Why Agency Matters Most

Weekly Commentary • Aug 30 2023
Why Agency Matters Most
David McAlvany Posted on August 30, 2023
  • Gold Carries With It Its Own Agency
  • Central Planners Chase The Illusive “Neutral”
  • Jackson Hole No Surprise: Higher For Longer

There are a whole collection of things, false beliefs, conventions that are considered to be normal anymore, but really what they have been is the experiments of a class of elites, and I’m including in this academics, central bankers, and policymakers, and they think this stuff works indefinitely, but like some traders who’ve lost their context, they’ve confused brains with a bull market. —David McAlvany 

Kevin: Welcome to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany. 

Iceland. Iceland. Is it really icy or is it green? That’s what I’ve heard.

David: It’s incredibly green. It’s like Kona with six to 12 inches of moss. It’s actually really amazing. In some respects, it reminds me of the southwest because there’s such stark and empty space, and it’s everywhere, and that’s the sense that you get when you’re in the high desert of the southwest is it’s stark and it’s empty. It’s just dry there and it’s incredibly wet here.

Kevin: Well, you rented an RV. It sleeps fewer people than you have in the RV. You’ve got a fairly large family now, Dave. How’s that going?

David: Yeah, that’s an interesting question. I think we’re going to be able to write some interesting works of sociology at the end of this trip. I’m remembering now, my dad had as an experiment back in the 1970s, late ’70s, he decided he was traveling so much that he would buy an RV, and better to be together as a family than be absent. And so he had a number of places that he was going throughout the northwest, and so he’s locked into this one small area in Seattle, Washington for two weeks. Just so happens that my mom is with me and my older sister, and she’s older by about three and a half years and we’re both under five years old, and she’s in this RV for about two weeks with nothing but the pouring rain.

I’m fairly certain that there was some damage done to the relationship, and I’m wondering, now I’m just, I have this sense that maybe this trip to Iceland and the RV, what made sense on paper, it’s very different. The pitter-patter of rain is romantic if it’s for 20 minutes or if it’s for an hour, but if it stretches much beyond that, it begins to grate on the nerve. Again, I’m recalling the suffering my mother might’ve experienced in the ’70s.

Kevin: You know what it reminds me of? It reminds me of the RV trips that you take that end up being hotel stays. I remember when I went on a fishing trip with a friend, we planned on catching enough fish to just eat. We had a little Dinty Moore stew with us, and guess what? We ate Dinty Moore stew the whole time. 

So I’m going to shift now. I’ve got a question that’s coming up with people. Clients are saying, you guys are saying rates are higher for longer and maybe even higher and higher. Is there a point where people move out of gold and over into the Treasury market? I’m thinking the Summers-Barsky thesis that you turned me on to years ago. Are we getting close to that or not?

David: Absolutely. It’s something to keep an awareness of, and this notion that real rates matter, you got to keep your eyes on it. Real yields are at their highest level since 2009, and there’s good reason for the gold investor to pay attention to real yields on the rise since at a certain threshold, an unknown threshold, we think of 3 to 4% above inflation, investors view the income over inflation to be more compelling than sitting in a gold ounce or bar or what have you. Pure and simple, opportunity cost. Zero rates, zero opportunity cost, it’s just that simple. Higher rates, net of inflation, and money talks. Is gold likely to weaken if we have further rates rising? Has inflation moderated enough to create that opportunity cost, turning from sort of a trickle of investor dollars to ultimately a flow or flood out of gold and into Treasurys? And I have my doubts about that.

Kevin: Well, and your doubts probably come from the fact that a lot of people don’t buy gold for return. I don’t. I don’t look at Treasurys versus gold. I look at gold because it’s off the grid. I look at gold because it’s outside of this controlled financial system, and I look at gold because frankly there’s geopolitical risk right now.

David: I think there is a reason to recall that real rates ultimately will matter, but I’m not concerned about it at this point for three reasons. The geopolitical risk, which you mentioned, is more pervasive now than at any time since the end of the Cold War. The second reason is that we’ve got global economic and trade constraints which seem to be building in a new era of deglobalization. I think there’s dangerous currency volatility and real danger to the financial system, which I think folks are keenly aware of. So it’s both a political or geopolitical, but also economic, and in this case it’s a world or a global economic, concern that I think has longer term investors taking significant positions in gold. The third reason is that at some point the mal in the recent era of investment craziness will come home to roost, and safe haven buyers of gold will exceed those who are interested in income. Again, these are your interested bond investors who might exit a gold position. Gold is quickly approaching its day in the sun.

Kevin: Yeah, I think about the times, 1987 crash, the 2008 crash, gold went down initially, but it was because of the mal in malinvestment that gold popped up and actually offset the losses on the stock side. But I just was listening to Morgan giving his brief to the office here, Dave. You would’ve enjoyed it. I know you’re enjoying Iceland, but Morgan was amazed at how resilient gold has been. I mean, how long have we been over $1,900 an ounce? This isn’t just sort of a fluke. We’ve been hanging over 1,900 an ounce as interest rates have risen more rapidly than we’ve seen in years.

David: Yeah, and I think that’s worth keeping in mind. Not only do we have a reasonably strong dollar, relatively high interest rates, but gold has more than held its own here at 1,900, and I think Morgan’s summary of the gold market, if you want to look at that, it’s available in the last Hard Asset Insights over this weekend. It’s an important read if you’re interested in gold, if you’re curious about the metals market. One highlight that caught my attention was the 23 consecutive weekly closes over 1,900 an ounce. Again, we’re not at these levels, above 1,900, on a spike to a temporary peak which may prove to be very unsustainable. We have been at these levels. We are building a base for the next move to even higher prices, and it’s in spite of interest rates now being at the highest level that we’ve seen in 15 years.

So has that opportunity cost really impacted in terms of interest rates? Has it really impacted the gold price? I think the answer would be no. So even though in theory these higher rates and a stronger dollar could be the kiss of death for gold, it has not been that way. Twenty-three consecutive weekly closes over 1,900 an ounce. That is something. I would say while you’re in the Market News section of the website looking at Hard Asset Insights, I’d encourage you to also read the weekly recap. It gives you a one-paragraph review of this Commentary. If you don’t have time to listen to it, you can at least get a paragraph summation of it. Hard Asset Insights, again, a condensed version, Golden Rule Radio and Credit Bubble Bulletin. So if you want kind of the Cliff Notes version on a weekly basis, head to the Market News section and look for the weekly recap. They’re really well done.

Kevin: Yeah, people just wait all year long for the Jackson Hole meeting, and I think about, we went to the movie a couple of weeks ago, Mission Impossible. It’s just three hours of high stimulation, right?, just continual. Jackson Hole this year, it wasn’t Mission Impossible. Jackson Hole, talk about yawning. Could you imagine actually having to endure that meeting twice?

David: I took my youngest son to watch Dune, and it’s a good movie, it’s a really good story, but it is slow. It’s very slow. It’s close to three hours, but yeah, it’s kind of the opposite end of the spectrum. I’m talking about the Dune that was out two, three years ago. I know there’s another one coming out here.

Kevin: It weren’t for the sand worms, why would you go? You know those big worms? I don’t know why you’d go.

David: It’s moments like this that as a father you’re like, “Well, maybe it would’ve been a good idea to give the six-year-old caffeine.” I mean, generally speaking that’s a bad idea, but that was last week’s Jackson Hole meeting. Last week’s meeting of central banks provided very little in terms of drama, and it did reconfirm that rates are indeed at these elevated—and I guess we’d have to think about elevated in terms of the recent past—but at these elevated levels for the foreseeable future.

Kevin: Yeah. So what you’ve been saying. Higher for longer, they’re going to be elevated, but there are consequences. I’d like to talk about the consequences. They may not be happening right now, but the consequences to people who have to roll their debt over.

David: And that’s where the time involved matters so much, and this is what we’ve talked about in recent weeks, that the elevated level of global interest rates becomes consequential if they stay here for an extended period. The time involved is critical as older obligations set in motion, and again, this is past tense, at record low levels of interest rates are now being reset, and there’s a whole host of things that are happening or have happened in the interim. Asset values were at that point at record high levels, and so now you’re having to refinance an asset which is at a diminished value but the debt is still up there and you’re doing it on a higher interest basis. Interest expense could be 2, 3, 4 times the previous levels, and that pressures the debtor’s ability to keep up with higher payments.

I think a good illustration of this is in Canada, where most home mortgages have to be refinanced in five years or less, and it’s a little bit like a roll call. You might not be the first on the list, but your name is on the list and it’s going to be called at some point in the next five years. As time passes, more property owners have to refinance, and the debt outstanding remains reflective of the overpaid prices on the asset. Payments are ratcheting higher, and you don’t necessarily have an asset that’s worth the same amount, so your incentive to even walk away from the asset is there. What’s unfortunate is the market value of the underlying assets can shrink. So this goes back to something Richard Russell said, the debt remains the same. He was fond of saying that while asset values fluctuate, debt is permanent. In the current context, it’s the high levels of indebtedness on a diminished asset value with higher servicing costs that creates the real pressure.

Kevin: Yeah, and so to give another analogy, when a person has a nice income coming in but maybe it’s not permanent, and they go out and they make debt up to that level and their income goes down. How often have you purchased assets in the past, Dave, from people who had fluctuating income but high debt? They had fixed the debt at a level that they couldn’t service. Well, that’s the same thing with asset prices. What about commercial real estate? Because I know there’s an awful lot of that coming, as far as needing to be rolled over, and the price or the value of the asset already has been falling.

David: Yeah. So US residential real estate is obviously a little bit different than Canadian real estate. We get to fix our debt, if we choose to, for up to 30 years, and that’s a subsidized number because Fannie Mae and Freddie Mac allow for a below-market rate. You should not be able to fund 30-year debt at 3 or 4%. Now it’s up to 7.3%, so it is on the increase, but commercial real estate here in the US, like Canadian residential real estate, commercial real estate’s at the leading edge of this sort of dynamic reset—1.5 trillion in US commercial real estate coming due over the next 18 months, and the current value of those properties is down, by some estimates, 31% on average. So more in some cases and less in others.

Kevin: Well, and you know who has to also roll their debt over, and not in 30 years, but sometimes in 1, 2, 3, 5, 10? Our own government.

David: I think this is really a fascinating thing to see. The private markets take advantage of low rates and finance debt 10, 50, and in our comments, Kevin, you and I have talked about how some companies were financing debt on even 100-year terms at low single digit numbers, right?

Kevin: Yeah.

David: Governments didn’t take advantage of that, and so they have more debt today, none of it financed on longer terms, so they’re now subject to rolling over large quantities of their debt at ridiculously high numbers. This is the kind of stuff I was raised on. Jane Fonda, not one of my Dad’s favorite actors of all time, but the movie Rollover was about this major debt crisis and how everything works as long as there’s someone willing to refinance the paper. But government debt is now under increasing pressure as governments who’ve been accustomed to spending more than they bring in, in terms of revenue, issue more and more debt.

The difference now versus even a few years ago, it’s at higher costs, which is a unique dynamic. Increasing supplies of government debt alongside increasing interest rates, which are a thing of themselves, it means that the added supplies of debt add even more upside pressure to interest rates. Too much supply, not enough demand, it will influence the price of any asset, but with bonds, the price declines on one side of the equation equates to a further rise in yields on the other side of the equation.

Kevin: You know, I’m a person of habit. I wear white shirts, khaki pants every day. I have this tendency, once something really works for me, I just continue to do it over and over and over. It drives my family nuts. But if you’re in the government, spending is their white shirt, khaki pants habit. I mean, they don’t change very quickly. The government looks like it’s still going to spend as much, if not more, no matter what the interest rates are.

David: Yeah. And the meeting in Jackson Hole confirmed that for sure. Governments all over the world are intent on spending money they don’t have, and if required, they’ll finance what they don’t have at the elevated interest rates currently on offer in the market. Will this evolve eventually into a debt doom loop? That’s a situation where the interest costs as a percentage of government revenue are growing exponentially, and then they add to the deficits in meaningful quantities, with both spiraling out of control.

Kevin: For so long, Dave, I’ve heard that Japan is the model that maybe we can imitate. I mean, the rates are still at amazingly low levels. How is that?

David: Well, there’s always trade-offs, and a part of maintaining very low interest rates has been not only a compliant public that is interested in financing that debt and is willing to put their savings into Japanese government bonds, which is a unique dynamic in and of itself, but in addition to that, they’ve been willing to sacrifice the stability of the yen. And so the trade-off has been low rates with a cheaper value for the currency. 

Rates in Japan are still at ridiculously low levels, but with ridiculously high levels of debt. Yeah, we’re here a stone’s throw away from 300% debt to GDP. It doesn’t take much of an increase in rates to mess things up when you’re dealing with that mountain of debt. Why is yield curve control so hard to kick? Here we are looking at the Japanese—and I think the US is on the same road—at the end of a massive borrowing binge, and the Bank of Japan has to hold rates down. They have to. We’ve talked about that in recent weeks as well.

The choice for the Bank of Japan—this is a true dilemma: keep rates low through yield curve control, save the Japanese fiscal picture from that doom loop, or tempt fate with an out of control currency devaluation. Here’s where you’re at. Yen yield curve control, strengthen the yen, but deal with interest costs that exceed what the state is able to keep up with. That’s your alternative. So the 10-year at 66 basis points, that’s 66 hundredths of 1%, doesn’t sound scary, but it’s the quantity of debt that you multiply by to figure out what the interest expense is, and that can change rapidly.

Kevin: Dave, it seems like when central bankers are starting to look like they maybe can’t control things the way that they could, or the government with CPI, with inflation, they seem to always have a new flavor of the month. It’s like, hey, what we’re going to do now is we have this new mathematical theory, I think it’s called r-star now, where they’re like, “This is the newest, greatest thing that is going to determine what central bankers do.” So let’s talk about Jackson Hole again and this new superhero called r-star.

David: Yeah, Doug Noland’s discussion over the weekend on r-star, that’s the—this is really getting to the boring stuff, the nitty-gritty—it’s the theoretical neutral rate of interest. It’s a metric that made its way into the Jackson Hole discussion last week, and what I liked about it is it was a reminder of the market having a mind of its own. Central banks are right now surprised. They’re surprised by r-star. They’re surprised by this theoretical neutral rate of interest and not expecting it to be as high as it is, and they wonder how high it has yet to go. The r-star is, again, the rate that neither adds stimulus to an economy nor restricts economic growth. So again, it’s your neutral level. Today, the economy’s still growing, and I think this is what they’re surprised by. The economy’s growing. This rate is moving higher. It’s not supposed to be moving higher. It should be static. It should be at a lower level. They’ve experimented with it being at a lower level.

Now, Doug is right to extend the conversation beyond theory and include the frenzied dynamics afoot within the financial market, and we have this compliments of Wall Street engineering, we have this compliments of the massive quantities of leverage within the financial system which go beyond normal credit dynamics. The surprise seems to be with restrictive rates set by the Fed, which have not been restrictive to the financial markets in the least and maybe not even for the economy. So Powell coming away from this meeting said very clearly, “We have rates at a restrictive level,” and yet the economy is growing. We’ve got financial markets going bonkers. We look at the Atlanta GDPNow—that measure—estimate for 2023 growth is running at over 5% per year. So Powell may think he’s restrictive, but the economy and the financial markets are well past 2022. It’s not as if something is happening to them, and I think Doug’s right to say, yeah, there’s other dynamics afoot. The amount of leverage, the amount of speculation, the amount of malinvestment that continues is now far in advance of what Powell and the central bank community can control.

Kevin: Do you wonder if actually the central bankers are going to be humbled by growth instead of a recession? I mean, they can’t slow the growth down right now. What probably should scare them is that’s going to require higher and higher rates. There’s a point where something breaks.

David: Yeah, I like the return of humility to central bank discussions on these matters. Not knowing how high r-star will go is a new experience for the Fed. It was not long ago that there was a swagger amongst academics. There was a presumption of control amongst central bankers that that number was not merely something to be observed, like the ambient temperature in the room. What is the temperature in the room? No, they thought it could be controlled more like a thermometer on the wall. We’ll tell you what the temperature in the room will be because we’re in control of the mechanisms.

So I think it’s interesting. There’s almost a bit of irony here, where this idea of neutral interest rates— Instead of it meaning lower forever, which is what they assumed they could do, we’re on the other side of that with currently the higher-for-longer discussion being solidly in place. Lower forever is what has oozed out of Michael Woodford’s classic book on interest rates with its neo-Wicksellian approach to what “neutral” means. Knut, you might recall, is the Swedish economist. He was the guy, the guy on natural rates prior to sort of the Keynesian appropriation of the term.

Kevin: You know, as I’m sitting here thinking about them talking about neutral, do you realize if they just went away, the central bankers completely went away, they wouldn’t have to worry about having rates too low or too high for stimulus growth or shrink or recession? This whole managed thing, the very fact that they’re looking for a neutral rate is basically disqualifying them because you don’t need control to do that. Neutral occurs in a free market.

David: I get to see this interaction with my kids where they’re all asking for intervention at a certain point during the day where they don’t like the outcomes and they want a father or mother to step in and rewrite the rules in the middle of the game. It’s worth looking and saying, “I know it might look and sound like the Lord of the Flies, but this will sort itself out. If I stay out, these kids will figure it out eventually.” And that is kind of the market dynamic. It’s rough and tumble. There’s some uncertainty attached to it. It may in fact get a little messy, but the reality is, it’s problematic for their growth and development if they assume that I am going to intervene everywhere and always on their behalf, not even really knowing what the facts of the matter are, just the facts as they’ve been presented to me.

Kevin: Yeah, so equilibrium, I’m going to use neutral and equilibrium as the same thing. Equilibrium, I guess it’s a little like Animal Farm. All men are created for equilibrium, but some are more equilibrium than others.

David: I know it’s simplistic, but I think of equilibrium and a pool and what it looks like to have a ball resting on the surface of the water. Equilibrium as defined by Woodford might be a more ideal number with that ball held below the waterline, and what neutral looks like to me in that sense is anything but natural, held there by design, some sort of academic engineering. We’ve certainly seen financial engineering, and Doug is very concerned about that, rightfully so, but this academic engineering is another part of that, and it’s frankly not sustainable. It’s the opposite of natural. It’s unnatural.

Kevin: So we’re paying the consequences right now of the lie that we allowed ourselves that equilibrium was zero rates. Remember the years that we were doing this Commentary saying, “This is going to catch up because zero rates are not equal rates.”

David: It’s right, because really when their holding rate’s artificially low, it’s a means of redistribution of wealth, and you think, “Oh, well, it’s always going to be from the rich to the poor.” No, I think if you’re talking about political economy, you’re talking about redistribution to whoever is designated the winner, whoever they want to designate as the loser, and there may be reasons beyond sort of the rich and poor categorizations that are not immediately obvious. We experimented with zero rates, and indeed discovered that far from being neutral—neither stimulative nor restrictive—they were just redistributive. Playing with r-star versus merely observing it, again, this fits neatly into the category of financial repression. I think there’s a sadness coming out of Jackson Hole that some of the things that they could do before they don’t feel that they can do now, and it’s upsetting. It’s disappointing.

For new listeners to the Commentary, this may sound like a rather jargon-filled discussion, but between the theoretical concepts and the reality of where we’re at in an overextended credit cycle, here at the tail end of a boom in asset pricing, a boom cycle, there are a whole collection of things, false beliefs, conventions that are considered to be normal anymore, but really what they have been is the experiments of a class of elites, and I’m including in this sort of academics, central bankers, and policymakers, and they think this stuff works indefinitely, but like some traders who’ve lost their context, they’ve confused brains with a bull market. And now they believe that they can play God with the ebbs and flows of credit by setting the price of credit, and it’s now humbling. It’s humbling when it’s not working the way they want it to.

Kevin: Yeah, it’s funny, confusing brains with the bull market. How often, and I’m sure all our listeners can relate with this, how often have you known somebody who happened to be at the right place at the right time, made a bunch of money in an investment, and then all of a sudden thinks that that’s how it’s done every time. And it boiled down to the momentum of a market or just a fluke? A lot of times that fluke can turn into momentum for a year or two or three. People can think that they’re geniuses, and unfortunately it’s very hard for those people to keep their money afterwards.

David: Well, and as time goes on, the confidence grows. You’ve got market practitioners that act most boldly when momentum has conferred its benefits to them and when things seem to be going their way, without appreciating that their choices have nothing to do with the results. It is a mere coincidence of tides and financial flows. The r-star measure is moving away from zero and is now uncomfortably higher than anticipated. If the Fed intends on restricting growth, rates are going to have to be higher than they currently are. So again, returning to humility, the rate is something to be observed. Observed, not controlled. And to Doug’s point, there’s more going on than meets the eye, even if you’re just observing one metric of interest rates and the Feds now-squirminess with it being higher than they would like it to be. Current dynamics have mal written all over them, which is why, again, to Doug’s point, there’s more going on than meets the eye. Current dynamics have mal written all over them.

Kevin: You know, we talk about the free market. I was talking about the equilibrium and what we would call neutral, which would eliminate the control factor of central banks or fiscal spending. I wonder with this new central bank digital currency, the digitization of money, if we’re not just adding a new form of control where we can hide this malinvestment a little longer.

David: Well, I mean, isn’t this the irony that we come into a period which is perfectly primed for gold to move higher, and to borrow from Alan Greenspan’s paper back in the ’70s, “Gold and Economic Freedom,” this is an asset that provides, almost guarantees, agency, but it’s the digital currency experimentation, which is where frustrated central planners are headed next to more or less utopianize the economy and gin up their desired economic results.

There at the Jackson Hole meeting, there was one Kansas City Fed paper which was submitted by Barry Eichengreen. He’s been on our program before as a guest on the podcast. As a contributor to this paper, he acknowledged that we have high levels of debt that are not likely to change anytime soon, and previous types of financial repression are less feasible than in the past. Cry me a river, but here it is, it’s something that is lamentable from their standpoint. Financial repression, again is just the power to choose winners and losers, and the fact that that is waning, inflation and market-driven rates have shifted the balance of power away from the planning community. One more note from Eichengreen’s observation is that public debts are not going to decline significantly for the foreseeable future. That suggests that the need for new financing, the new supplies of debt coming to market will continue, and that’s a part of why interest rates are not coming down anytime soon.

Kevin: Well, Dave, last week you and I were talking and sort of debating the BRICS currency meeting, and I ended by saying, “Just give me my gold,” and you talked about agency. Do I want to give the agency of my future over to these controllers, whatever they want to call it, whether it’s r-star or the new central bank digital currency, or do I want to hold something that carries its agency with it? To me, that’s equilibrium.

David: It was fascinating, wasn’t it, the conversation we had with Carmen Reinhart so many years ago, and the idea that debts were increasing, the idea that currency pressures were a possibility. In our after-conversation, the discussion about owning gold and owning real estate and getting out of debt, in spite of higher inflation being a possibility, that was not the point. You want to be in a place of stability financially where your debt levels are low, you’ve got reasonable liquidity, you’ve got protection from a system that is not particularly designed for the craziness that we see. 

Again, thinking in terms of geopolitical change and change dynamics in terms of global trade and the global economy, do you really want to give up agency in that kind of environment? The reasons to own gold, maybe that’s a fourth reason, going back to what I said earlier, why am I not concerned about higher rates and gold in this environment, geopolitical risk, global economic and trade constraints. At some point, the mal in the recent era of investment craziness coming back home to roost, and maybe the fourth is because agency has never been more important.

*     *     *

You’ve been listening to the McAlvany Weekly Commentary. I’m Kevin Orrick, along with David McAlvany. You can find us at mcalvany.com. That’s 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.

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