Tag Archives: Currency

Seth Levine: COVID-19 Is Not The Last War

These are truly remarkable times in the investment markets. The speed, intensity, and ubiquity of this selloff brings just one word to mind: violence. It would be remarkable if it wasn’t so destructive. Sadly, the reactions from our politicians and the public were predictable. The Federal Reserve (Fed) faithfully and forcefully responded. Despite its unprecedented actions, it seems like they’re “fighting the last war.”

Caveat Emptor

My intention here is to discuss some observations from the course of my career as an investor and try to relate them to the current market. I won’t provide charts or data; I’m just spit-balling here. My goal is twofold: 1) to better organize my own thoughts, and; 2) foster constructive discussions as we all try to navigate these turbulent markets. I realize that this approach puts this article squarely into the dime-a-dozen opinion piece category—so be it.

Please note that what you read is only as of the date published. I will be updating my views as the data warrants. Strong views, held loosely.

The Whole Kit and Caboodle

Investment markets are in freefall. U.S stock market declines tripped circuit breakers on multiple days. U.S. Treasuries are gyrating. Credit markets fell sharply. Equity volatility (characterized by the VIX) exploded. The dollar (i.e. the DXY index) is rocketing. We are in full-out crisis mode. No charts required here

With the Great Financial Crisis of 2008 (GFC) still fresh in the minds of many, the calls for a swift Fed action came loud and fast. Boy, the Fed listen. Obediently, it unleashed its full toolkit, dropping the Fed Funds rate to 0% (technically a 0.00% to 0.25% range), reducing interest on excess reserves, lowering pricing on U.S. dollar liquidity swaps arrangements, and kick-starting a $700 billion QE (Quantitative Easing) program. The initiatives are coming so fast and so furious that it’s hard to keep up! The Fed is even extending credit to primary dealers collateralized by “a broad range of investment grade debt securities, including commercial paper and municipal bonds, and a broad range of equity securities.” Really?!

Reflexively, the central bank threw the whole kit and caboodle at markets in hopes of arresting their declines. It’s providing dollar liquidity in every way it can imagine that’s within its power. However, I have an eerie sense that the Fed is (hopelessly) fighting the last war.

The Last War

There are countless explanations for the GFC. The way I see it is that 2008 was quite literally a financial crisis. The financial system (or plumbing) was Ground Zero. A dizzying array of housing-related structured securities (mortgage backed securities, collateralized debt obligations, asset-backed commercial paper, etc.) served as the foundation for the interconnected, global banking system, upon which massive amounts of leverage were employed.

As delinquencies rose, rating agencies downgraded these structured securities. This evaporated the stock of foundational housing collateral. Financial intuitions suddenly found themselves short on liquidity and facing insolvency. It was like playing a giant game of musical chairs whereby a third of the chairs were suddenly removed, unbeknownst to the participants. At once, a mad scramble for liquidity ensued. However, there simply was not enough collateral left to go around. Panic erupted. Institutions failed. The financial system literally collapsed.

This War

In my view, today’s landscape is quite different. The coronavirus’s (COVID-19) impact is a “real economy” issue. People are stuck at home; lots are not working. Economic activity has ground to a halt. It’s a demand shock to nearly every business model and individual’s finances. Few ever planned for such a draconian scenario.

Source: Variant Perception

Thus, this is not a game of musical chairs in the financial system. Rather, businesses will be forced to hold their breaths until life returns to normal. Cash will burn and balance sheets will stretch. The commercial environment is now one of survival, plain and simple (to say nothing of those individuals infected). Businesses of all sizes will be tested, and in particular small and mid-sized ones that lack access to liquidity lines. Not all will make it. To be sure, the financial system will suffer; however, as an effect, not a primary cause. This war is not the GFC.

Decentralized Solutions Needed

Given this dynamic, I’m skeptical that flooding the financial system with liquidity necessarily helps. In the GFC, a relatively small handful of banks (and finance companies) sat at the epicenter. Remember, finance is a levered industry characterized by timing mismatches of cash flows; it borrows “long” and earns “short.” This intermediation is its value proposition. Thus, extending liquidity can help bridge timing gaps to get them through short-term issues, thereby forestalling their deleveraging.

Today, however, the financial system is not the cause of the crisis. True, liquidity shortfalls are the source of stress. However, they are not limited to any one industry or a handful of identifiable actors. Rather, nearly every business may find itself short on cash. Availing currency to banks does not pay your favorite restaurant’s rent or cover its payroll. Quite frankly, I’m skeptical that any mandated measure can. A centralized solution simply cannot solve a decentralized problem.

Fishing With Dynamite

The speed and intensity at which investment markets are reacting is truly dizzying. In many ways they exceed those in the GFC. To be sure, a response to rapidly eroding fundamentals is appropriate. However, this one seems structural.

In my opinion, the wide-scale and indiscriminate carnage is the calling card of one thing: leverage unwinding. It wouldn’t surprise me to learn of a Long Term Capital Management type of event occurring, whereby some large(?), obscure(?), new (?), leveraged investment fund(s) is (are) being forced to liquidate lots of illiquid positions into thinly traded markets. This is purely a guess. Only time will tell.

Daniel Want, the Chief Investment Officer of Prerequisite Capital Management and one of my favorite investment market thinkers, put it best:

“Something is blowing up in the world, we just don’t quite know what. It’s like if you were to go fishing with dynamite. The explosion happens under the water, but it takes a little while for the fish to rise to the surface.”

Daniel Want, 2020 03 14 Prerequisite Update pt 4

What To Do

This logically raises the question of: What to do? From a policy perspective, I have little to offer as I am simply not an expert in the field (ask me in the comment section if you’re interested in my views). That said, the Fed’s response seems silly. Despite the severe investment market stresses, I don’t believe that we’re reliving the GFC. There’s no nail that requires a central banker’s hammer (as if there ever is one). If a financial crisis develops secondarily, then we should seriously question the value that such a fragile system offers.

Markets anticipate developments. I can envision a number of scenarios in which prices reverse course swiftly (such as a decline in the infection rate, a medical breakthrough, etc.). I can see others leading to a protracted economic contraction, as suggested by the intense market moves. Are serious underlying issues at play, even if secondarily? Or are fragile and idiosyncratic market structures to blame? These are the questions I’m trying to grapple with, weighing the unknowns, and allocating capital accordingly.

As an investor, seeing the field more clearly can be an advantage. Remember, it’s never different this time. Nor, however, is it ever the same. This makes for a difficult paradox to navigate. It’s in chaotic times when an investment framework is most valuable. Reflexively fighting the last war seems silly. Rather, let’s assess the current one as it rapidly develops and try to stay one step ahead of the herd.

Good luck out there and stay safe. Strong views, held loosely.

Seth Levine: Commoditizing My Framework For A New Paradigm

When it comes to investing it’s never different this time; nor, however, is it ever the same. This difficult-to-navigate paradox creates a scarcity of longevity. Today’s persistently low yield environment has upped the ante and put many marquis names out of business. To be fair, alpha’s been elusive of late. It’s not that anyone suddenly became dumb. Rather, traditional methodologies are less robust today. Perhaps adopting a commodity framework can help generate returns in these investment conditions.

Let’s face it, investment yields are scarce. Those on sovereign bonds evaporated. Corporate credit interest rates are numbingly low. Earnings yields on stocks are paltry (i.e. multiples are high). Real estate cap rates are tumbling. No matter what the cause—central banks, safe asset shortages, the proliferation of passive investing, a lack of growth, whatever—cash flows derived from invested principals are small. Unfortunately, this is the current state of the investment markets. It’s our job to play the hand.

Money Now for Money Later

Valuation lies at the heart of my investment framework … at least it did, historically. As Warren Buffett famously said, “Price is what you pay. Value is what you get.” This resonates with me; however, I’m currently rethinking my position. Price is easy to determine, just look at it. What about value?

Before answering this seemingly simple question, it’s helpful to clarify just what investing is all about. Making money, right? Well, one can make money in lots of ways. I can perform a service for my employer in exchange for a paycheck; I can bake some cookies and sell them on my corner; I can also buy a bond and earn its yield. In all cases I make money, yet in different ways. (Note, that’ll use money interchangeably with currency, despite a pet peeve).

In the first case (the job), I trade my time and labor for money. In the second (the baker), I also buy raw materials in order to produce higher value goods. In the investment case, however, I purchase an (assumed) income stream using money that I currently have in order to earn even more over the course of time; it’s money now for (more) money later. Thus, investing is the act of making money from money.

With a clear definition of investing in hand, we can get back to our question of valuation. Valuation is a way to assess the attractiveness of an investment. In other words, it’s a way to frame how much money we expect to make (or lose) in the future in return for our money today. More later for less now is the objective—risk aside.

Today, however, cash flow yields are low when compared to history. Thus, investing appears less attractive under a traditional valuation framework. Yet, the “show must go on”, especially for us professionals. We must find a way to grow our capital in spite of these challenges.

Herein lays the dilemma: What to do when one’s approach no longer applies? Abandoning discipline is simply not a satisfactory solution for serious investors. We all need investing principals to guide our actions. Luckily, my friend Daniel Want, the Chief Investment Officer of Prerequisite Capital Management and one of my favorite investment market thinkers, offers some helpful advice.

Everything’s Commodity-like

In a recent client letter, Want notes that:

“When ‘everything’ is commodity-like… when bonds, fixed income securities and even most equities have minimal to no yield … , then it’s not a ‘valuation’ paradigm you need, but rather you need more of a merchant-type trading philosophy to guide your portfolio operations – you need to focus more on capital/money flows and positioning in order to harvest the natural swings in market prices driven by the underlying behaviours of participants …”

Prerequisite Capital Management’s January 10th, 2020 Quarterly Client BRIEFING

According to Want, traditional valuation-based frameworks are less efficacious in low yield environments. Rather, the supply and demand dynamics of capital flows matter most. I’m certainly sympathetic to that! However, I think this view can be harmonized with a valuation approach without overhauling one’s entire investment philosophy.

When everything is “commodity-like”, the final price dominates its return profile. Remember, the purpose of investing is to earn money, not to hold the underlying assets. Thus, as yields converge to zero (and below, absurd as it may be), positive returns increasingly require the selling at a higher price; or as Want puts it, to “harvest the natural swings in market prices.” In essence, all assets become “trading sardines.”

“There is the old story about the market craze in sardine trading when the sardines disappeared from their traditional waters in Monterey, California. The commodity traders bid them up and the price of a can of sardines soared. One day a buyer decided to treat himself to an expensive meal and actually opened a can and started eating. He immediately became ill and told the seller the sardines were no good. The seller said, ‘You don’t understand. These are not eating sardines, they are trading sardines.’”

Seth Klarman, Margin of Safety via ValueWalk

Thus, as yields dissipate, all investment decisions converge to price speculation … even for bonds that can only return par. (Please see the Appendix at the end of the article for some illustrations.) However, valuation need not be cast aside whole cloth. Rather, it must be reframed to acknowledge that all the “value” lies in the asset’s terminal value, when it’s finally exchanged for cash—be that at maturity or an intermediate sales date.

I find Want’s framework of recasting financial assets as commodities to be clarifying. It helped me override my previously held notions of valuation and provided me with a more powerful framework with which to understand the current investment landscape.

The Commodity-like World

What might this commodity-like world look like? Well, perhaps more commoditized (pun intended). Want continues:

“… Such swings won’t always make sense to a traditional analysis paradigm, it’s likely going to be best to dispassionately view each ‘asset class’ category as simply ‘categories of inventories’ that you may or may not wish to hold at different times depending upon how capital is behaving, where the money is flowing (& why), and how participants are positioned. A more detached and objective approach to markets will be even more valuable than usual.”

Prerequisite Capital Management’s January 10th, 2020 Quarterly Client BRIEFING

In other words, as differentiations of cash flows diminish, investment decisions increasingly shift from allocation within asset classes to allocation among asset classes. Thus, the importance of (tactical) asset allocation increases in Want’s framework.

I can see other investment implications of a more commodity-like world. Perhaps:

  • Speculation in bonds increases and investment horizons shorten as investors take a more total rate of return approach in light of falling yields; volatilities could rise
  • Equity investment time horizons extend, as higher multiples force investors to look further into the future for required growth to materialize; volatilities could fall
  • Commodities appear more attractive as storage costs become less of a relative disadvantage in a world where bonds don negative yields
  • Correlations converge as interest rate sensitivities increase
  • Security selection’s role in portfolio construction shifts to risk management as the risk of loss dominates return profiles
  • Or, I’m wrong about all of the above!

Unfortunately, we’re short on historical precedents for the current paradigm. Hence, we can only guess what impacts might materialize. However, I suspect that focusing on capital flows as Want suggests is a useful framework.

Reframing for the New Paradigm

It’s an understatement to call these challenging times for active management. Many traditional investment frameworks simply don’t work as well. Is it truly different this time?

Rather than abandon valuation in my framework, I’m reframing my decisions. Commoditizing my investment approach has brought some clarity to these confounding times.

Rather than abandon valuation in my framework, I’m reframing it. Conceptualizing “’everything’ [as] commodity-like” helps. We must speculate on all assets, plain and simple, looking to terminal values for returns. While my acceptance has been slow, commoditizing my investment framework has brought some clarity to these confounding times.

Appendix: Speculation Rises as Yields Fall

In this section I show what happens to hypothetical bond returns (using IRR) when coupons fall, maturities shorten, and when a sale occurs at a higher price prior to maturity. Note that in all cases the value shifts more towards the final payment. Thus, the incentive for speculation rises as yields fall. Assume all values are in U.S. dollars and undiscounted for simplicity. This exercise is for illustration purposes only.

Example: Initial Bond

Below is the payment stream for a hypothetical bond that matures at par in 5 years with a 10% coupon.

Note that the holder receives $150 in total payments. The final payment ($110) accounts for 73% of all value received.

Example: Falling Coupon

Here, I illustrate the payments for the same hypothetical bond but with a lower coupon of 5%.

Note that only $125 is received—due to the lower interest rate—and that the final payment ($105) accounts for a greater percentage (84%) of the total value.

Example: Shortened Maturity

Next, I show the payments for our 5% hypothetical bond but with a 3 year maturity instead of 5.

Here, only $115 is received due to 2 fewer years of coupon payments, though the IRR remains constant. As a result, the final payment occurs in year 3. It also accounts for 91% of the of the total value received.

Example: Pre-maturity Sale

In this last example, I illustrate what happens to the 5% hypothetical bond with a 5 year maturity when sold at a higher price ($105) prior to maturity (shown year 3).

There are a couple of interesting points to note. Since it was sold for $5 more than the maturity value (par), our total payments amount to $120. While this is $5 less than had it been held to maturity, the IRR increases to 7% (from 5%). The final payment now accounts for 92% of the total value received—the highest percentage of all our examples.


Note that the pre-maturity sale example had the highest return for the hypothetical, 5%-coupon bond. The sale price also dominated the return profile, illustrating how the bond became a more effective total rate of return instrument, ripe for speculation.

Seth Levine: The Unsurprising Repo Surprise

Have you heard? There’s trouble in the repo markets. Even casual investment market participants probably know that something’s amiss. While only a handful of investors participate in repo, this obscure corner of the investment markets rests at the epicenter of the financial system—hence all the attention. The turmoil caught many by surprise, prompting the Federal Reserve (Fed) into emergency action. However, the real surprise is, in my opinion, why this took any of us by surprise to begin with?

What is Repo

Repo is financial jargon for a repurchase agreement. While it sounds complex, repo is simply a form of short-term, secured lending. The borrower sells collateral (typically a high quality bond) to a lender. At the same time, it agrees to repurchase the same collateral back at a later date for a predetermined and higher price; hence the moniker repurchase agreement. The borrower receives the use of currency for this short period. The lender receives interest in the form of the price difference.

If this sounds overly complicated, it’s because it is. The details, however, are unimportant for our discussion. One need only grasp that repo sits at the bottom of the financial system pyramid. It’s a primary funding source for many large institutions that comprise the plumbing of financial markets. Due to leverage, small disturbances in the repo (and other money) markets can ripple through the entire system. This is what some fear.

What Went Wrong

Repo rates dramatically spiked on September 17, 2019, more than doubling the previous day’s (using SOFR as a proxy). This is highly unusual for the most illiquid of all markets, let alone one of the most trafficked. Arbitrage should render this behavior anomalous as the rise in repo rates represented a highly profitable opportunity. Why weren’t the big banks picking up all this free money? With the Great Financial Crisis (GFC) still fresh in the minds of many, the rumor mill kicked into overdrive surmising why.

Repo rates (estimated with SOFR) unexpectedly spiked on September 17, 2019.

The cause of this unexpected rate spike is still a matter of speculation. The financial system is highly complex with innumerable inputs and outputs making it difficult to establish direct, behavioral links. However, it’s likely that routine balance sheet mismanagement by the Fed was the culprit (as discussed by George Selgin here and Zoltan Pozar of Credit Suisse).

The Fed’s responsibilities expanded as a result of the GFC. These, and other regulatory changes, might have created some idiosyncrasies that underpinned the unexpected rise in repo rates. One is that the Fed now banks the U.S. Treasury. The Treasury used to have bank accounts with private institutions. It now keeps its money at the Fed in an account called the Treasury General Account (TGA). Another important development is the increased size of the foreign repo pool. The Fed avails its balance sheet to “about 250 central banks, governments and international official institutions.” While not new, the aptly named foreign repo pool usage is up nearly 3-fold since 2014.

The significant growth in the TGA (blue) and foreign repo pool (red) after the GFC creates new balance sheet volatility for the Fed to manage.

The chart above illustrates that both the TGA and foreign repo pool are large and volatile. They are also relatively new in their importance to the Fed from an operational perspective. Let’s not forget that while the Fed is a central bank, it’s nonetheless just a bank. Unpredictable and violent swings in account balances are difficult to manage—community, commercial, and central bank alike. Too be sure, we may later discover different reasons for the repo rate spike … but not until later.

Centralization Breeds Instability

It’s easy to get bogged down in the details when analyzing the financial system. After all, it may be the most complex one we’ve built. Thus, applying some more macroscopic principles can help in understanding the system as a whole.

Generally speaking, decentralized systems are more stable than centralized ones. We intuitively get this and can witness its widespread application throughout the man-made and natural worlds. We diversify our investment portfolios, manufacturers source from multiple suppliers, organisms spawn many offspring, and successful animals eat varied diets. Decentralization is a primary thesis for Bitcoin, breeds a fear of monopolies, and is why I find capitalism so attractive (among other reasons).

Imagine if you kept your entire net worth in a single account at a single bank and it failed (ignoring FDIC insurance, which protect against just this). Your wealth would disappear overnight. What if your investment portfolio comprised of a single stock and it went bankrupt? Such reckless behaviors are rightfully condemned. Yet, we expect differently from our financial system; why?

For some reason we believe that centralizing our monetary system reduces volatility and increases stability. Thus, the financial system is either a complete outlier or the premise is false. Modern day economies are built on the belief of the former, yet the evidence is underwhelming.

Merely a Matter of Time

I find no reason to believe that centralizing our financial system holds unique benefits. It’s just another type system. From a stability perspective, all benefit from decentralization. It follows that our financial one should too. Thus, I believe it was (is) only a matter of time until the monetary system broke (breaks) again. It happened in 2008—which I see as a run on banking collateral rather than a housing market collapse (ask me to explain in the comment section if you’re interested in my view)—and it will inevitably happen again. It has to because the future is unknowable and risks are concentrated.

It’s not that decentralization breed omniscience. No, omniscience doesn’t exist. Rather, it allows for discovery. Decentralized systems have more actors striving towards the same goals. However, all will not proceed in the same way. Inevitably, some will fail and some will succeed and to varying degrees. Diversity ensures that the failures are inconsequential to the system as a whole. Yet, we all benefit from the knowledge that those who succeed discover. Hence, human prosperity advances.

Following the GFC we changed a bunch of rules and allegedly strengthened regulations. Despite the best of intentions, these actions further homogenized behavior ensuring that the system breaks again! Remember, centralized systems are most fragile. Further centralization—which is what laws and regulations actually do—limits diversity by raising the barriers to entry (compliance costs money) and conforms incentive schemes (to comply with regulatory demands). Thus, we got fewer actors behaving in more similar fashions. The financial system became more fragile as a result, not stronger. Here we are, a decade later, and low and behold trouble’s a brewin’ in financial markets again, and in new and unforeseen ways.

Principles Bring Clarity

In the end, the presence of a central bank and the myriad of rules and regulations are counterproductive. They work to limit competition, stymie diversity, and ultimately increase frailty. Progress requires failure and centralized systems are not flexible enough to allow for this. If a centralized actor goes down, so goes the whole. “Too big to fail” is only a feature of centralized systems.

While unexpected, the breakdown of repo markets should come as no surprise. Further centralization of the financial system increased its fragility qua system. Of course, predicting how and when it might fail ex ante is nearly impossible. If the current problems were obvious they wouldn’t have escalated to this point.

That said, the inevitability of a system failure doesn’t make it an investible theme, especially for casual observers. In fact, waiting for a repeat of the GFC may be expensive in opportunity cost terms and cause one to miss out on other profitable investments. Rather, I plan to simply keep this analysis in the back of my mind. If financial markets seize up (again), I know what to look for: decentralizing, market fixes.

Following causal chains of events is one of the many challenges of macro investing. While the spike in repo rates is perplexing, proper first principles can bring some clarity. Faulty ones, however, breed only surprises.

Seth Levine: Why Are We So Scared

I always find this time of year to be self-reflective. Year-end provides a natural point for critiquing past performance and fitting it into a broader investing context. These holidays in particular have a way of foisting this perspective upon me, and with deep meaning. As a parent of two young kids, my holidays now kick off with Halloween. Perhaps stuck in this spirit, I find myself wondering: Why are we so scared?

I can’t seem to shake this sense that we live in a culture that’s scared. I see a number of signs across the economic, political, and investment landscapes that seem support this observation. To be sure, this is not universally true on an individual level. However, as a culture we seem to have lost our mojo, our swagger, and the confidence that fuels significant economic advancements.

Why Scared

Scared is psychological state. It connotes being afraid or frightened. Scared feelings typically arise when one feels helpless in a situation or believes he/she is unable to improve it via action. Thus, it’s closely associated with victimhood. Scared is not a feeling that accompanies independence, confidence, and capability.

By all accounts this is the best time in human history to be alive. It’s never been easier to access information, collaborators, and different perspectives, nor in such abundance. These conditions should enable self-reliance and wealth creation. They are a perfect crucible for unbounded development and prosperity.

Yet, economic independence doesn’t seem as valued today as it once was. The cultural impetus shies away from proximal challenges and looks to others for solutions—and in particular, for political solutions. This doesn’t square with the times.

In my view, this shift is a matter of confidence and self-esteem. It’s not the shirking of responsibility that’s telling; it’s the unwillingness to engage with the issues. Confident individuals face challenges head-on. Scared ones look to others. Problem solving often requires creativity, not reverting to staid and ineffective ideas. The former is a strength of the market; the latter is a politician’s. To be sure, there’s a time and place for politicians and bureaucrats to assist. However, economics is not the place and these are not the times. The obsession with finding political fixes for economic underperformance suggests to me that we lack the self-confidence to tackle it ourselves. We seem scared.

Central Bank Dependence

The clearest example of this in the investment markets is the neurotic obsession with central banks. I commonly hear people critique their ignorance and ineffectiveness only to follow with—the same people, mind you—what central bankers ought to do next. I thought central bankers were ineffective?

It’s time we stop looking to central banks for solutions. They don’t have them. In fact, I see no need for them at all. In theory, central banks were created to oversee the money supply. Dual mandates were afterthoughts. Since the money supply merely reflects economic activity, this should be a fairly mundane task and one that decentralized private banking centers performed quite well (despite the popular narrative).

Today, however, our opinions of central bankers are quite different. They are viewed as omniscient, economic alchemists. We look to central bankers to manipulate business cycles, control inflation, and prescribe prosperous economic conditions. Where did this come from and when did it become so prevalent? Central banks can’t create money let alone produce these other conditions. They fall under the purview of the productive economy and thus are products of our actions alone. The perception of central bank dependence is false and marginalizes our own economic efficacies.

Political Dependence

The central bank obsession is, in my view, part of the more general, cultural shift towards increased political dependence. This can be observed by the rise of populism writ large. From Trump’s presidency in the U.S., to Brexit, to the Five Star Party in Italy, to the yellow-vest movement in France, there’s a clamor for retrenchment within national borders. The U.S.-China trade war is just another iteration of this, justified rationalized or not.


To me, there’s a common theme to these movements. They are indicative of a reversion to tribalism, the cutting of global ties that underpin modern day prosperity, and represent a fear of “the other” mentality common in all primitive and destructive cultures.

Why is it important where the human who produced your steel resides? Seriously, why does it matter to you? If that person’s so evil the solution is simple: deal with someone else. I promise you there is no greater commercial influence than that. Just put yourself in the shoes of a business owner to see (go ahead, close your eyes and imagine).

Why are we suddenly seeking politicians to protect us from the ever-changing world? Economic issues are those of voluntary exchange and they are dynamic. Very few problems require political fixes. Seeking them indicates that one is too scared to trust his/her actions. It’s a skepticism over the power one commands in the marketplace. It’s cowardly.

The Monetary Policy—Fiscal Policy False Dichotomy

It’s often helpful to compare and contrast ideas against extreme conditions. Doing so can surface the essential issues for easier analysis. This is especially true for complex concepts such as those found in economics. Oftentimes, impacts are not obvious and secondary and tertiary effects must be considered.

In the investment markets we often hear about fiscal or monetary policy initiatives. Whenever the economy needs a boost, commentators opine that more accommodative monetary policy might be needed (such as lower interest rates). Or perhaps this particular instance requires a fiscal policy response (like lower taxes and/or greater government spending). Whatever the case may be, prescriptions are framed as being a matter of monetary policy or fiscal policy initiatives.

Nothing, in my view, illustrates cultural fear more than this false dichotomy of monetary policy—fiscal policy. They are conceptually similar and not appropriate book-ends of a conceptual dichotomy. Rather, monetary and fiscal policies are different flavors of central planning. Both seek government intervention in the economy, differing only by their preferred branch. Monetary policy utilizes central bank action while fiscal policy seeks legislative cures. They are not opposites.

The true opposite to central planning is economic liberty. Thus, the proper spectrum, in my view, has economic freedom on one side (deregulation and less controls) and central planning—i.e. fiscal and monetary policy, which are greater controls—on the other. One side reflects independence and confidence while the other forceful paternal shelter. Considering monetary or fiscal policy actions only rejects self-reliance as an option altogether. It’s a scared perspective.

Pacifying Investment Decisions

I also see the shift to passive investment strategies to fit into the fear of independence theme. To be sure, there are virtues of passive investing. Track records and fees relative to active management are compelling enough. But are these the sole motives?

Source: Morningstar

What if a fear of underperforming popular indices or standing out plays a part? Speculating on the future often yields wrong outcomes; it’s part and parcel with investing. As a colleague of mine is fond of saying, “we’re not bootstrapping treasuries.” By this he means that earning returns requires taking risks. Sometimes things don’t pan out as planned and losses occur. The trick, of course, is to minimize the losses; not neurotically seek to avoid them.

Are allocators more concerned with finding the comfort of consultants’ consensus rather than investing according to their own observations? Could career risk play a part in this trend? Are we too scared of being wrong to invest in themes that might play out over longer time horizons?

Share Buybacks Are Safest

What about share buybacks? Much has been made about the magnitude at which corporations have repurchased their shares. Why is this happening at such an unusually high level?

Source: 13D Research

To be sure, I take no issue with share repurchases and see them as a legitimate use of capital. However, even accretive buy-backs have short-lived impacts. They last only a year when year-over-year comparisons are made. Why aren’t businesses investing in projects that could yield multi-year benefits? Are executives simply playing it safe, too scared to commit capital to projects that might fail? Are the majority of shareholders really so shortsighted?

Scared As An Investment Theme

It’s easy to roll your eyes at this article and dismiss it as another meme. However, my intention is neither to seek scapegoats nor to emotionally vent. Rather, I’m interested in exploring whether this behavior is part of a larger cultural phenomenon of fear. If so, the next downturn could push us further from economic liberty and more towards political controls. This would surely have investment implications.

Of course, there is no such thing as “we.” We is just an aggregation of “I’s.” Thus the real question is: Why am I so scared? While an uncomfortable, if not antagonistic question to ask, it’s critical to understanding this emergent theme.

The world is in constant flux. No one should appreciate this more than investors. Change is the essence of our jobs—to profit from the movements in asset prices. Prices don’t move in stagnant conditions.

Yet, as a culture we seem terrified by change. I find this puzzling since we’ve never been better equipped to adapt and capitalize from it. Those investors who embrace change will survive and thrive. Those who don’t could perish from this business. What could be scarier than that?

In The Fed We TRUST – Part 2: What is Money?

Part one of this article can be found HERE.

President Trump recently nominated Judy Shelton to fill an open seat on the Federal Reserve Board. She was recently quoted by the Washington Post as follows: “(I) would lower rates as fast, as efficiently, and as expeditiously as possible.” From a political perspective there is no doubting that Shelton is conservative.

Janet Yellen, a Ph.D. economist from Brooklyn, New York, appointed by President Barack Obama, was the most liberal Fed Chairman in the last thirty years.

Despite what appears to be polar opposite political views, Mrs. Shelton and Mrs. Yellen have nearly identical approaches regarding their philosophy in prescribing monetary policy. Simply put, they are uber-liberal when it comes to monetary policy, making them consistent with past chairmen such as Ben Bernanke and Alan Greenspan and current chairman Jay Powell.

In fact, it was Fed Chairman Paul Volcker (1979 to 1987), a Democrat appointed by President Jimmy Carter, who last demonstrated a conservative approach towards monetary policy. During his term, Volcker defied presidential “advice” on multiple occasions and raised interest rates aggressively to choke off inflation. In the short-term, he harmed the markets and cooled economic activity. In the long run, his actions arrested double-digit inflation that was crippling the nation and laid the foundation for a 20-year economic expansion.

Today, there are no conservative monetary policy makers at the Fed. Since Volcker, the Fed has been run by self-described liberals and conservatives preaching easy money from the same pulpit. Their extraordinary policies of the last 20 years are based almost entirely on creating more debt to support the debt of yesteryear as well as economic and market activity today. These economic leaders show little to no regard for tomorrow and the consequences that arise from their policies. They are clearly focused on political expediency.

Different Roads but the Same Path –Government

Bernie Sanders, Alexandria Ocasio-Cortez, Elizabeth Warren, and a host of others from the left-wing of the Democrat party are pushing for more social spending. To support their platform they promote an economic policy called Modern Monetary Theory (MMT). Read HERE and HERE for our thoughts on MMT. 

In general, MMT would authorize the Fed to print money to support government spending with the intention of boosting economic activity. The idealized outcome of this scheme is greater prosperity for all U.S. citizens. The critical part of MMT is that it would enable the government to spend well beyond tax revenue yet not owe a dime.   

President Trump blamed the Fed for employing conservative monetary policy and limiting economic growth when he opined, “Frankly, if we didn’t have somebody that would raise interest rates and do quantitative tightening (Powell), we would have been at over 4 instead of a 3.1.” 

Since President Trump took office, U.S government debt has risen by approximately $1 trillion per year. The remainder of the post-financial crisis period saw increases in U.S. government debt outstanding of less than half that amount. Despite what appears to be polar opposite views on just about everything, under both Republican and Democratic leadership, Congress has not done anything to slow spending or even consider the unsustainable fiscal path we are on. The last time the government ran such exorbitant deficits while the economy was at full employment and growing was during the Lyndon B. Johnson administration. The inflationary mess it created were those that Fed Chairman Volcker was charged with cleaning up.

From the top down, the U.S. government is and has been stacked with fiscal policymakers who, despite their political leanings, are far too undisciplined on the fiscal front.

We frequently assume that a candidate of a certain political party has views corresponding with those traditionally associated with their party. However, in the realm of fiscal and monetary policy, any such distinctions have long since been abandoned.


Now consider the current stance of Democratic and Republican fiscal and monetary policy within the TRUST framework. Government leaders are pushing for unprecedented doses of economic stimulus. Their secondary goal is to maximize growth via debt-driven spending. Such policies are fully supported by the Fed who keeps interest rates well below what would be considered normal. The primary goal of these policies is to retain power.

To keep interest rates lower than a healthy market would prescribe, the Fed prints money. When policy consistently leans toward lower than normal rates, as has been the case, the money supply rises. In the wake of the described Fed-Government partnership lies a currency declining in value. As discussed in prior articles, inflation, which damages the value of a currency, is always the result of monetary policy decisions.

If the value of a currency rests on its limited supply, are we now entering a phase where the value of the dollar will begin to get questioned? We don’t have a definitive answer but we know with 100% certainty that the damage is already done and the damage proposed by both political parties increases the odds that the almighty dollar will lose value, and with that, TRUST will erode. Recall the graph of the dollar’s declining purchasing power that we showed in Part 1.

Data Courtesy St. Louis Federal Reserve

Got Money? 

If the value of the dollar and other fiat currencies are under liberal monetary and fiscal policy assault and at risk of losing the valued TRUST on which they are 100% dependent, we must consider protective measures for our hard-earned wealth.

With an underlying appreciation of the TRUST supporting our dollars, the definition of terms becomes critically important. What, precisely, is the difference between currency and money? 

Gold is defined as natural element number 79 on the periodic table, but what interests us is not its definition but its use. Although gold is and has been used for many things, its chief purpose throughout the 5,000-year history of civilization has been as money.

In testimony to Congress on December 18, 1912, J.P. Morgan stated: “Money is gold, and nothing else.” Notably, what he intentionally did not say was money is the dollar or the pound sterling. What his statement reveals, which has long since been forgotten, is that people are paid for their labor through a process that is the backbone of our capitalist society. “Money,” properly defined, is a store of labor and only gold is money.

In the same way that cut glass or cubic zirconium may be made to look like diamonds and offer the appearance of wealth, they are not diamonds and are not valued as such. What we commonly confuse for money today – dollars, yen, euro, pounds – are money-substitutes. Under an evolution of legal tender laws since 1933, global fiat currencies have displaced the use of gold as currency. Banker-generated currencies like the dollar and euro are not based on expended labor; they are based on credit. In other words, they do not rely on labor and time to produce anything. Unlike the efforts required to mine gold from the ground, currencies are nearly costless to produce and are purely backed by a promise to deliver value in exchange for labor.

Merchants and workers are willing to accept paper currency in exchange for their goods and services in part because they are required by law to do so. We must TRUST that we are being compensated in a paper currency that will be equally TRUSTed by others, domestically, and internationally. But, unlike money, credit includes the uncertainty of “value” and repayment.

Currency is a bank liability which explains why failing banks with large loan losses are not able to fully redeem the savings of those who have their currency deposited there. Gold does not have that risk as there is no intermediary between it and value (i.e., the U.S. government or the Japanese government). Gold is money and harbors none of these risks, while currency is credit. Said again for emphasis, only gold is money, currency is credit.

There is a reason gold has been the money of choice for the entirety of civilization. The last 90 years is the exception and not the rule.

Despite their actions and words, the value of gold, and disTRUST of the dollar is not lost on Central Bankers. Since 2013, global central banks have bought $140 billion of gold and sold $130 billion of U.S. Treasury bonds. Might we say they are trading TRUST for surety?


To repeat, currency, whether dollars, pounds, or wampum, are based on nothing more than TRUST. Gold and its 5000 year history as money represents a dependable store of labor and real value; TRUST is not required to hold gold. No currency in the history of humankind, the almighty U.S. dollar included, can boast of the same track record.

TRUST hinges on decision makers who are people of character and integrity and willingness to do what is best for the nation, not the few. Currently, both political parties are taking actions that destroy TRUST to gain votes. While political party narratives are worlds apart, their actions are similar. Deficits do matter because as they accumulate, TRUST withers.

This article is not a call to action to trade all of your currency for gold, but we TRUST this article provokes you to think more about what money is.

Negative Rates Are Destructive But Profitable

“Remember that Time is Money.”

Benjamin Franklin, Advice to a Young Tradesman

It’s unfortunate that such genius identifications as the above have long been forgotten by the economic community. First penned in 1748, Benjamin Franklin makes the connection between human effort—or rather the application of human effort towards productive work—and the effect/product, i.e. wealth. We measure this increase in prosperity, of course, in terms of money. Thus, “Time is Money” (or rather, time is potential money). They are one in the same since time is the one truly scarce resource with which all living creatures have to work.

However, you’d never know this by a look at today’s markets. Negative interest rates are now common place and widely accepted as a policy tool. In fact, a tradition of thought is being established as a means of “normalizing” them. Pushing deeper into negative territory seems all but a foregone conclusion. No longer is the absurdity and devastation of such policies discussed. No longer discussed is that negative interest rates negative human life.

Negative Interest Rates Negate Human Life

“Negative interest rates negative human life” is a bold statement, I know, but I stand by it. I suspect “Big Ben” would too. We both understand what economics is all about. It has nothing to do with fine tuning commercial activities for some nebulous greater good. Rather, economics is about individual, human happiness. It’s about making the most of our time on this planet; to use our time, effort, and brainpower to maximize the human experience while it lasts. The better use of time we make—via productivity—the more wealth can be created, the more comfortable and fulfilling our lives, and the better the existence we can enjoy. Hence, time is money in a pure, genuine, and profound way.

This is why negative interest rate policies (NIRP) are so pernicious and beyond absurd, irrespective of whether or not they saved the collapsing financial system in 2008. NIRP implies contractions on such fundamental scales that they cannot be beneficial. Specifically, that either: 1) your time and efforts are valueless (or worse, destructive), or; 2) your currency is valueless. In other words, action is detrimental to survival; time is not money, and; one’s currency choice is not important. None could be more obviously false.

Time and Effort Are Valuable

Your time and effort are valuable. Fundamentally, these are your survival tools. If time and effort were not valuable then there would be no need to ever take any action of any sort. You’d be better served to lay curled up in the fetal position than to attempt to work. This is clearly false. Human survival (and thriving beyond this basic need) requires one to produce and trade for values. This requires action; hence time and effort are valuable.

Time is Money

If time were not money then no one would work, full stop. Why toil if the fruits of one’s labor did not exceed the effort and time spent while working? Humans work for the purpose of survival; however we’re lucky that civilization has sufficiently advanced such that immediate survival is no longer of primary concern for much of the developed world.

Instead of concerning ourselves with food and shelter, human effort can be diverted towards life enhancements. Today, engineers make software, artists make films, ride-sharing drivers transport us, and financiers fund dreams. Without people working on such projects there would be none of the results. There’d be no Ubers and iPhones and movies and biotechnology and office buildings without men and women applying their time towards these endeavors.

If time were not money why on earth would anyone work? Surely there would be better ways to spend one’s only truly scare resource of time. Simply doing nothing and conserving energy would be an evolutionary advantage. Why work if there are no values to gain?

Working to lose would favor not working or acting at all. This is the absurdity of negative interest rates. To apply capital only to lose it—i.e. NIRP—would favor not applying capital in the first place. Thus, NIRP’s existence implies a contrived construct to exist, not one grounded in natural law.

Sound Money Is Universally Desired

Another possibility of NIRP is that it says something negative about the currency and not necessarily output. The currency is depreciating over time. But this too is nonsensical. Why would anyone use a depreciating currency given the choice? In fact, no one ever chooses such inferior currency, looking at history. These circumstances typically arise with a healthy dose of force. Poor currencies are typically foisted upon an unwilling population and they typically don’t last; no one wants to lose value in a transaction. If a currency cannot serve as a reliable unit of account, the populace will eventually find something that can—officially or unofficially sanctioned.

Thus, people will flock to the best currency option available so long as they are not forced to choose otherwise by regulation and statute. This in part explains the U.S. Dollar’s dominance in international financial transactions. True it’s the “reserve currency” but it’s the reserve currency for a reason and the dominance of the U.S. Navy is not one. Rather, the respect for the rule of law, deep capital pools, and established and incentivized institutions are what likely preserves the U.S. Dollar’s reserve status. Don’t kid yourself; an IMF mandate for settling trade in renminbi would yield no (material) results. Economic actors will act according to their best interests, factoring in the price of non-compliance. Thus, the “bag-holders” are always those compelled to hold depreciating currency.

Sweet Siren’s Song

The challenge with negative and low rates is just how profitable they can be to trade. Hence, they should not be ignored, in my view. I introduced the chart below nearly a year ago. It illustrates how much return potential is embedded in the 10 year U.S. Treasury bond (USTs) expressed as a function of its current yield (see here for a more detailed description). As yields have fallen, the appreciation/depreciation potential has dramatically increased. No longer are USTs boring, yield providing investment vehicles. In the environments of NIRP and ZIRP (zero interest rate policy) they are now total-rate-of-return vehicles ripe for speculation and outperformance.

Today’s Bizarre State of the World

These dynamics gave us the current state of the world. Investors cheer the stupidity of NIRP because they yield profits. The more ZIRP, NIRP, and QE (quantitative easing) the more capital gains can be reaped despite no detectable economic benefits produced. Hence, investors cheer the nonsensical which policymakers mistake as as endorsements. A self-reflective loop is established.

Many claim that NIRP, ZIRP, and QE saved the failing financial system. This, however, is mere conjecture. We simply don’t know what would have arisen from the ashes, better or worse. Counter-factual claims cannot be empirically debated.

Thus to claim that NIRP is beneficial displays one’s bias and, in my view, is grounds for mistrust on non-objectivity. This is particularly true since we can see how truly absurd the theoretical construct for NIRP is. Time is money and freely exchanging citizens desire sound currency, these we know as fact. Arguing to the contrary in papers or by inciting tradition can’t negate these.

So long as the academic and political will favors the incumbent policies they will likely be entrenched. The IMF recently published their playbook for the next economic slowdown and NIRP plays prominently. Economics (true economics) illustrate why these next rounds will also fail to stoke economic activity.

There’s no breaking the link between time and money and the desirability for sound currency. These are universal truths. That said, bond math illustrates that trading “rates” in such an absurd environment can be lucrative, at least for the time being. Thus, I find it useful to know both: the absurd and the trading potential. Profitably trading won’t negate the deleterious effects of NIRP, but it can help preserve one’s capital for better, more intellectually sound times.

Superforecasting A Bear Market

There’s an ongoing debate about whether or not the U.S. is approaching a recession. As an investor, this question is of utmost importance. It is precisely at these times when fortunes can be made and lost. There’s no shortage of pundits with strong opinions in both the affirmative and negative camps armed with plausible narratives and supporting data sets. How to decide which side to take? Applying some proven forecasting methods to historical data can help bring clarity to this question.

Forecasting is tricky business. It’s really hard to do well consistently, especially in investing.

Fortunately for us, Philip Tetlock has made a study of forecasting. In the book Superforecasting: The Art and Science of Prediction (aka Superforecasting) he and coauthor Dan Gardner share their findings of a multi-year study aimed to discover the best forecasters, uncover their methods, and to determine if forecasting skills could improve. There are many great lessons conveyed in the book. We can thus apply them to our problem at hand: the question of whether or not the U.S. will enter a recession.

The Lessons

By running a series of geopolitical forecasting tournaments, Tetlock and Gardner discovered a group of elite forecasters and uncovered their best practices. Ironically, specialized knowledge played little role in their success. Rather, it was their approach.

Superforecasting had a profound impact on me. I took away a more concretized framework for dealing with predictions. Rather than feeling my way through a situation, Superforecasting gave me a method I could apply. Well-devised forecasts share four characteristics:

  1. They’re probabilistic
  2. They start with a base rate formed by an “outside view”
  3. They’re adjusted using the specifics of the “inside view”
  4. They’re updated as frequently as required by incoming facts, no matter how small the increments

Think Probabilistically

The best forecasters (aka Superforecasters) made predictions in a probabilistic manner. In other words, outcomes weren’t binary—i.e. something would or would not occur. Rather, the Superforecasters ascribed a probability to a forecast. For example, they would assign a 30% chance to the U.S. entering a recession rather than saying it was unlikely. This precision is important.

Establish a Base Rate Formed by an “Outside View”

Before making a prediction, the Superforecasters first established a base rate informed by an “outside view.” A base rate is merely a starting probability. It will later be adjusted. An outside view, as introduced in his book Thinking, Fast and Slow by Daniel Kahneman, is a perspective that looks for historically analogous situations for guidance.

To establish a base rate using an outside view, we should first look at previous recessions and periods where economic conditions were similar. How often did conditions deteriorate into recessions? What events tended to precede them? This should give us starting point.

Adjust Using the “Inside View”

After establishing a base rate using an outside view, the Superforecasters adjusted it by taking an inside view—another Kahneman concept. An inside view is a perspective that only considers the situation at hand. It ignores historical precedents and seeks to induce an outcome using only the current facts. In a sense, every situation is treated as unique.

Thus, the Superforecasters considered both the historical context and idiosyncratic characteristics to inform their predictions. In a lot of ways this resembles using deductive and inductive reasoning in concert with each other; a practice I condone. To follow with our example, a Superforecaster would adjust their 30% recession base rate up or down based on current economic and market conditions. It might be increased due to the prospect of a trade war; it might be reduced based on strong jobs data.

Frequently Updated

Lastly, the Superforecasters frequently adjusted their forecasts. They constantly updated their probabilities, even in increments that seemed insignificant if warranted by new information. While this might sound trite, Tetlock and Gardner found it to be a key component of accuracy. Thus, forecasts might be changed with each presidential tweet in our ongoing example.

Establishing a Recession Base Case

Armed with an improved forecasting method, I applied it to the recession question. I ditched my bullish or bearish perspective and established an outside view base rate. Here, I illustrate my process using two of the most hotly debated metrics: the Institute for Supply Management’s Purchasing Manager’s Index (PMI) and the U.S. Treasury yield curve (YC), defined by the 10 year U.S. Treasury bond minus the Federal Funds Rate.

I compiled monthly data through July 2019. I then looked at the frequency of negative monthly returns for the S&P 500 index (SPX) after a specific threshold was breached. For the PMI I used its latest reading of 51.2. For the YC I looked at periods of inversion (i.e. when the spread was zero and below). Once these months were identified, I calculated the SPX’s return over the following 1 month, 3 months, 6 months, 12 months, and 24 months.

Note that I analyzed SPX returns and not whether or not a recession occurred. As an investor, my only concern is if asset prices will rise or fall, not recessions as such. It just so happens that recessions and falling stock prices coincide; but it’s the values that we ultimately care about, not recessions.

Findings From PMI Data

Below is my analysis of SPX returns for when the PMI historically reached these levels (51.2). Note that my data covered 858 months for my 1 month sample period and 835 months when looking at 24 month returns (i.e. 23 less data points). The PMI was 51.2 or below in 322 of those months, or ~38% of the time across sample periods. During these instances, successive SPX returns were negative for 14% of the months using a 24-month time horizon and 35% of the months using a 1-month one. Thus, 29% is a reasonable base rate for taking a bearish stance on the SPX over a 6 month time horizon using an outside view of PMI data.

Also, note that the longer the negative return environment persisted the larger the average losses.

Here is a similar table examining YC inversions. Both the instances and magnitudes of negative SPX returns appear to be higher for this data set. A base rate of 52% seems reasonable for taking a bearish stance on the SPX over a 6 month time horizon for this data set.

Findings From Combined PMI & YC Data

It’s an even rarer occurrence for the YC to invert when the PMI is 51.2 or below. This happened in just 65 months out of the past 780, or 8% of the time. SPX returns were negative 28% to 55% of the time depending on one’s timeframe, with 3 month displaying the highest frequency. We could use a 46% base rate for a 6 month time horizon. While losses were less frequent using this dual-signal than the YC alone, they were also more severe. Average drawdowns ranged from 4.3% to 31.4%.

Calibrating Your Grizzly

This analysis affords us two advantages. First, it removes the binary guesswork in trying to predict a recession. We no longer need to make a definite call on whether returns are likely to be higher or lower under the current conditions; we can take a more nuanced, probabilistic approach. Secondly, we can establish a starting base rate that is grounded in historical data.

According to the best practices discussed in Superforecasting this is just the first two steps in creating a robust forecast. The base rate requires adjusting by considering an inside view of today’s economic and market landscapes. It must also be updated as new information materializes.

The conditions examined (a PMI lower or equal to 51.2 and an inverted YC) were recently triggered. History suggests that we’re in a serious position. In the past, SPX returns were negative nearly half the time over the succeeding 3 to 12 months. To be sure, using just two signals is not an exhaustive process. However, it was a good first step in helping me calibrate my bearish instincts.

I’ll leave it to you, the reader, to apply your own inside view of the markets to this base rate. Ultimately, we must determine the extent to which “it’s different this time.” While forecasting is guesswork by definition, Superforecasting provided me with a useful framework to apply to all investing situations. Hopefully I’ll do so profitably.

Recovering Perma-Bear At A Crossroad

Hello, my name is Seth and I’m a recovering perma-bear. (Hi Seth.) It’s true that I used to think that doom was inevitably just another quarter or two away. I was hyper-aware of the business cycle and the encroachment of government into the free markets. Thus, I concluded that growth would end soon. From an investment perspective I was simply wrong. It’s only now that I know that I lacked a robust process—a way of making sense of the investment landscape so that I could act profitably; that investing is mostly about managing losses; and that human ingenuity can overcome lots of adversity.

I’m better now, truly. Yet, I find myself terrorized by the current economic landscape in the U.S. It appears to be weakening. Due to my affliction predisposition, I am mindful of confirmation bias. Herein lies my conundrum. What’s a recovering bear to do at such a crossroad?

There’s only rightful action to take; look at the objective facts, stripped of opinion.

Below is a shortlist of interesting charts that, in my opinion, characterize the economic landscape. To be sure, there is an endless, complex list that one can examine. However, my purpose here is not to make a call on the economy, per se. Rather, it’s to fortify my process; to look for confirming and refuting evidence. This blog, after all, is like my therapy. Thus, I will keep things simple and look at five sets of data for both the bullish and bearish cases.

Some Bearish Facts

To me, there is no better economic signal than the yield curve. While there are plenty of pundits with plenty of reasons for why one should discount its bearish message, explaining away the data is precisely what I’m trying to avoid. The simple fact is that inversions (and subsequent steepenings) have strong correlations with forthcoming recessions (importantly, not causation). They don’t, however, time them well. The yield curve first inverted in March. This is nothing to ignore.

The economy is often touted as strong. However, the trend in corporate profits reveals otherwise. They actually peaked in the third quarter of 2014 and have been declining ever since. Note that last year’s tax cuts did in fact reverse the trend on an after tax basis (red line), but no benefit to pretax earnings (blue line) are evident. Since economic activity is strictly a function of production, corporate profits are the best measure, in my view, of the economy’s health. Note that this is different and more robust than the oft-cited S&P 500 earnings per share metrics

The trend in ISM’s manufacturing Purchasing Managers’ Index (PMI) is another negative item. It has a long history as a leading indicator of business cycles. We can see below that manufacturing PMIs have trended sharply lower for both the U.S. and elsewhere. This likely portends weakening conditions ahead.

Employment trends are also cited as a strength of the economy. However, it is a lagging indicator. Initial jobless claims provide a more real-time snapshot. Here, we can observe two facts. The first is that initial claims are at extremely low levels. While this appears bullish, they might have recently bottomed. A reversal in trend—which is too early to call just yet—would be troublesome.

Purchases of big ticket items, such as cars, can also provide some economic insight. Declining auto sales are more data that paint a gloomy economic picture. Of note, they have plateaued for both new (the first chart below) and used cars (the second chart below). True, they are coming off high levels, and used car sales rebounded as of late (not shown); but declines are declines nonetheless.

Some Bullish Facts

To be sure, not every data set is negative. Perhaps the most obvious, positive signal is the U.S. stock market. Equities are discounting mechanisms. If investors were truly worried that a change in corporate fortunes were upon us then this sentiment should be reflected in equity prices. Sitting near the at-time-highs suggests that investors are not concerned.

Retails sales are also strong. While no economy, including the U.S., is “consumer led” (I’m sorry, consumer spending makes up 70% of GDP which is only a proxy for economic output, not an actual measure of it), a drop in spending would logically follow a drop in economic production. Here too, we see continued year-over-year expansion of demand.

While manufacturing PMIs are trending lower and flirting with contractionary levels, ISM’s U.S. service sector PMI points to continued growth. This tempers the former’s negative read since the service sector is the larger of the two.

ISM’s Non Manufacturing PMI indicates future growth is likely.

source: tradingeconomics.com

As noted above, employment trends are still positive. Unemployment remains low and has yet to bottom. Furthermore, worker compensation is on the rise. These also suggest that economic conditions remain favorable.

However, the most bullish signal to me is that being bearish is commonplace. Growth scares tend to catch people by surprise. Thus, today’s setup does not seem conducive to producing the kind of negative shock that leads to market selloffs. As shown below, most investors are already defensively positioned.

Looking Both Ways

So there you have it, a bunch of facts about the economy and markets. While I come out bearish, the purpose of this is article is not to convince you of my position. Rather it’s to present some commonplace data in order to overwhelm my own inherent biases.

Does a weakening economy mean recession? Hardly so. However, if one mentally models economies and markets as carry trades (as I explain here and more thoroughly in this report beginning on page 7) it becomes evident why even slowing of growth matters. But even if a recession were obvious and evident, we investors care about asset prices, not recessions as such. Thus, profitable trading might entail positioning in counterintuitive ways.

The first step to recovery is admitting that you have a problem. I suffered from a major case of perma-bear-itis. Building a process is just the second rehabilitating step. Progress comes piecemeal. Thus, this recovering perma-bear intends to thoroughly look both ways before venturing out across the investment crossroads.

Investing On Persistent Foundations

The volatility in the investment markets over the past few months has been truly astonishing. Prices are violently fluctuating and the range of traditional volatility indicators like the VIX have exploded. Just look at the daily moves of the popular U.S. stock market indices for example. While it’s generally folly to attribute specific causes to market action (there are simply too many actors with too many motives), I think it’s fair to say that the trade negotiations with China likely played a part. This got me thinking. How sound a strategy is it to trade the news, so to speak, and what makes for a good investment thesis? Upon reflection, I came to this idea of persistence; that building investments around the metaphysically given is more powerful than those built upon the man-made.

Erratic news flow created large intraday price moves in the S&P 500 and swings in the VIX

The Metaphysically Given & The Man-made

As you might know, I have a penchant for the abstract. I find exploring subjects from a first principles perspective helpful in bringing clarity to chaotic markets—overconfidence bias notwithstanding. Simply, what is should dictate the actions we ought to take. This applies to life as well as investing. Generally speaking, the better I can understand a market trend, the clearer of an investment case I can build.

Within philosophy, there’s a branch that deals with the fundamental study of “stuff.” It’s called metaphysics. Metaphysics examines the nature of the world as we know it. Broadly speaking, there two categories of stuff. The first is the metaphysically given. The second is the man-made.

The metaphysically given are things native to the natural world. Not just the objects but also the immutable laws of nature that govern them. Rocks are hard and sink in water, apples ripen and fall from trees, fish have gills and breathe and swim underwater, and people are mammals with an ability to think abstractly. The metaphysically given merely describes of world without consideration for human influences.

The man-made is the opposite. It is those objects—both physical and conceptual—that arise from human action. Cars, mathematics, and investment markets are all man-made objects; they could not exist without us.

Thus, a country’s border is an example of the man-made. Its physical land is a metaphysical fact.

The Relevance To Investing

Investing is all about information. Prices reflect that which participants currently know about the world. They change when facts change. A stock’s price might rise on account of better than expect financial performance as investors adjust their outlook for a company. The current price is deemed too low and buying bids up the price. It might also rise also due to capital inflows into the asset class as a whole, or as its price trend attracts strategies seeking such patterns. Thus, changes in information related to capital flows impacts investment performance.

Information is constantly changing. However, not all information is created equally. Some is more impactful than others, both in magnitude and duration. Certain news has lasting effects in markets while others’ are fleeting. Thus, the persistence of new information matters. Distinguishing between the metaphysically given and the man-made can provide insight into the impact that information might carry.

The Metaphysically Given & Man-made In Markets

Drawing an analogy from philosophy, we can consider the metaphysically given as the physical structures within capital markets. Similar to the natural world, these cannot be changed easily. Thus, when new information necessitates a price adjustment, the movements can be strong and hard to arrest once initiated. For example, metaphysically-related information might pertain to business cycles, capital cycles, trader positioning (like Commitment of Traders reports), algorithmic trading rules, regulatory requirements (such as risk-based capital guidelines), and changes to federal and state laws. Once new information sets the price of an investment in motion it persists until the market rebalances at the appropriate level.

Man-made information, on the other hand, can create trades with fleeting impacts. These rest upon data that are easily changeable. Those closely watching the markets of late should be familiar with such occurrences. Tweets, central bank messaging, OPEC meetings, executive orders—these circumstances lack persistence. They are reversible with a few taps of a thumb. Hence, man-made price movements can be volatile and profits temporary.

These applications are not limited to macro-level concepts. For example, the revenues associated with products on a new car are more persistent then those from launching a new flavor of yogurt. The same car model is typically sold for 3 to 5 years. Suppliers rarely change over this lifespan. Thus, one’s revenues should be reliable (so long as the vehicle sells, of course). Consumer food preferences, however, frequently change and there are few competitive barriers to entry. Fortunes can come and go in an instant. Similarly, cost savings associated with supply chain changes are likely to be lasting, while those resulting from a reduction in advertising might not.

Build On The Metaphysically Given

Not all information changes are equal when it comes to investing. Some will be more powerful and relevant than others. Understanding the persistence of such can help. A deeper knowledge of what something is can better frame what we ought to do with our trades.

In drawing this analogy I saw that investment theses built around the metaphysically given should be more persistent than those relying on the man-made. The price action tracking the flip-flopping of Trump’s trade tweets and Powell’s dovish pivot should illustrate just this. Volatility increased as information deemed relevant for market prices not only fluctuated daily—but whimsically. To be sure these were relevant for investors; however, the metaphysical persistence of the information was weak. Easy come, easy go.

While I find framing persistence using terms borrowed from philosophy insightful, there are countless ways to construct this analogy. What’s important is that the information underpinning an investment thesis is well-understood; how powerful an impact it might have and how reversible it may be.

In my opinion, it’s wiser to build one’s investment portfolio on the metaphysically given. Here, one can be more confident in—and hence more fully capitalize on—the persistence of the causal relationships underlying a given price change. Quite simply, the shape-shifting man-made is not suitable bedrock upon which to build one’s wealth.

In The Fed We Trust – Part 1

This article is the first part of a two-part article. Due to its length and importance, we split it to help readers’ better digest the information. The purpose of the article is to define money and currency and discuss their differences and risks. It is with this knowledge that we can better appreciate the path that massive deficits and monetary tomfoolery are putting us on and what we can do to protect ourselves.  

How often do you think about what the dollar bills in your wallet or the pixel dollar signs in your bank account are? The correct definitions of currency and money are crucial to our understanding of an economy, investing and just as importantly, the social fabric of a nation. It’s time we tackle the differences between currency and money and within that conversation break the news to you that deficits do matter, TRUST me.

At a basic level, currency can be anything that is broadly accepted as a medium of exchange that comes in standardized units. In current times, fiat currency is the currency of choice worldwide. Fiat currency is paper notes, coins, and digital 0s and 1s that are governed and regulated by central banks and/or governments. Note, we did not use the word guaranteed to describe the role of the central bank or government. The value and worth of a fiat currency rest solely on the TRUST of the receiver of the currency that it will retain its value and the TRUST that others will accept it in the future in exchange for goods and services.

Whether its yen, euros, wampum, bitcoin, dollars or any other currency, as long as society is accepting of such a unit of exchange, trade will occur. When TRUST in the value of a currency wanes, commerce becomes difficult, and the monetary and social prosperity of a nation falters. The history books overflow with such examples.

Maslow and Currency

Before diving into the value of a currency, it is worth considering the role it plays in society and how essential it is to our physical and mental well-being. This point is rarely appreciated, especially by those that push policies that debase the currency.

Maslow created his famous pyramid to depict what he deemed the hierarchy of human needs. The levels of his pyramid, shown below, represent the ordering of physiological and psychological needs that help describe human motivations. When these needs are met, humans thrive.

Humans move up the pyramid by addressing their basic, lowest level needs. The core needs, representing the base, are physiological needs including food, water, warmth and rest. Once these basic needs are met, one then seeks to attain security and safety. Without meeting these basic physiological and safety needs, our psychological and self-fulfillment needs, which are higher up the pyramid, are difficult to come by. Further, as we see in some third-world countries, the social fabric of the nation is torn to shreds when a large part of the population cannot satisfy their basic needs.

In modern society, except for a few who live “off-the-grid,” fiat currency is the only means of attaining these necessities. Possession of currency is a must if we are to survive and thrive. Take a look back to the opening paragraphs and let’s rephrase that last sentence: possession and TRUST of currency is a must if we are to survive and thrive.

It is this most foundational understanding of currency that keeps our economy humming, our physical prosperity growing and our society stable. The TRUST backing the dollar, euro, yen, etc. is essential to our financial, physical and psychological welfare.

Let’s explore why we should not assume that TRUST is a permanent condition.

Deficits Don’t Matter…. or Do They?

Having made the imperative connection between currency and TRUST and its linkage to trade and commerce along with our physical and mental well-being, we need to explore the current state of the United States government debt burden, monetary policy, and the growing belief that deficits don’t matter.

Treasury debt never matures, it is rolled over. Yes, a holder of a maturing Treasury bond is paid in full at maturity, however, to secure the funds to pay that holder, the government issues new debt by borrowing money from someone else. Over time, this scheme has allowed deficits to expand, swelling the amount of debt outstanding. Think of this arrangement as taking out a new credit card every month to pay off the old card.

The chart below shows U.S. government debt as a percentage of GDP. Since 1967 government debt has grown annually 2% more than GDP.

Data Courtesy: St. Louis Federal Reserve

Continually adding debt at a faster rate than economic growth (as shown above) is limited. To extend the ability to do this requires declining interest rates, inflation and a little bit of financial wizardry to make debt disappear. Fortunately, the U.S. government has a partner in crime, the Federal Reserve.

As you read about the Fed’s methods to help fund deficits, it is important to consider the actions they routinely take are at the expense of the value of the currency. This warrants repeating since the value of the currency is what supports TRUST in the currency and allows it to retain its functional purposes.

The Fed helps the government consistently run deficits and increase their debt load in three ways.

  1. The Fed stokes moderate inflation.
  2. The Fed manages interest rates lower than they should be.
  3. The Fed buys Treasury and mortgage securities (open market operations/QE) and, as we are now witnessing, monetizes the debt.


Within the Fed’s charter, Congress has mandated the Fed promote stable prices. To you and me, stable prices would likely mean no inflation or deflation. Regardless of what you and I think, the Fed interprets the mandate as an annual 2% rate of inflation. Since the Fed was founded in 1913, the rate of inflation has averaged 3.11% annually. That rate may seem inconsequential, but it adds up. The chart below illustrates how the low but consistent rate of inflation has debased the purchasing power of the dollar.

Data Courtesy: St. Louis Federal Reserve

$1 borrowed in 1913 can essentially be paid off with .03 cents today. Inflation has certainly benefited debtors.

Interest Rate Management

For the better part of the last decade, the Fed has imposed price controls that kept interest rates below what should be considered normal. Normal, in a free market economy, is an interest rate that compensates a lender for credit risk and inflation. Since Treasury debt is considered “risk-free,” the predominant risk to Treasury investors is earning less than the rate of inflation. As far as “risk-free”, read our article: The Mind Blowing Concept of Risk-Free’ier.

If the yield on the bond is less than inflation, as has recently been the case, the purchasing power and wealth of the investor declines in the future.

The table below highlights how U.S. Treasury real rates (yields less CPI) have trended lower over the past forty years. In fact, over the last decade, negative real rates are the norm, not the exception. When investors are not properly compensated by the U.S. Treasury, the onus of government debt is partially being put upon investors. We have the Fed to thank for their Fed Funds (FF) policy of negative real rates.

Data Courtesy: St. Louis Federal Reserve

Fed Balance Sheet

The Fed uses its balance sheet to buy and sell U.S. Treasury securities to manage the money supply and thus enforce their interest rate stance. In 2008, their use of the balance sheet changed. From 2008 through 2013, the Fed purchased nearly $4 trillion of Treasury and mortgage-backed securities in what is called Quantitative Easing (QE). By reducing the supply of these securities, they freed up liquidity to move to other assets within the capital markets. The action propped up asset prices and helped keep interest rates lower than they otherwise would have been.

Since 2018, they have reversed these actions by reducing the size of their balance sheet in what is called Quantitative Tightening (QT). This reversal of prior action essentially makes the benefits of QE temporary. However, if they fail to reduce it back to levels that existed before QE was initiated, then the Fed permanently monetized government debt. In plain English, they printed money to extinguish debt.

As we write this article, the Fed is in the process of ending QT. Based on the Fed schedule as announced on March 20, 2019, the balance sheet will permanently end up $2.28 trillion larger than from when QE was initiated. To put that in context, the balance will have grown 269% since 2008, as compared to 48% economic growth.

Data Courtesy St. Louis Fed

The methods the Fed employs to manage policy as described above, all involve using their balance sheet to alter the money supply and help the Treasury manage its deficits. We can argue the merits of such a policy, but we cannot argue a basic economics law; when there is more of something, it is worth less. When something of value is created out of thin air, its value declines.

At what point is debt too onerous, deficits too large and the Fed too aggressive such that TRUST is harmed? No one knows the answer to that question, but given the importance of TRUST in a fiat currency regime, it would be wise to avoid actions that could raise doubt. Contrary to that guidance, current fiscal and monetary policy throws all TRUST to the wind.

Prelude to Part 2

As deficits grow and government debt becomes more onerous, the amount of Fed intervention must become greater.  To combat this growing problem, both political parties are downplaying deficits and pushing the Fed to do more. In part 2 we will explore emerging fiscal mindsets and what they might portend. We will then define money, and with this definition, show why the difference between currency and money is so important. 

Opportunity Of Misplaced Inflation

The global economy is apparently facing a significant problem. Inflation’s gone missing! Central bankers can’t seem to stoke it no matter how deftly they act. Neither lowering interest rates to zero (and less) nor endless amounts of Quantitative Easing (QE) appear to make any difference. This, we’re told, is a problem that is equally as serious as it is perplexing. However, this position puzzles me. What if it’s not inflation that’s lacking, but rather our understanding of it? More importantly, might this disconnect have significant ramifications for investment portfolios?

In my opinion, there are two ways in which inflation is misunderstood. The first stems from misapplying a commodity-based monetary standard practice to a fiat convention. The second potential error is placing too much importance on unit prices as an economic signal. It’s possible, I think, that both had a hand in producing the 40-year secular decline in interest rates.

Inflation Is A Currency Phenomenon

Milton Friedman famously said that “inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” The Merriam-Webster dictionary defines inflation as “a continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services.” Here, we can see that inflation is a relative term. It compares the value of goods and services to money.

While these definitions are commonplace today, they are in fact modern redefinitions. Inflation was first used to describe the value of (paper) currency compared to a monetary standard, not to goods and services. Emperors clipping coins didn’t devalue money per se. The standard, which was typically defined as some unit weight of commodity metal, remained constant. Rather, they merely lessened the monetary value of each coin in circulation. Hence, it took more currency to purchase the same goods and services. The same held true for paper currencies convertible into gold. Lowering exchange rates reduced their purchasing power. This was inflation. To clarify Dr. Friedman’s definition, inflation is not a monetary phenomenon, it’s a currency phenomenon!

Inflation Was Lost In Translation

Today, however, we operate under a fiat monetary standard. There is no physical definition of a dollar apart from the currency itself. A dollar is simply what someone else is willing to accept for it in trade. Given that governments create the fiat currencies used in commerce (currencies, not money!), it follows that monetary authorities would require some metric to assess if the quantity produced is optimal.

Enter the modern—and in my view, flawed—concept of inflation. It’s determined by tracking the change of the average price of a basket of goods. There are many different indices with many different mixes of goods and services, with many different kinds of adjustments made. Inflation’s use in monetary policy is to provide policymakers with an objective signal with respect to the amount of currency in circulation.

“In the earlier definition, inflation is something that happens to the circulating media at a given price level; in the later definition, an inflating currency is defined to exist when it produces a rise in the general price level, as suggested by the quantity theory. What originally described a monetary cause came to describe a price effect.” [Emphasis is mine.]

Michael F. Bryan, On the Origin and Evolution of the Word Inflation

The attempt to bring objectivity to an arbitrary, fiat system is valiant. It is, however, flawed. Put aside the issues of measurement and representation of the popular indices (hedonic adjustments anyone?). Defining monetary value in terms of tangible goods and services ignores the most fundamental fact about human wealth and prosperity creation; and it’s hiding in plain sight.

Deflation Is The Hallmark Of Prosperity And Progress

There’s no surer way to scare a macroeconomist than to utter the word “deflation.” This euphemism for falling prices conjures up thoughts of economic depression, breadlines, unemployment, and poverty. Thus, deflation must be avoided at all cost it is thought. This fear has apparently short-circuited the critical thinking mechanism of some very bright people. None seem to realize that, by our modern definition, deflation is the hallmark of prosperity and progress.

Just think for a moment. The dramatic fall in general prices is a corollary to wealth. Affordability yields abundance, comfort, and joy. Who doesn’t want more and better goods and services at an exponentially cheaper cost? (Well, macroeconomists I suppose, but I bet most are compartmentalized on this subject.)

One study demonstrates this very fact by scaling food costs to the value of unskilled labor. It found that prices exponentially fell for basic needs.

  1. The time price (i.e. nominal price divided by nominal hourly wage) of our basket of commodities fell from 47 hours of work to ten … .
  2. The unweighted average time price fell by 79 percent … .
  3. Put differently, for the same amount of work that allowed an unskilled laborer to purchase one basket of the 42 commodities in 1919, he or she could buy 7.6 baskets in 2019 … .
  4. The compounded rate of ‘affordability’ of our basket of commodities rose at 2.05 percent per year … .
  5. Put differently, an unskilled laborer saw his or her purchasing power double every 34 years … .”

Marian L. Tupy, Unskilled Workers and Food Prices in America (1919-2019)

This becomes more starkly apparent if you remove money from the equation altogether. Consider this: Go back far enough and everyone was a subsistence farmer (or hunter/gatherer). In other words, virtually 100% of an entire population’s time and effort was spent on producing the basic necessities for survival. Today, less than 5% of those in developed countries work in agriculture. The other 95% produce everything else that improves our lives.

Source: Our World in Data

Now that’s some massive deflation, at least according to our modern definition! Were these horrible times? Hardly so! Deflation, it turns out, is present throughout all prosperous periods of human history. Of course no one called this deflation because, quite frankly, it’s not. True inflation is a currency phenomena. It has nothing to do with the value of goods and services.

Using the modern inflation concept in monetary policy simply makes no sense. Deflation is desirable. It’s inflation we should fear. A rise in general prices can only result from wealth destroying shortages or the imposition of unnatural competitive barriers (i.e. regulation and tariffs). The invisible hand ensures just this.

Inflation’s Usage Is Misplaced

Putting this aside for a moment, macroeconomists apply inflation inconsistently. It can connotes both economic growth (good) and monetary debasement (bad). What I find most bizarre though, is for exactly 2.0% inflation to be monetary panacea despite its arbitrary origin.

“’It was almost a chance remark,’ [former Reserve Bank of New Zealand Governor] Mr. Brash said in a recent interview. ‘The [2% inflation target] figure was plucked out of the air to influence the public’s expectations.’”

Neil Irwin, Of Kiwis and Currencies: How a 2% Inflation Target Became Global Economic Gospel

Furthermore, the importance that macroeconomists place on unit prices is misplaced in my view; that is if one is interested in monitoring economic conditions.

Inflation in macro is assumed to be information-laden. To practitioners, it signals tightening economic conditions such that prices rise. Falling prices, on the contrary, indicate excess “slack”; that resources are under-utilized and a cause for alarm. Perhaps most silly is the belief that price declines prevent consumers from spending. If this were truly the case few would own TVs and other consumer electronics; the Industrial Revolution would have stopped dead in its tracks.

Lost on these economists is that prices are just one tiny piece of the economic machinery. Companies change them for a whole slew of reasons. In fact, not only should prices fluctuate, they do because they are effects.

Getting Micro With The Macro

While on the surface this inflation perspective appears logical, it lacks a basis in reality. For inflation to carry significance, prices should be of paramount concern to businesses. After all, macroeconomics is merely the aggregation of the micro. Analyzing commercial activities reveals that this is simply not the case.

Consider this: Businesses seek to maximize profit (or cash flow). Profits are a function of both revenues and expenses. While important, prices are just one component of the profit algorithm.

Profit ($) = price ($ per unit) x volume (units) – costs ($)

From this equation it should be abundantly clear that a company’s fortune rests upon more than unit prices. In fact, profits might rise despite prices falling. This routinely happens when companies expand capacity or increase productivity (i.e. lower unit costs). Lower prices facilitate higher volumes which can increase efficiency. This combination often leads to greater profits, which is the ultimate goal .

True, falling prices might indicate a lack of demand. But often times they times don’t. The same applies for the economy writ large.

Profound Investment Implications

In summary, I find the treatment of inflation to be flawed in two ways. First, defining monetary stability in terms of goods and services is inconsistent with its original conception. Inflation simply has no relevance in a fiat currency regime due to the lack of an objective standard. Secondly, the fixation on unit prices for assessing macroeconomic health seems disconnected from microeconomic realities.

Today’s lack of inflation is not a problem; it’s prosperity. So long as markets and people are left free to create and work, deflation will likely persist. We should expect (and welcome) inflation target undershoots in spite of policymakers concocting all sorts of crazy theories and policies in order to stoke it. (Thank goodness!)

The investment implications are potentially profound. What if these misunderstandings underpin the secular decline in interest rates? If so, it seems likely that markets will continue to incorrectly process the incoming inflation data given how institutionalized inflation is in investment frameworks. This should present profitable opportunities for the rest of us. Perhaps the undershooting of inflation targets—and other related trends—will persist as the growth we’re enjoying continues. In that case, I, for one, look forward to disappointing inflation readings for years to come … for both my wallet’s and investment portfolio’s sake.

Why Foreigners Shun Higher Yielding U.S. Bonds : Reader Question – RIA Pro

Recently we received the following question from a reader and thought it might be helpful to answer it for all of our subscribers. The question is as follows:

“Who buys a French bond with a negative yield when they can buy a safer U.S. Treasury bond yielding over 2%?”

The simple answer: the economic incentive for a foreigner to own higher yielding U.S. Treasuries is significantly diminished or entirely erased when adjusted for currency and credit risks.

Following is a detailed analysis explaining the answer.

That question was recently posed following the publishing of Deficits Do Matter. In that article, we presented data showing the pace of foreign buying of U.S. Treasury securities had slowed considerably in recent years. Of concern, the amount of debt foreigners are currently buying is not keeping up with the increasing issuance of Treasury debt. Given that foreign holders are the largest investors in U.S. Treasuries, accounting for over 40% ownership, as well as their large holdings of corporate and securitized individual debts, this change in behavior should be followed closely.

Why are foreign investors shunning U.S. Treasuries despite significantly higher yields than many other sovereign debt issuers? The question is even more perplexing when one considers that U.S. Treasury securities are believed to be safer from a credit perspective and offer more liquidity than any bond outstanding, sovereign or otherwise.

When considering bonds of different countries, the analysis is not as simple as comparing yields. When factors such as foreign exchange (FX) rates and credit quality are factored in, the math becomes more complicated, and the results tell a very different story.

Buy and Hold

In this article, we walk through the calculations that buy and hold investors of sovereign bonds use to effectively compare yields on bonds from different countries. Before going into details, it is important to note that there are two other types of buyers and their decision making is different from that discussed in this article. One investor grouping consists of the banks, brokers and hedge funds that speculate on a short-term basis to take advantage of an expected change in yields. The other type of “investors” are the central banks and/or treasuries of countries that hold U.S. dollars for trade purposes. These dollar reserves are typically invested in highly liquid fixed income securities, with U.S. Treasuries generally the most desired.

Global bond mutual funds, pension funds and other types of institutional investors that buy foreign government bonds tend to hold them to maturity. These investors are constantly assessing yields, credit risk, liquidity status and many other factors to help them achieve the highest returns possible. This task is not as simple as comparing the stated yield of a German bund to a U.S. Treasury bond of similar maturity. As mentioned, two other important risk factors one must consider, assuming the investor holds to maturity, are expected currency exchange rate changes and credit risk.

Assume the perspective of a German-based sovereign bond fund. The German portfolio manager, when valuing various sovereign bonds, must take two steps to re-calculate yields so they are comparable on a risk-adjusted basis.

The first step is to quantify the credit risk. This is a relatively easy task as credit default swaps (CDS) provide a real-time market assessment of credit risk. These swaps are essentially insurance policies where the writer/seller of the swap receives semi-annual premium payments, and the buyer of the swap is entitled to be made whole if the bonds default. The less risky the bond, the lower the premium. Our German investor might buy a related CDS in conjunction with a Treasury bond to hedge the credit risk.

The second step is to gauge the foreign exchange risk. For our German portfolio manager to buy a U.S. dollar bond, he must first convert his Euros to U.S. Dollars. Going forward, each interest payment and the ultimate payment of principal the portfolio manager receives must be converted back from U.S. Dollars to Euros. The risk the portfolio manager bears is the changing FX conversion rate of future interest and principal payments from U.S. dollars back into Euros.

Our manager can assess and hedge the risk, if he chooses, using FX forward swaps. These swaps represent the “price” at which an investor can lock in an exchange rate between two currencies in the future. Investment banks facilitate a swap where mutually agreed upon future exchange rates can be negotiated. This transaction allows the investor to buy the foreign bond and establish certainty around the exchange rate at which future payments will be received and converted.

To walk through a transaction, let’s compare a 2-year German bund to a 2-year U.S. Treasury note. The yield on the German bund is currently -0.58% and the U.S. note yields +2.64%. At first blush, one might surmise that a German investor can pick up 3.22% (2.64% – (-0.58%) buying the 2-year U.S. Treasury. However, as we stated, the investor would then be assuming foreign exchange risk.

Currently, the two-year forward euro/dollar exchange rate is priced at 6.57% (3.23% annualized) higher than the spot exchange rate. If the Euro were to appreciate 3.23% each year, the previously stated 3.22% annual pickup in yield (benefit) would be entirely offset with a 3.23% currency loss, resulting in the German portfolio manager being largely indifferent between the two bonds.

In selecting the German bund over the U.S. Treasury, the investor is also taking on additional credit risk, as Germany is considered slightly riskier than the U.S. The current German two-year credit default swap (CDS) swap costs five basis points a year more than U.S. CDS. Factoring in the CDS swap, the new rate differential slightly favors the U.S. Treasury by 0.04%.

The table below provides this same analysis for Germany and four other countries.

As highlighted above in the Net Yield Difference column, investors in Japan are better off on a risk-adjusted basis (.21%) by buying their domestic 2-year bonds with a negative yield than buying 2-year U.S. Treasury notes at 2.64%. German and French investors are indifferent, while Italian and UK investors should favor U.S. bonds.

While the math can get confusing the important takeaway is as follows: For the countries shown above and many others not included in the table, the economic incentive to own higher yielding U.S. Treasuries is significantly diminished or entirely erased when adjusted for currency and credit risks.

Interest Rate Parity

This article is based on what economists call interest rate parity, a theory in which the interest rate differential between two countries is equal to the differential between the forward exchange rate and the spot exchange rate.

Financial theory, in general, rests on a bedrock that states that risk-free arbitrage opportunities, such as those shown above, should not exist. In reality, there are other factors such as capital requirements, liquidity concerns, and regulations that add costs and preclude some investors from participating in such opportunities and thus allow them to exist as highlighted above.


This analysis addresses the common misconception that U.S. Treasury bonds and notes offer significant relative value based solely on yield levels. As exhibited, there is little if any financial incentive currently for foreign buyers to choose U.S. bonds over European, British or Japanese bonds despite significantly higher yields on U.S. Treasuries. Required adjustments incorporating the foreign exchange component into the equation negates any optical advantage of higher yields in the U.S.

While there is certainly a yield that is attractive to foreign investors and will incentivize foreigners to fund U.S. deficits, based on the math that yield resides somewhere north of current levels. Either that or the U.S. dollar would have to strengthen further to offset the foreign exchange adjustments in play. A stronger dollar however presents other economic challenges beyond the scope of this discussion.

Considering the size of the current debt overhang in the U.S. and the increased supply of Treasuries projected to be coming forth over the next several quarters, this is an important and largely overlooked challenge. Each additional basis point required to meet funding needs raises the interest expense on the debt as well as the interest expense on all corporate, muni and individual new issues and floating rate debt. Given the excessive financial leverage employed by the U.S. economy, every basis point has a detrimental economic effect.

Are Emerging Markets Toast?

Domestic stocks outperformed international stocks for a long time. On a year-to-date basis, the S&P 500 Index was up more than 6% through July, while the MSCI EAFE Index was down slightly and the MSCI EM Index was down more than 4%. The international stock returns are after translation to the dollar, so they assume a U.S .investors bought them without using a currency hedge and received the dual return of the stocks in their local markets and the return of the local currency relative to the U.S. dollar.

In every instance (YTD, 3-, 5-, and 10-year periods), the international stocks performed better in their local markets before translation to the dollar. That means the dollar has been appreciating for a while. It has also been appreciating a lot recently.

There have been years over the past decade when international outperformed domestic. Last year was such a year. The S&P 500 produced a 21.83% return, while the MSCI EAFA delivered a 25.03% return and the MSCI EM Index delivered a whopping 37.28% return. But the recent long term has clearly favored U.S. stocks.

In the past emerging markets were said to be “coupled” with the developed world. If the developed world stopped spending, emerging markets suffered greatly. Also, there was coupling in the sense that emerging markets currencies would plunge when the dollar strengthened, and they’d have to spend all their reserves to prop up their currencies. Emerging markets countries borrowed debt in dollars or other developed world currencies, and dollar appreciation put an extra burden on them.

Has decoupling occurred now? Will the dollar’s rise crush emerging markets again, or have things changed? Are emerging markets able to stand alone now? Nobody knows. Clearly Turkey has been on a borrowing binge that it’s paying for now. But it’s not clear that’s the case with other developing countries.

It’s the dollar, stupid

Still, the FT’s John Authers writes of a “fragile five,” referring to five countries whose currencies are succumbing to a strong dollar — Turkey, India, Indonesia, Brazil, and South Africa. The currencies of these five countries also came under pressure during the “Taper Tantrum” of 2013 when Ben Bernanke talked of tapering his QE purchases.

Authers also notes that the price of gold tells us that the U.S. – or the U.S. dollar – is the cause of the current crisis. Gold has been depreciating; it has “behaved exactly like an emerging market currency, and has endured a true correction, dropping more than 10 per cent from the high it set early in the year.” All currencies depreciating relative to the dollar helps keep inflation in check, but it’s bad for the U.S. trade deficit. It doesn’t encourage American exports.

Authers wonders if the Fed will postpone future rate hikes the way it postponed reducing its bond purchases to temper the anticipation regarding the end of QE. This may indicate if emerging markets turbulence becomes calm.

On the other hand, perhaps Authers is putting too much faith in the Fed’s ability to assuage fears about rate hikes and the dollar. A  recent MarketWatch article noted that emerging markets governments drain their dollar reserves in an effort to bolster their currencies. That means there are potentially “fewer dollars available for interest payments, pushing investors to demand richer yields as compensation for holding riskier debt.” The article reported that dollars custodied by the New York Fed for foreign central banks had decreased by $60 billion to $3.04 trillion in May, off from its peak f $3.11 trillion in March. Given that emerging markets countries borrow in dollars (and other developed market currencies), this could spell more trouble. Time will tell.

Rising Rates And Funds

There’s always something else to worry about. For a while now, investors we admire such as Grantham, Mayo, van Oterloo (GMO) and Research Affiliates have been touting the cheapness of foreign stocks, especially emerging markets stocks. This past August James Montier of GMO argued that an allocation to the S&P 500 Index, given its valuation then, counted more as speculation than as an investment. Also, in November, Research Affiliates published a paper questioning whether anyone needed U.S. stock exposure.

Valuations of foreign stocks are indeed more compelling than those of their U.S. counterparts. But U.S. investors must account for other things when venturing abroad, including currency moves. When U.S. investors own a foreign stock that trades on a U.S. exchange, they receive two returns, the return of the stock in its local currency and the movement of the local currency relative to the U.S. dollar. In other words, U.S. investors take on foreign currency exposure when they own foreign stocks. Lately that has provided some pain as the dollar has surged thanks to rising interest rates. From the lows of this year in February, the U.S. dollar has surged more than 4% against a basket of foreign currencies.

And that means investors in foreign stock have suffered, though those stocks have not necessarily performed badly in their local currencies. For example, the MSCI EM Index has dropped 1.72% and 3.97% over the past month-to-date and three month periods, respectively, through May 9, 2018 when translated into dollar terms – in other words, for ordinary U.S. investors without a currency hedge. But in local currency, over the same two time periods, the same index has dropped only 0.73% and 1.46%, respectively.

In the realm of developed markets, the MSCI EAFE Index has delivered a month-to-date and three-month return through May 9, 2018 of -0.07% and 0.37%, respectively, when translated to the dollar. But it has delivered 1.10% and 3.29%, respectively, to investors with a hedge, thanks to the strengthening dollar and weakening foreign currencies.

Currency moves are hard to time, and that means most investors like to stay unhedged or hedged at all times. Is there one of these that’s better? A paper by asset manager AQR argues that, over time, investors haven’t gotten paid for the volatility they’ve incurred from foreign currency exposure. The lesson for long-term U.S. Investors is to hedge their currency exposure. That makes some sense because while currencies move up and down against each other over long periods of time, those moves tend to cancel each other out. There’s no long term gain to be captured from a currency bet.

Now, despite the dollar’s run lately, the greenback looks relatively high versus a foreign basket of currencies over a longer period of time. In that case, foreign currency exposure might actually help. So if investors are expecting the dollar to fall over a longer period of time, they can hedge some prearranged percentage of their foreign stock portfolio.

Some instruments with which investors can gain hedged currency exposure to foreign stocks are the Xtrackers MSCI EAFE Hedged Equity ETF (DBEF) and the xTrackers MSCI Emerging Markets Hedged Equity ETF (DBEM). The first gains exposure to the MSCI EAFE with a currency hedge, and the second gains exposure to the MSCI EM Index with a currency hedge.

May I Please Have Some Yield?

Apart from the esoteric realm of currency hedging, rising rates have also caused rates to, well, rise on short-term debt funds. And that can be a boon to investors – especially those with a penchant to ride out expensive markets with at least some of their money in cash. PIMCO’s Enhanced Short Maturity Active ETF (MINT) might be a decent choice for safety with some yield. It owns high quality short-term debt instruments (Effective Maturity – 0.61 years), including both sovereign and corporate debt, and its current yield is 2.18%. Not all the instruments are from the developed world, and the fund can take a bit more risk than the average money market fund. But the fund doesn’t use options, futures, or swaps and discloses its holdings on a daily basis.