loosen, they’d loosen a little bit more. But when you have private markets that have this much liquidity, it does call into question Powell’s ability to actually manage. I wonder if he’s a little bit worried about that right now.
David: You raise a great point because you’re talking about the transmission mechanisms for monetary policy, and the classic transmission mechanisms included commercial banking, and it’s not that way anymore. So things have morphed, although I don’t think the memo got back to the Federal Reserve Board that the transmission mechanisms are broken. You’ve got liquidity in the private credit market, and surely it is a fraction of that in traditional bond market. What I was mentioning a moment ago is really key. Its liquidity or lack thereof will be a factor that’ll make for some fantastic losses in the years ahead.
Bloomberg in early July wrote about this sort of hottest of hot market segments, which is gaining in popularity. It’s already been popular with institutional investors. With the college endowment that I help with, that’s all the rage. Private equity, less liquid assets for higher rates of long-term returns, that’s kind of been the mantra.
Kevin: Goose it for the gain.
David: Yes.
Kevin: Goose it for the gain.
David: So you got Dave Swensen and the folks at Harvard and Yale that have popularized this over the last 20 or 30 years, and it’s been very true, it’s been very helpful. You’ve gotten a greater long-term return by sacrificing liquidity. But this is an endowment, and that endowment has a lifespan which you would argue is in perpetuity. What the Bloomberg article was focused on is the fact that this market segment in particular is becoming very popular in retirement funds. And the key distinction here is that retirement funds, you need those funds within a few years.
Kevin: You need liquidity.
David: And so when you need the funds, you need the funds. And the endowment is in a little different situation. It’s in perpetuity. Retirement funds are not in perpetuity. It’s an immediate thing. So you are moving beyond the institutional domains of pensions and endowments with the typical buyers of illiquid assets. And so yeah, perhaps Powell’s right about a more restrictive policy if your focus is bank loans.
But it’s a bit like one parent saying no to a child’s demand. “You can’t have that. No, you’re not allowed to do that.” And the child moves to sort of the weaker willed or more easily worked parent and gets better terms. That’s what’s happening in the lending markets. You have the restrictive and you have the accommodative at the same time, and the markets have found a work-around to the more restrictive bank lending. Credit’s still flowing and there’s ample liquidity in the system, which is one of the reasons why the stock market continues to do very well, because there is ample liquidity and there will continue to be ample liquidity until there’s not, right?
So markets have found a workaround. Wall Street has taken market share from commercial banks. I think that’s a critical transition in our financial market structure. And there’s prime brokerage lending to hedge funds. There’s structured products, there’s private equity firms and other Wall Street entities that have pivoted to meet the loan demand on very different terms than the terms offered by your commercial banks. But the markets are not more restrictive than they were a year ago. Current financial conditions remain as if 450 basis points increase in rates never happened. There’s not much tightening at all.
Kevin: Yeah, but there really was, and there really is, and you may not feel it right now, but you’ve got loans coming due. And I’ll never forget, Dave, about 10 or 12 years ago, our family went on a cruise, and you pay for the cruise—you spend and you spend and you spend, and you feel like you paid for everything. So you add a little bit, and you go, “Let’s eat at the fancy restaurant tonight instead of just going to the cafeteria.” And so all the things you prepaid for before, you’re starting to go, “Yeah, I’ll take that third Mai Tai. I’m on a boat, I’m not driving, no big deal.”
And it adds up. And I’ll never forget the day of checkout, the line of people who had their credit card in hand, and they had to settle up before they got off the boat. You look at these people’s faces, and their cruise cost twice what they thought, right? That day’s coming. We did have a 450 basis point rise, we’ve got debt that’s coming, and it’s going to roll over.
David: The ones who’ve been in a privileged position are corporations, and they have had time on their side—and I say have had—some have felt very little impact from rising rates because they wisely took advantage of extending the terms on their debt throughout the period of record low rates a few years back.
Kevin: But isn’t there a rollover coming?
David: Yeah. So those restrictive impacts, the impacts of higher rates, they’re even more lagged, even more delayed in terms of a timeframe within the corporate sector.
Kevin: I’ll take that third Mai Tai.
David: But higher rates will bite there too.
Kevin: Oh, yeah.
David: The rollover calendar is different for the corporates than for government debt, and that includes governments all over the world. The rollover calendar is a key factor to keep in mind when figuring out the lagging effects of interest rate policy.
Kevin: But let me ask you, okay, if interest rates really were to fall quickly, maybe that wouldn’t be an issue. Isn’t it the length of time that interest rates stay high that actually creates the problem?
David: Yeah, extent and duration, those are the two factors. And so if you have a radical increase in rates, then everybody’s going to feel the pain to some degree.
Kevin: But if they stay high for long—
David: That’s the duration piece, and that’s where you begin to feel it. This year I started swimming at our local lake in May. April was a little chilly, too chilly, still in the 40s, too cold.
Kevin: But you get in when it’s in the 50s.
David: Well, but the lagging effects of cold water in the body, they’re real. And I think the thing that comes to mind is that they’re also cumulative with time. So this year was a no wetsuit year, which tends to exaggerate the cumulative effects. And you know what it shortens? It shortens the timeframe to my core temperature getting too low. So I’m in for 10, 15 minutes and that’s all I could take at temperatures in the mid 50s.
Kevin: I’m in for 10, 15 seconds in the mid 50s, Dave, so good for you.
David: Your body does adjust a little bit with time, but even then it would take me an hour to get my core temperature back to normal. You get to the low 60s, I can add another five minutes. In the mid to upper 60s, total time extends to 30, 35 minutes. All I want to say is that externalities and lagging effects are interesting to consider. And you are coming up against this sort of lag where things begin to freeze because you’ve been there long enough for them to freeze.
Kevin: So since we’re talking about water, you remember the rage, that ice bucket challenge that was going on?
David: Yeah.
Kevin: You could see the people’s face, they would dump that ice on themselves, but it was over very quickly.
David: Timeframe matters. Exactly. So it’s short and sweet. The discomfort is over abruptly after it begins. It’s cold, but the duration is nothing.
Kevin: Right, right.
David: So the longer rates remain on the high end, the more time there is for debt to mature, to be refinanced. And so, unfortunately, we’re talking about being refinanced at higher numbers, not lower numbers. Six months of higher rates is no big deal, one year, also, for most entities it’s no big deal, limited lag effects. But as you extend to two or three years, the cumulative effect becomes paralyzing.
So financial markets freeze up if rates are high for a longer period. This is one of the reasons why we come back to China, commodities, inflation, and the fact that interest rates are likely to be here longer because the factors driving inflation simply are not going away. It’s not a merely a function of monetary policy. There’s other things that go well beyond monetary policy. At this point, it’s fiscal policy, it’s wages, it’s commodities. And frankly, the ones who are at risk are not corporations because they have bought themselves time. Governments are most at risk because of front-loaded maturity schedules. Given enough time, corporations are going to feel the heat as well, but it’s the governments which over the next 12 to 24 months are really under the gun.
Kevin: Well, and our government has been spending an awful lot of money. I mean, how much is coming due at a much higher rate?
David: It’s fascinating, we raised the debt ceiling a month ago. You know how much we’ve issued in Treasury bills, bonds, and notes just since we raised the debt ceiling? This is less than six weeks ago. $814 billion.
Kevin: Wow.
David: We’re getting after it. The US government I think serves as a cautionary tale if you’re talking about this maturity schedule. 2023 has over 6¼ trillion dollars in US treasury debt coming due.
Kevin: At a higher rate than before.
David: Yep. 2024, just over 3 trillion. 2025, close to 2½ trillion. 2026, near 2 trillion. 2027 and 2028, between 1½ and 2 trillion as well.
Kevin: All at higher rates than what it was borrowed at.
David: So you’ve got 17½—just call it 17½ trillion in debt to roll over in the next six years. That’s over half of all of our federal debt outstanding. And it’s rolling over at interest rates that are one, two, even three times the old numbers, which is why the interest component is so concerning.
Kevin: This is the guy checking out after a really nice cruise. He remembers that third Mai Tai, but this time it costs the, what, the price of 9 or 10?
David: The speculation is that the dollar’s demise is based on the BRICS’ adoption of some sort of a gold standard and an alternative reserve currency. That’s not the issue. If the dollar is going to die, it’s going to be of self-inflicted wounds. It’s not going to have anything to do from external alternatives.
Kevin: It’s its core temperature dropping below living standards.
David: And that’s because of decisions that the US Treasury has made, that the US Congress has made. And again, this is math that gets really tough. Financial Times reported—this is on the UK, not the US—but that the UK so far this year, 10.4% of government revenues will go to interest payments. 10.4% of government revenue—
Kevin: That’s for England?
David: That’s for England.
Kevin: UK?
David: And they reported, this is supposedly the highest level of any high income country. I totally disagree. The US is higher. The US has exceeded 652 billion in interest costs in the first nine months of our fiscal year, will surpass 900 billion for fiscal year 2023.
Kevin: And so what percentage is that?
David: Well, in the calendar year, by the way, that’ll go past a trillion. That is over 20%—
Kevin: Wow.
David: —of federal tax receipts. Another example of how things change: Germany paid 4 billion euros in interest in 2021. Four billion. Wall Street Journal reports that this year the expense will go from 4 to 30 billion—seven and a half times what the cost was two years ago.
Now, benign number, nobody’s worried. 838 billion in revenue. 3.6%. They can handle it. Again, if you’re talking about the pressure on the US dollar, think about how our creditors view a situation where 20% of our revenue is going to interest costs. And interest costs are not that high from a historical perspective. They’re high relative to what they’ve been of late.
Kevin: Right, not like what we had in the ’70s. But do you remember the geniuses that were talking about Modern Monetary Theory when money was free. When money was free, Modern Monetary Theory, which is, “Hey, just print it, spend it, borrow it, print some more, spend it, borrow it.”
David: It’s inconsequential.
Kevin: That’s right.
David: And they have a point, in a world of zero interest rates.
Kevin: That’s what we talked about last week. When money is free—
David: Money printing is inconsequential.
Kevin: Yeah.
David: You can see how tempting Modern Monetary Theory is if credit carries no cost. Now, that argument falls flat as rates run at higher and higher levels. Time is out for government borrowers, and the clock is ticking for corporations. They’ve got some time. But if beating inflation takes more time, and we’re still fighting it out to 2025, even 2026 or 2027, commercial real estate rollovers, we already know that in the pipeline we’ve got a trillion and a half of commercial real estate rollovers. That’s a problem.
Corporate debt rollovers, tallied by S&P Global, also problematic. 900 billion here in the US for this year. Over a trillion in 2024, 1.14 trillion in 2025, 3.1 trillion in corporate bonds coming due in a very short period of time. It makes for really what is the tale of two capital markets. You’ve got some companies that are going to be under extreme pressure because they leveraged their balance sheet. They wanted to grow through borrowing. And now all of a sudden growth is a scarce commodity and interest rates are moving higher. Others are going to be fine. If you’ve got a strong cash position, liquidity position, enabling growth by acquisition, I think you’re going to be in a phase where you get to buy really good assets at a discounted price. So it is sort of the tale of two capital markets because of where rates are taking balance sheet pressure in the years ahead.
Kevin: Okay, and this isn’t just governments. I mean, corporations may face the same thing.
David: Well, that’s what I’m saying. Forbes highlighted three of the members of the S&P 500 which this year have 40% or more of their debt coming due. This is a good illustration of the lagging effects of monetary policy in a very existential form. They may not survive. If you’ve got to roll over 40 or 50% of your debt, and the last time you locked in your interest costs it was at 1 or 1.5% and now it’s going to be 5.5 or 6%—or even more if you’re a junk borrower, wow, it’s an existential event.
Kevin: So I’m thinking outside of the box. Let’s just say I’m going to think outside of the country, and I’m thinking carry trade. Carry trade. If I have to pay 5 or 6% in my own currency, why in the world wouldn’t I go to Japan and only have to pay half of 1%?
David: I don’t know if this has to do with island nations or not, but there is something weird. The last major carry trade debacle included Iceland. Borrowing costs were on the increase, didn’t like what you were going to get from the local bank, so the local bank—
Kevin: They borrowed from Switzerland.
David: Yeah. So the local bank was like, “Hey, we can arrange a loan for you, but it’s going to be in Swiss francs.” So you lock in a near zero rate in Swiss francs for three or four or five years, 0.5%, 1%, or less—really cheap mortgage money. But then the problem is we go through some financial ups and downs. The Swiss franc takes on safe haven attributes. As people buy the Swiss franc, the Swiss franc appreciates. And now those who borrowed in Iceland—
Kevin: In Swiss francs.
David: Not in their own currency.
Kevin: In Swiss francs.
David: Borrowed in Swiss francs, they have to pay back—
Kevin: At a higher—
David: In a currency that is 5% more expensive, 10% more expensive, 30% more expensive. And as the currency is running away from them, they realize the math doesn’t work anymore. They default on their paper. Now you’ve got a banking crisis in Iceland because of the “original sin.”
Kevin: So it’s not the carry trade, it’s carry the body out trade.
David: That’s right. And so I met my dad in Hawaii this weekend to pick up my daughter. Part of her Summer was at that orphanage in the Philippines. Our conversation turned to opportunities and risks in the current market environment. And one significant unknown risk we lingered on was Japan.
Kevin: The carry trade.
David: Yeah.
Kevin: The Japanese carry trade.
David: Exactly. Opportunities, certainly, in Japan. But the carry trade is a simple yet high-stakes game of borrowing in one geography in order to benefit from low interest rates in that geography, using the loan proceeds to invest in higher yielding geographies. The quantities in the carry trade are unknown, but are thought to be in the trillions of dollars. Trillions, making what happened in Iceland insignificant. I mean, there was a rounding error in terms of the borrowed money from Switzerland. This is something that is highly impactful to every risk asset on the planet. US equities, derivatives, options, if you look at your emerging markets where carry trade investors have moved from yen into South African rand, Mexican pesos, for not only the currency appreciation of the peso, but also the higher yield—
We began with Pan, the newest lead officer at the People’s Bank of China. I’m going to conclude with the Bank of Japan. It was only a few months ago that the Bank of Japan was given a new lead as well, Ueda. He made no ripples in the glass-like looking pond, which is Japanese monetary policy. Very little has changed there for the decade, not until last week. And the reference rate for the 10-year bond was raised from 0.5% To 1%.
Kevin: And that increases the value of the currency, which is what you were talking—
David: Attractiveness. It increases the attractiveness of the currency, which may increase the value as people move to the end. He disavowed that this change was a change in the decade-long policy of yield curve control, just a wider band in which to allow for Bank of Japan operations.
But the consideration is this: higher rates change the carry trade dynamic and higher rates promote a stronger exchange rate. It’s more attractive. And appreciating yen is the death of the yen carry trade. Now, why is that important? Because there are trillions—exact quantities unknown, but trillions—in leveraged bets which have to be liquidated to cover yen exposure.
Kevin: If the yen continues to rise or if it does rise.
David: Yep. So just like a depreciating currency is a risk on the other side of the trade, an appreciating currency in the country where the carry trade originated, it’s a form of a financial crucible. Paying back a loan at a higher and higher currency value strips the profit from the trade, introduces losses. Iceland went through a banking crisis a few years ago as real estate purchases were financed at cheaper rates in Swiss francs. And people do understand that there is a safe haven dynamic which the franc, the US dollar, even the yen, take on—safe haven characteristics at appreciation in currency when there’s destabilization in any form or fashion in the world financial system.
Those loans come under pressure, as did the Icelandic real estate market. And so this is a global trade on a massive scale. I think it’s going to be very interesting to see what unfolds. I don’t know if anything major happens in the short term. What has begun is this rate normalization. Is it the end of yield curve control? The end of the yen carry trade—at least this episode? There’s the distinct possibility that in the coming months we see a large-scale financial event like what was referenced in Hemingway’s The Sun Also Rises. Hemingway answers the question, “How’d you go bankrupt?” And his response is, “Two ways: gradually and suddenly.” 2023 and 2024 promise to impress on the entertainment front with some form of either drama or action thriller, or a horror show. And at this point, we can’t be sure which.
Kevin: You’ve been listening to The McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany. You can find us at mcalvany.com M-C-A-L-V-A-N-Y.com, and you can call us at (800) 525-9556.
This has been the McAlvany Weekly Commentary. The views expressed should not be considered to be a solicitation or a recommendation for your investment portfolio. You should consult a professional financial advisor to assess your suitability for risk and investment. Join us again next week for a new edition of the McAlvany Weekly Commentary.
