Shifts Happen – Episode Eight

Grant Williams (00:10):

Before we get going, here’s the bit where I remind you that nothing we discuss should be considered as investment advice. This conversation is for informational and hopefully entertainment purposes only. So while we hope you find it both informative and entertaining, please do your own research or speak to a financial advisor before putting a dime of your money into these crazy markets. And now, on with the show.

Welcome, everybody to another edition of Shifts Happen. Joining me as always is the man who, more than anybody else chronicles all these shifts in real time, the ever brilliant Luke Gromen. Hi, mate. How the devil are you?

Luke Gromen (00:50):

I’m doing great, Grant. How are you?

Grant Williams (00:51):

I’m fine, I’m fine. I’m bouncing around as always, but nothing seems to stop while I bounce around. It just tends to speed up, and every now and then I need to kind of sit down and shake my head at all the stuff that’s going on. But fortunately, I get to read your work and it condenses it all for me into one often depressing almanac to help me know what’s going on.

So look, you and I haven’t spoken on a podcast for some time now, and there’s always just so much to catch up. The longer we leave it, the tougher it gets. Now I want to start with something we were chatting about just off-air before we started, and that is rates traders. And I want you to explain to people in simple terms why you could possibly be the most hated man in the rates trading market. Because I think from that stems a lot of the stuff we’re going to talk about.

Luke Gromen (01:37):

Yeah. I had a couple of different people sitting in senior seats, well-recognized hedge funds, that are friends and clients say, “Luke. These rates traders fucking hate you. They fucking hate you. I’m on this macro chat or this macro group, and your name comes up and, ‘Ugh.”

Grant Williams (01:58):

That guy.

Luke Gromen (02:00):

“’Fucking Gromen.’” And I said, “Why? I’m a nice guy. I’m personable. I harbor no ill-will.” And what they said is that, “If you’re right, a lot of the world they know is over, a lot in terms of rates trading, et cetera of the last 20, 30 years.” And I get it. And what that is, is just ultimately the fiscal situation requires a level of oppression that makes what they do difficult to continue doing or redundant perhaps in some cases.

Grant Williams (02:34):

I was just going to say, I’d go as far as obsolete in many cases.

Luke Gromen (02:36):

Obsolete.

Grant Williams (02:37):

Yeah, exactly. Yeah.

Luke Gromen (02:38):

And that’s kind of where we are. And you’ve seen hints about it. You go back five years to this BlackRock whitepaper, which was Stan Fischer and Jean Boivin and Hildebrandt from the Swiss National Bank saying, “In the next crisis we’re basically going to go direct. We’re going to spend a bunch of fiscal, we’re going to cap rates, and we’re going to inflate.” And they sort of did it and we’ve sort of backtracked. But ultimately, the more things go on, the less and less there seems to be any other way out, number one. And not only that, but as we were just talking about offline, policymakers keep pursuing things that make the situation more urgent to do that, whether that’s pursuing war in Europe, in the Middle East, et cetera, et cetera, trade policy, tariffs, what have you, with China, all of that. It just brings forward the date that that is going to have to happen.

Grant Williams (03:30):

We’ll get into all that stuff in a second, but just from a high level, you obviously thought a lot about this because written a lot about it. As I said, you chronicle it better than anybody. So when you think through what it is that either the policymakers don’t get or they refuse to acknowledge or they realize they’re in so deep now, they may as well just keep pushing and hand it off to somebody else, how do you kind of handicap those three possibilities? Because it seems to me it has to be one of them, right? Because the numbers are so glaringly obvious at this point, it has to be one of those.

Luke Gromen (04:04):

I think it’s probably some blend depending on where you are within policy circles. I think there is a small number of policymakers who do understand that there’s nothing else to do other than just try to keep it going as long as you can and pull the levers and what have you. And I would argue Yellen has kind of shown herself in her moves, which have been very pragmatic, right? Move to the front end of the curve, run down the RRP. She this year, I think, made one of the more important macro pronouncements of the last decade, when she basically took the economic orthodoxy of the last 40 years and threw it in the trash in The Wall Street Journal saying, “This whole free trade thing.” She basically sounded like Donald Trump in 2016 on trade.

So I think there’s a small number of policymakers who get that. And then, the rest I think are some level of either not thinking through the second derivative impacts. Perfect example was last year in third quarter of ‘23, you had a whole slew of former White House economists and Nobel Prize-winning economists and economic journalists said sort of the papers of record and The Washington Post and New York Times and The Wall Street Journal, they all came out and said, “Well, wow. The deficit just doubled in fiscal 2023. We weren’t expecting that at all. How did that happen”

And to me, it was the most obvious thing in the world. As you know, I was writing about it a year earlier, saying, “The deficit is probably going to double, because stocks went down. And when stocks go down, it’s the key marginal driver of receipts, and the deficit is going to blow out and you’re going to have this issuance bubble.” And so, I think there’s some level of them that just, they don’t think of second and third derivatives, like ever. That’s fine. And then, I think there’s another group, and I don’t know how to divide them up, but they’re basically, they’re so dogmatic that if I’m right, their academic credentials are shot. They can’t pivot. They basically have to do the Thelma and Louise in terms of their professional credentials, like right off the cliff. And hey, good luck. Have fun storming the castle.

Grant Williams (06:13):

Yeah. Right. But this idea of financial repression, the thing that fascinates me about it is it’s been so obvious that this was ultimately where we were headed for such a long time because there really wasn’t a way out of this. And the reasons were clear and the logic was really inarguable, but it seems so far away. And there’s this scene in Monty Python and the Holy Grail where there’s these two guys guarding the castle, and John Cleese is running at them with a sword. He’s going to try and storm the castle and save the bride. And they stand there and the camera cuts to him charging, and he’s a long, long, long way away. And it cuts back to the two guards. And it cuts back to John Cleese, and he is a long, long, long way away. And it cuts back, and they’re just kind looking at each other, not really figuring out what’s going on. And it cuts back in and suddenly, he’s right there and he stabs them both in the chest and runs in and ransacks the castle.

And it feels like that’s what’s going on here. Russell Napier has been talking about this stuff for maybe five years. And the case he made five years ago was so compelling and at the time, as airtight as you could make something that you’re forecasting five years into the future. You’ve been writing about it for a long time now, multiple years. And yet, suddenly we’re here, and to your point just a few moments ago, it seems to be catching people by surprise. And I just don’t understand how that can possibly be.

Luke Gromen (07:38):

I don’t either. 70 million Baby Boomers were born, it stood to reason they were going to turn up 65 someday. I go back to the great series on the Vietnam War by Ken Burns. I think it’s towards the end if I remember, but the point is this. The US had this giant supercomputer, and they uploaded all of the factors that they knew going into the war and how many tanks and how many men. And they loaded in and what the enemy had and so on and so forth. And they did this in 1970. And they asked the computer, “When is the US going to win the Vietnam War?” And the computer came back and said the US won the Vietnam War in 1966.

So there’s always a great inability… What is it? The greatest shortcoming of the human race is the inability to forecast the exponential function. So I think you’re dealing with exponentials, I think you’re dealing with politics. When there’s as much money in politics as there is, it’s in nobody’s interest to be a realist. You’ve got things you can’t control in terms of pandemics and wars, et cetera, that accelerate these things. You have had venerable leaders come out and say, “There is a problem.”

Stan Druckenmiller. I routinely hear traders tell me he’s the greatest trader in history, he’s unbelievable. And he is. And Stan Druckenmiller in 2016 said, “This is the most obvious trade I’ve ever seen in my life. This is going to happen. It’s so obvious.” And yet, many of the same traders that will tell me that Stan Druckenmiller is the greatest trader ever, will at the opposite side say, “This is never going to happen.”

So there’s a cognitive dissonance/dogma/inability. Albert Bartlett is the physicist’s name, the inability to deal with the exponential function or see how fast it can happen, just all of it rolled up together. I think ultimately there’s just this inability. And then, when you layer on there’s a refusal to realize the real politic of it. Every time something bad has happened, they kicked the problem upstairs and printed the money. My entire career, kicked the problem upstairs, print the money. And so, to me, the least controversial thing in the world is they’re going to kick the problem upstairs and print the money. Except because it’s a sovereign debt bubble after all the other upstairs can kicking, there is nowhere to kick it except the currency.

I was at a conference a little over four years ago, early 2020, and I kind of laid all this out and I had a pretty well-known bond manager who was there. And it was not the kind of conference where everybody makes a presentation and you sort of share thoughts after. Mid-presentation, this bond manager interrupted me, screaming at me, I’m wrong, I don’t know what I’m talking about, and I should sit back down. And if I told you who this was, you’d be shocked. I was shocked. I was literally taken a little back. Luke, there’s no way they would ever buy corporate bonds. Literally less than six months later, they were buying corporate bonds with printed money. And so, there’s this dogma around like, “Oh God, if this happens, then my world view is completely shattered.”

And unfortunately, I don’t care. It is what it is. So to me, I don’t understand why it’s not more obvious. And then, I think once you say, “Okay, this obviously has to happen. Well, what are the implications?” Well then, it feeds on itself. Why would I own bonds? Why would I ever own bonds? And that gets into this, there’s very much a dogmatic, almost religious, if you talk to people in the plumbing, these aren’t bonds. These are pristine collateral, risk-free. On the other side, they’re just bonds. They’re bonds that they will print dollars to make whole.

And so, the people that are like, “These are pristine collateral. They’ll always keep whole,” and the people over here saying, “Well, they’ll just print the money,” it’s a different way of saying the same thing. So I think that world, and that kind of gets into the initial point of if I’m right, if the financial repression thing plays out as it seems very obviously it’s going to, it is and will continue to at an accelerating pace, that whole, “These are pristine collateral,” that sort of makes anyone holding that stuff the sucker at the card table.

Grant Williams (12:18):

Right. Look, if that’s pristine collateral and, “Hey, and we can print as much pristine collateral as we want,” it kind of defeats the object of the whole thing, right? But that point, and I am shocked about that story you just told about the conference, and I don’t even know who it is you’re talking about. But I guess the interesting thing about that is the pushback will be, “Oh yeah, but they did it because of Covid.” Right? Which I get. “Look, you couldn’t have seen Covid coming, so this was extraneous.”

But of course, the important point here is they’ve done it and now it’s a thing. Buying corporate bonds is now a thing. It’s a tool that they have used, and therefore they will use again whenever they feel the need to. And so, that cat is well and truly out the bag now. And that’s the component of this, that again, I think people don’t seem to realize is you go back to ‘87 and what Greenspan did after the Wall Street crash, that was kind of the starting pistol for all this stuff, to me anyway, the reactions they did there. And it’s just been creeping and creeping and creeping and creeping. And they are buying sovereign bonds and they will buy stocks just the same way the Bank of Japan bought stocks. Right?

All these things, you can see where this is going because they have to. This isn’t some kind of thing they’re sitting down and going, “Hey, wouldn’t it be a good idea if we buy corporate bonds?” It’s like, “We don’t have a choice.” And so, if you can look at it through that lens as you do and say, “Okay, here’s the situation. What can they do to ameliorate it in any way, shape, or form?” There’s your answer. That’s what they’re going to do, because they’re not going to magic real growth. And we’ll talk about the growth that you’ve been highlighting because it’s not real growth. They’re not going to default because they’ve got no need to. Inflation is a really tricky way out of this thing as we’ve seen. So forcing people to do things with their capital and forcing bonds down people’s throats and giving them as many as they need or more, it’s the only feasible answer. Right? There isn’t anything else they can do.

Luke Gromen (14:22):

No. And I think it’s important to really keep going back to that first principle, which is, and this isn’t true anymore, but three, four years ago, five years ago, no one was really paying any attention to the actual underlying fundamentals of the risk-free asset, the Treasury bond. Right? And so, the first principle of why they’re going to do all this is because they have to in order to make the fiscal situation sustainable. Because like you said, defaulting is not an option. Because you default, that’s the collateral underpinning everything else, and everything falls apart. So you know they’re not going to restructure/default. That’s just not on the menu of options.

So it reminds me in certain ways of 2004, 2005, when people would say, “Well, these subprime mortgage bonds are AAA rated. And no AAA-rated bond has ever defaulted.” And that was true. But just because you put a bunch of lipstick on a pile of dog shit and call it AAA doesn’t actually make it AAA, which doesn’t really matter until the cash flows aren’t there.

And similarly, we’ve had this sort of, “Okay, this is AAA-rated bond. This is risk-free. This is the base, this is the collateral for your entire system.” And that was fine when you were running surpluses in 2000, when your deficits were 2% of GDP in a recession, when you had shown a demonstrated willingness to be a good fiscal actor and a good global policy actor and not to weaponize the underlying currency system.

But 3, 4, 5 years ago, no one was looking at it saying, “Well, wait a second. The risk-free asset, I looked at this as a security.” This is an entity which has run losses for 24 straight years, deficits. This is an entity whose debt is trading right now, $35 trillion, call it $5 trillion in receipts, seven times revenues, debt of seven times revenues. Off balance sheet, OPEB liabilities, call them $100 trillion for easy math. It could be $200, who knows, of 20 times revenues. That’s not a AAA piece of paper.

And then, once the deficits are structurally at seven, and we can talk about it, but the CBO piece last week is just mind-boggling. Right? They need rates to go down 100. They’re modeling 7% deficits, never below 6% deficits for the next 10 years, no recessions that entire time, 175 to 200 basis points of rate cuts, unemployment never goes above 4.5%. And yet, the deficit is 6%-7% the whole time. The underlying fundamentals, this is not AAA-rated paper.

And now, of course it’s AAA-rated paper on a nominal basis. And that’s the whole point, is once the fundamentals have deteriorated to the point where the only way to keep it AAA rated is on a nominal basis by injecting evermore liquidity, then there you go. That’s the new operating environment we’re in. And once that the GDP gets to 120% post-Covid, austerity go off the table. You can’t do austerity at those levels with deficits, because you actually make the deficit go up, because you trigger a downturn and the deficit blows out. You’ve got to devalue the currency first. You’ve got to devalue the debt before you do the austerity, otherwise you blow up the bond market either way.

So you’ve got this, I just think that the consensus is now starting to actually consider the fiscal position and the debt position of the reserve currency issuer from a fundamental standpoint. They’re not liking what they see. They see the problem, but we were just saying offline, we’re sort of in the bargaining phase of it. We’ve gone from denial and anger to bargaining. We’re not yet to grief.

Grant Williams (18:11):

We’re a long way from acceptance, too.

Luke Gromen (18:12):

We’re a long way from acceptance. Yeah.

Grant Williams (18:15):

Okay. So let’s go back and just talk about this CBO projection, because the CBO numbers for a while now, if you’ve looked at the projection chart they put out, it’ll make your head spin, and it has done for four or five years. And yet again, it’s kind of been one of those things that people have really ignored. But for some reason, this latest one, I think because the deficits are now at this 6%, 7%, 8%, 9% we’re at those sort of numbers now in this piece, suddenly, it is seeming to matter to people. So walk us through this latest CBO report and talk about what it was that you found in there that, I think you called it, that the US would need a super bubble based on that report. So talk us through what you saw and where you think it leads.

Luke Gromen (19:02):

Yeah. So you had a CBO report that says you never have a recession for the next 10 years. And as a matter of course, they never project recessions, just to keep apples to apples, to keep the politics out of it. I understand why they do that. But it’s helpful to understand because the last three recessions have seen US deficits rise by 600, 800, and 1200 basis points of GDP, respectively. Today from a starting point of 7%. So you’ve got a deficit for the next 10 years that is projected to never go below 6% GDP, with no recessions, with unemployment never going above 4.5%, and with 175-200 basis points of rate cuts built in.

And what I said about that is ultimately, what’s really disturbing about it, and again, disturbing is just a case of whether you’re the windshield or the fly, and I like to be the windshield. What’s disturbing about it is we’ve heard the financial repression case. “Hey, they’re just going to have to financially repress.” Ray Dalio’s the Beautiful Deleveraging. This report tells you the Beautiful Leveraging has failed spectacularly. It’s going to need to get very, very messy deleveraging, which is to say very high rates of inflation for a sustained period of time, multiple years.

You can see that despite the fact, so we’ve showed over and over and over in our research that the biggest marginal driver to consumer spending growth, GDP growth because consumer spending is two-thirds of GDP, and tax receipt, marginal tax receipts are stocks. It’s intellectually offensive, but policymakers have allowed this to happen. This is what we saw in ‘22, ‘23 that all these other people didn’t that were surprised by the deficit doubling in ‘23.

So knowing that basically you can project what the deficit is going to do by looking at the stock market the year before and just saying, “Okay, the stock market’s up 20% receipts will probably be up 10-12%. No problem, holding employment constant. So you’ve got the S&P up 20%, year-over-year roughly, give or take. You’ve got home prices, which also correlate with receipts. Again, this is the system they wanted and now they’re getting it good and hard. Home prices are up at all-time highs. Stocks are up 80% since Covid. Home prices are up 44% since Covid. But receipts are just flat since 2022, because we had that tight…

So that’s a problem, the financial repression school, which I agree with. The problem is they’re not repressing nearly enough. Ten-year Treasury yields have been 100-300 basis points above nominal GDP growth in this country since 1Q ‘23. And yet, debt-to-GDP has risen every single quarter. That’s not how it’s supposed to work. Right? We went back in this report, we said, “Okay, the last time we saw the 10-year Treasury yield so far above nominal GDP growth as it has been for much of the last five to six, maybe even eight years in this country, was in the 1970s. And in the 1970s, when 10-year yields were so far above nominal GDP growth that the GDP went from like 60 to 30. Great. We’ve been doing it the last 10 years and it’s gone from 80 to 120. That’s problem number one.

In the 1990s we saw, especially the second half of the 90s, we saw US debt-to-GDP fall, again I’m going from memory, but it’s probably from 60% to 40% of GDP driven by this massive asset bubble, by this massive stock bubble. We were running surpluses.

Now we’ve got stocks up 80% in four years. The Warren Buffett metric, which is total equity market cap as a percent of GDP, which Buffett has said, “Hey, it’s the best metric valuations,” it’s 20% higher than it was in ‘99. And yet, our deficit is 7% versus in ‘99 we were running 2% of GDP surpluses.

So we’ve got 10-year Treasury yields well above nominal GDP growth, which used to drive declining debt-to-GDP. Now it’s rising. We have a way bigger stock bubble on the Warren Buffett metric, valuation metric than we had in the 90’s, and yet it too is still seeing a rising debt-to-GDP. And then lastly, in the early 2000s, we had home prices and the stock bubble, you saw debt-to-GDP basically flatten out. It basically didn’t grow once you were out of the recession, call it ‘03 until things fell apart in ‘08. Debt-to-GDP really didn’t move. Here too, we’re up 44% since 2020. We are fully, I want to say 40 or 60% above 2005 highs in home prices. And again, debt-to-GDP is rising again.

So in summary, there have been ways to do a Beautiful Deleveraging in the past. The easiest thing you do is you put rates above growth and away we go. It delevers. That’s not working. Then in the 90’s, you could also do stock bubble. That’s not working. Then in the 2000’s, you can do housing bubble. That’s not working. And not only are each of them not working, all of them in concert are not working.

And so ultimately, “It’s the debt, stupid.” Right? To paraphrase James Carville. It’s the fact that the GDP is 120%, you raise rates to fight inflation, and now you’ve got a trillion-dollar line item in interest that you didn’t have two years ago. And it feeds on itself. And so, the Beautiful Deleveraging has catastrophically failed.

What does that mean? Ultimately, it means we’re that much closer to yield curve control. Do I sell stocks on that? No. Why would I sell stocks? I sell bonds on that. I buy gold. I buy Bitcoin. Because when I said they need a super bubble, if we go into a slowdown, forget a recession. And I don’t think we’re going to have a recession, that’s separate discussion, barring some sort of catastrophic financial crisis that policymakers are like, “Oh, screw it. We’re all going to go to Turks and Caicos and let the system collapse.” That’s not going to happen.

So if you have a growth slowdown, the deficit is going to blow out even faster and more. And the debt’s going to go higher and more. And so, because of the way they’ve let this evolve, what this tells us is that the only way to avoid a debt spiral is that the S&P, which is up 20% year-over-year now goes up 40% or 60% or 80%. And home prices, which are whatever, up 44% since Covid, they need to be up 80% or 120%.

And that’s the only way out. And I didn’t make the rules. This is how they wanted the system to evolve. This is how they allowed it to evolve. This is the policy choices they made domestically, economically, trade, foreign, and now they’re getting what they wanted good and hard. And here we are.

Grant Williams (25:37):

But when you talk about those are the things they need, which I agree, unfortunately, they can’t have those things if interest rates are at appropriate levels to combat the one thing that’s now holding their feet to the fire, which is inflation, which is why this whole idea of yield curve control is so important. But the CBO report, it came out, what, a week or so ago in June. And the estimates for the deficit have jumped 30% in a quarter, essentially, four months.

It was bad enough in February when I read that report. Right? I’m reading that and it just blows my mind. And I put the chart in everything I did around there saying that, “People, look at this.” But it’s jumped 30% in four months. And people are finally starting to take note of that. How does that change behavior? Because if you start to take note of this stuff now, if you start to say, “Okay, the problem has reached a level where our previous solution to it, which was, ‘Ah, it’ll all work itself out,’ is no longer an option, how does behavior change amongst the investing classes?

Luke Gromen (26:45):

It’s interesting because I don’t think it’s going to change, because in light of everything I just described and it’s all there in the public, it’s all out in the open, term premiums, 10-year term premiums when I checked last week are still negative. That to me is the most insane. The equivalent of Pets.com and the sock puppet and the Superbowl commercials in 2000 and Ninja loans in ‘05 are negative term premiums on 10-year pay. That’s insane. That makes zero sense, given everything we just described.

I think a good chunk of the institutional structure of money management, whether that be some of the stuff that Mike Green has talked about with sort of this inexorable passive bid on one hand. And then, on the other hand, the marginal swing flows, if you will, are driven by people with a one-month mandate. And so, they don’t care until it’s one month out. And when it’s one month out, by the way, they’re not going to be able to get out of it. They’re stuck. It’s too late.

So the opportunity I think really is for people, sort of the Anthony Dedens of the world, who just have long-term patient capital or for investors, individual investors who can act in that same way, which is to say, “I’m unlevered. I’ve got a slug of gold. I’ve got good franchises. I’m going to avoid long-term fixed rates, sovereign debt, particularly amongst the worst cases. And then, I’m going to go live my life.”

That’s the right strategy of this. It’s not the end of the world, it’s just the end of an era. And it’s been a long time since it’s happened here in the West. I described this to a friend of mine who was in Ukraine in the 1990s when the Soviet Union went through this, and he is just like, “Oh. Well, then I’ll just buy my wife more gold jewelry,” and proceed to do another shot of vodka with me. Right? It is like, “Oh, shit happens. So what? Who cares?” It’s only in America where you describe this and people are like, “Oh, no. Then the zombies come and then the world ends.” And then, you’re like, “No. It’s really as simple as they close the bank, they reopen the bank. They add a zero to your grocery bill, have a good day. Thanks for playing.”

That’s the extreme cases. It’s not my base case here, and that’s why I say, if you’re just waiting for a month ahead, “Well, I’ll just buy gold when I need to.” When you need it, as Simon Mikhailovich said, “No one is going to be selling.” I’m not going to be selling my gold when it becomes that obvious. Are you kidding?

Grant Williams (29:05):

Yeah. No look, I think that’s absolutely right. And there’s been a lot of head scratching about gold. People have not really understood why it’s doing what it’s doing, why it’s so strong given everything that’s happening. And to me, there are a bunch of reasons, but this is perhaps one of the most important ones, is what you’re talking about now, this impairment of the collateral system, this impairment of the accepted risk-free asset, and the idea that you need finally a totally neutral reserve asset.

It has to be neutral now. It can’t be the purview of the US or the EU or anybody, for that matter. It has to be neutral, because we’ve reached that phase of the cycle now where it’s kind of every man for himself. And the only way to opt out of all that is gold and Bitcoin, if you have the confidence that that will remain unimpaired as well, which for me personally, I don’t because I just haven’t had it proven to me. I could be completely wrong and I’m fine with that. But that seems to be where we are, this idea that we have to find a new benchmark for pristine collateral, and there aren’t too many of them around. There just aren’t.

Luke Gromen (30:15):

No. You look at when gold separates from real rates the way it has for the past two years, it’s a huge, huge message. And to me, the message is simple. It is the United States cannot afford to make its debt nominally money good unless real rates are negative, full stop. It’s not complicated math. And then, politically you look at, “Okay. Well, what is the United States spending its money on?” And the answer is right now about 125% of receipts are entitlements, untouchable, interest. Okay, great. They can touch that by cutting rates, which is not going to hurt gold in my opinion or defense, which in my opinion isn’t going to be touched. If anything, that’s going up and you’re seeing calls for that.

So when you look at that and then you layer around what you were saying in terms of the heightened risk of seizure, et cetera, et cetera, you need a neutral reserve asset. You want debt. Chinese government bonds are not going to become the next pristine collateral. And to be clear, that’s not what the Chinese want. They have no interest in that. The Japanese can’t, the Europeans can’t, the British can’t. And that kind of gets us through the SDR currencies. And so, it’s gold. And that’s kind of, “Well, what’s the BRICS currency? There’s no BRICS currency. It’s not going to overtake the dollar.” I know. There is no BRICS currency. The BRICS currency is gold.

Grant Williams (31:41):

You threw in there your high confidence that there won’t be a recession, which will catch some people by surprise, and some people will listen to what you said so far and kind of put the pieces together. But you wrote a piece talking about federal outlays and that being the driving force for this no recession call. And so, walk us through that, because again, it’s another super interesting angle on this that a lot of people aren’t paying attention to.

Luke Gromen (32:07):

Yeah. People are used to focusing solely on the private side other than in recessions. Right? And you’ve got to figure out what countercyclical deficit spending is in recession. But other than that, if you’re studying the United States economy, all you’ve got to watch is what’s the private sector doing? And let’s watch ISM and let’s watch industrial production and all this stuff.

The reality is it’s very simple. US federal spending is 23-24% of US GDP. And in April, it was up 23% year-over-year. In May, it was up 22% year-over-year. That’s running at a 5.1% nominal GDP growth number all by itself. The rest of the economy, the other 76%, 77% would have to be falling at nearly 7% to just have flat GDP nominally. That’s not happening. That’s not happening. It’s not going to happen. Because by the way, full year, if I remember right, Great Financial Crisis, GDP fell 3%. So basically, you need the private sector to do a 2X GFC decline. And is it slower? Sure.

And so, I look at this, I go, “People are reflexively not paying any attention to federal spending. So they’re not paying attention to the 5% nominal GDP it’s driving. They’re focused on the private sector, and they’re reflexively doing what they always do and have always done for their entire careers when that happens, which is buy the long end of the curve. Who is buying 4.3% 10-year Treasuries when the federal government alone is driving 5% nominal GDP growth? I would love them on the other side of all my trades. It would be awesome. It makes no sense to me.

Ten-year yield I think is going higher, which creates its own issues. But that’s why I think when you look at, “Okay, why are there no recessions? What are we going to cut?” Well, it’s like we just said. 120% of receipts, so right now we’re shelling out $3.3 trillion a year in entitlements to Boomers. $3.3 trillion is 12% of GDP, 14% of GDP. Okay. They’re getting that come hell or high water every year. Defense is, call it $900 billion or just short of 4% of GDP. That probably is going to go up. Okay. And then, interest, which is call it $1 trillion, $1.2 trillion, also about 4% of GDP.

Okay. Well, the only one of those of three that are going to go down is interest. And if we cut rates, that’s going to be stimulative, in my opinion. And so it’s like well, if nothing changes, the Feds are going to drive, because interest expense, entitlements, they’re going to keep driving this. It’s not like entitlements are stopping next year. They’re going to drive this growth. And the only thing that can really stop is interest. And if they cut rates, I think stocks go up. I think risk rips. And I think as that happens, you get stimulative. So to me, it’s extremely unlikely that we get a recession.

Grant Williams (34:58):

You come at this from different angles, but no matter which direction you come at it from, you end up with buy stocks, buy gold, buy Bitcoin, fade credit, right? Sovereign credit, at least. That’s just kind where you end up, no matter which way you kind of carve this onion up.

Luke Gromen (35:15):

Yeah. Certainly, mid to long-term credit. Right? Sure, at the front end, I still own a decent chunk of T-bills. I’m happy flipping that coupon, particularly in the context of my non-income producing assets, which are big in gold and Bitcoin. You look at those across the spectrum, it’s great. The government’s paying me 5.3% to hold gold and Bitcoin while their fiscal situation plays out.

I didn’t always see it that way. I sort of started from sort of that same traditional mindset in 2022 as vis-a-vis the recession. Right? You could, “Okay, they’re raising rates. The debt’s too high.” We saw the slowdown initially, and then we saw the dollar weaken, and Yellen ran down TGA in third quarter of ‘22. I thought the Fed would pivot. The Fed didn’t pivot. I was wrong. But I was wrong for the right reason; Yellen pivoted. She ran down TGA, weakened the dollar on a pronounced basis.

And so, I was like, “Okay. Well, once that fades, then we’ll get back to sort of the regularly scheduled recession.” And that was right around the time when I saw Warren Mosler start really pounding on this, “Hey, the rules are different with 120% debt-to-GDP.” And I just started kind of working through it, going, “Okay. Yeah. When was the last time the US raised rates 500 basis points with 120% debt-to-GDP?” And the answer was never. I’m like, “Okay. Well, that means my model is, somewhere it’s wrong, my mental model, my model. Let’s talk through this.”

And you start going, “Oh, my God. Interest. Great. So they’re going to go hire for longer, great. Go higher for longer. Take rates to 10%.” And that’s actually what we did for clients in the second quarter of ‘23. “Great. Take rates to 10%.” On $35 trillion in debt, that’s $3.5 trillion in interest pro forma. On a $28 trillion economy, that’s 12% GDP growth. That’s not stimulative. It’s redistributive, it’s regressive. It’s a lot of different things. But that is a version of Covid. That’s just, “Hey, the government’s going to give certain people a bunch of money and it’s going to curtail the private sector, because the private sector won’t like 10% rates. And the government will just print the money to pay out the 10% interest either way. And we’re going to be right back there.”

And so, it’s been… It wasn’t like I saw that right away. But as I saw the markets, the feedback of, “Okay. This recession is not happening. Why isn’t it?” And I’ve come around to the view it isn’t going to happen for the reasons I said.

Grant Williams (37:33):

Well, now let me change tack and talk to you about something that you and I started talking about earlier this week in a DM conversation, but I wanted to save it for this. And that was the Niall Ferguson article about the US being the Soviets, which I found fascinating. I’m a huge fan of Naill’s, a huge fan of his. And for anyone listening that didn’t read that piece, A) you should read it. It was his inaugural piece of writing for Foreign Policy.

And he basically posited that we’re in this new cold war, but it’s the Americans who are the Soviets now. And he went through the reasons why, which I’ll let you read the piece, because he lays it out in great detail. And it’s produced a lot of backwards and forwards on it, a lot of debate. And a couple of guys came out and absolutely hauled him over the coals for it. And I thought he defended his corner brilliantly as he tends to do. But what was your thoughts on that? I know you read it and I know you were thinking about it. I’m curious to hear your kind of takeaways from it.

Luke Gromen (38:28):

I, like you, respect Naill greatly. I think he’s a tremendous mind, a tremendous intellect to me. As you know, you and I have talked about this stuff for a long time. And so, I thought it was a really important signpost in terms of timing, in terms of what our friend Ben Hunt calls a common knowledge game. Right? You can see where we are in narratives and processes by watching when something becomes allowed to be said, when it becomes allowed to be said, when it becomes common knowledge. And so, it’s one thing for a bald, crazy guy in Cleveland to write several years ago, “Hey, opiate deaths and the deindustrialization” and more recently citing some of Ferguson’s work, “that the US is in violation of what’s something called Ferguson’s Law” that he coined, which is once your debt service goes above your defense spending as a hegemon, you tend to not be hegemonic for long, and that the US is there.

And so, it’s one thing for the crazy guy in Cleveland to say. It’s another one for a guy who is at Cambridge, Harvard, London School, one of the most unbelievable resumes out there, to say this to people in halls of power, in seats of power. If they’re open-minded, they’ll listen to the crazy guy in Cleveland. They’ll all listen to Niall.

And so, that to me was the significance of it, because there wasn’t a lot in there that surprised me. There was one thing he added on in his defense when someone went after him hard on it, which was, “Look. Males age 40-69 now have a longer life expectancy in Russia than they do in the US.” And given how much guff I’ve taken about being a Putin lover and Russia, all this crap, I was going to say, “Look. Here’s more proof about what an authoritarian Putin is. He’s not even letting his people die early like Biden is.” Right? And I just decided it was too snarky for me, but I saved it for you.

Grant Williams (40:28):

Yeah. Yeah, thanks buddy.

Luke Gromen (40:31):

But no, so there was not a lot factually there that surprised me because I’ve lived it. I’ve been to the opioid funerals. I’ve seen the kids dying. I’ve seen the frustration with the wars. I’ve seen the deindustrialization and the social problems it has wrought. And I’ve written about it. To see it picked up at that level, with that level of an intellect, that level of a gentleman highlighting this to people in a publication where they will see it, I thought it was really important. I thought it was a big, big milestone.

Grant Williams (41:05):

Yeah. When I look at all this stuff and I think it through, what it seems to me is happening, and it kind of makes sense, is that the entire edifice inside which we’ve all grown up and lived is basically crumbling before our eyes. And so, that’s really difficult for people to understand and even harder for them to accept because it’s never happened before, so it can’t happen. This is all we’ve known.

And so, when you read that piece by Niall and you read the reaction to it, what I found so interesting was each point he made, he laid out all the data. And if you can just step back far enough to just take it at face value and just look at the data and say, “Okay, I’m not going to make the US the US. I’m not going to make Russia Russia. I’m going to make one the hegemon and one a failed superpower and take them in isolation. It’s really tough to kind of push back too hard on this stuff.

And yet, and this comes back and ties everything we’ve talked about together, people insist on pushing back. They insist on pushing back about the CBO numbers. They insist on pushing back about the recession. They insist on pushing back about American hegemony, about risk-free collateral, about the Treasury market, all of it. Every single component of the world as it has worked for our entire lives is something that can’t be challenged.

And that, I just find it really interesting because the chances are it’s all going to get challenged at the same time. And I wonder what the response is going to be from people when it’s not just challenge, but it’s demonstrably gone the other way and they have to now not just deal with this kind of intellectual exercise of, “Hey, what if?” That they can just go, “Ah, it’ll never happen.” They are confronted with all the things that you’ve laid out, all the things that you’ve laid out, and they have to deal with them as a reality. And I don’t know how that goes. I really don’t know how that goes, not well, I suspect.

Luke Gromen (43:03):

Yeah. It’s been something that’s been actually troubling me quite a bit in recent weeks, because I’ve been seeing the early stages of a sign of psychosis almost around that. Which is to say, you and I sitting here a little over two years ago, we recorded a podcast talking about Russia and Ukraine. And it had a very simple premise, which was that at its core, if you take Russian oil and gas, and to a lesser extent, commodities out of the net supply of global markets, the resulting commodity inflation will go so high, so fast, it will collapse debt markets and blow up the West and the world economy at the same time. And therefore, Russia has far greater staying power and leverage than the current narrative says, particularly if China supports them, which it probably will do because our policymakers have stupidly said, basically pointed at China, “You’re next after Russia goes down.”

And as I look back and I take an objective audit of that, pretty good. And so, man, I don’t know about you, but I took a lot of guff for that. And I appreciate you putting it out in front of the paywall. It was very widely viewed, and it was very… I think it helped the public dialogue of it. But yeah, sometimes when you’re out in the early line saying that you catch a lot of guff.

And so, now that we are seeing at a US inability to supply weapons, systems getting, “Oh, Russia’s GDP is 1/10th ours, they’re not going to be able to keep up.” Well, I frequently hear economists pooh-pooh purchasing power parity, usually vis-a-vis China. Right? Well, China, their economy is bigger than ours in a purchasing power parity, and every American economist goes, “Ugh, purchasing power parity. Ugh” Try it. Ask any of your economist friends, “Hey, what do you think of purchasing power parity?” “Ugh.” Okay.

Except that should have an asterisk though, because in wartime, the only thing that matters is purchasing power parity. How much can you make and how fast can you make it? And we forgot that lesson. The Germans had better technology. They had better machine guns, they had better planes, they had better missiles, they had better tanks, they had better all of it. We just made way more shit cheaper. And we just overwhelmed them, at least until we got into things like the P-51 Mustang and some other things we were doing late in the war. But early on, it was just like quantity has a quality all its own, baby.

So we’re now seeing the actual, real-time fallout of offshoring our industrial base to China. We can’t produce that much. And I think, to your point, that has woken people up in these halls of power. It started, I think with Covid with, “What do you mean I can’t get a mask?” “Well, they’re all made in China, sir. We need to ask them nicely.” “Okay, that has to start changing.” Right? So that was sort of step one. Step two, I think in this awakening, has been 2022-2024, “Sir, the Russian…” It’s almost like the Hitler meme where they explain to him it’s not going so well and he loses his mind.

Grant Williams (46:13):

Yes.

Luke Gromen (46:13):

Right?

Grant Williams (46:13):

I’m familiar with that.

Luke Gromen (46:16):

Yes. Yeah, yeah. Right. “Sir, the Russians are outproducing us.” “Wait. We have 10 times GDP.” Well, in peacetime, if your GDP is $27 trillion because you’re flipping monkey JPEGs back and forth to each other and flipping houses back, that’s great. Awesome. Sell CDS away. Have fun. But when it’s war, can you make shells? Can you make tanks? Can you make missiles? Can you make chips? Yes or no? And as long as China was siding with Russia, because again, we said basically it’s like, “You’re next after we’re done with these guys.” Well, maybe that’s not what we should have said.

So there’s this awakening of like, “Oh, gosh.” And when you see it in things like Janet Yellen, Berkeley economist, government economist, Fed economist her whole career, everything this woman believed for 40 years, and then in The Wall Street Journal, I used to think that if someone wanted to send you goods for debt, you should send them a thank you note. I would never, ever again send China a thank you note. I give her credit. She is actually… Again, I was completely wrong about her. She is real politics. She understands it. She understands the levers she has. She’s a realist. And she is telling you the economic policy of the United States of America for the last 40 years was wrong.

And I think we’re in very early days of that. And the more we get that, you get, I think two reactions. Number one, I think there’s an optimistic one, but I think the other side is there’s a group that is, “Oh gosh, I was wrong. I would rather burn down the world than admit I was wrong. I would rather go to World War III and send Luke’s kids to Ukraine to die than admit I was wrong about all of this.”

And what has been scaring me recently has been exactly that, where you’re seeing this, the president of Serbia last week, which I wrote about, saying, “We’re very close to the precipice.” The Russians cannot afford to lose. It is existential to them. And so, you’ve got on the Western side, there’s guys looking to save face. It’s a very dangerous scenario.

So to answer your question, I don’t know. I can guess what they’d do. There’s one or the other. They’re either going to say, “Okay, let’s retrench and reshore and let’s inflate the debt away and let’s come out stronger.” And that’s the happy outcome. And the unhappy outcome is like August, 1914, and we foolishly charge into a situation that is sort of very, very dangerous, because it would very quickly, in my view, escalate to nuclear war because no one can afford to lose. And it’d be very foolish and tragic.

Grant Williams (48:53):

Yeah. This is all sobering stuff, but that’s where we are. Right? That’s the reality of it. You have to assess things how they are, not how you’d like them to be. But how do you think the shifting politics, particularly in Europe, might change this outcome? Because obviously, what we’ve seen in France, what we’re about to see in the UK in 10 days’ time, what we’ve seen in Germany, what we’ve seen right across these European elections, there’s a message being sent there. And what Macron has done, I suspect, is going to be viewed in time as one of the dumbest political moves of certainly the last 50 years. But how do you think this shifting political landscape affects particularly the conflict that you were just speaking about? Does it give us more of a chance with fresh faces to come to the negotiating table and negotiate sort of peace? Or does the fact that most of the incoming politicians are likely to be populists of some shade. Does that stiffen their resolve?

Luke Gromen (49:54):

I think it’s actually cause for optimism, because we’ve one of the things that’s been interesting to watch, and I’m not a huge political guy, but there’s been sort of this complete turning on the heads of a lot of the political norms of my youth and young professional career. Which is to say the left was always pro-peace and pro-big government and lots of deficit spending, and the right was always pro-war and tight fiscal. And now the right is anti war. And I don’t know that they’re still kind of tight fiscal. I can’t even get it out. It’s very-

Grant Williams (50:32):

They want to be, they want to be.

Luke Gromen (50:34):

Yeah, right. It’s like, “Yeah. Lord, make me chaste, but not quite yet.” Whereas the left is… And the right has also been the personal freedom side, at least over here. We’ve gone from the… And the left has gone less personal freedom, more war, more big spending, and it’s like… So I’m actually very optimistic that the populists will, in this shift right, I think in Europe in particular, I don’t think there’s an interest…

I think there is a, as best I can tell and take it with a block of salt because I’m the last guy you should be talking to on European politics. But just from between what I’ve read and what I’m seeing here, the rise in populism is, I think, I would almost term it less a rise in populism and more a rise in common sense as it relates to the geopolitical side. It almost like a standing down, trying to force the politicians to stand down. Like, “Listen. We don’t want war with Russia. It’s not in our interests. It’s not in anybody’s interest. We don’t want war with China. We want to renegotiate the term of trade, but war over Taiwan is not in our interests.”

And the last 20, 25 years, UK and US in particular, policymakers and everyone around London and Number 10 and the White House, they have zero credibility around war. Their ability to say, “No, this…” I don’t know. I can name four Hitlers in the last 12 years. Right? I got Assad and I got Saddam, and I got Putin and I got… And the reality is neither Putin or Assad nor Saddam offshored our factory base to China. They did, our leaders did.

So I think populism is a misnomer. I think it’s really much more a common sense ism, where people are like, “No. Okay. Allowing 9 million people into the US in a single year is not the right thing to do. Is immigration good? Yes. Is a wide open door good? No. That’s going to cause…” So there has to be something in between there. So I think it’s a shift right. I don’t care right or left, I think just for the moment here, it’s a shift towards common sense so I’m optimistic.

Grant Williams (52:53):

I agree with you on just about every word of that. I think when you are as far left as we’ve been in those policies, a shift right is actually, in its first instance, a shift back to the center, which I think is good for all of us. Right? So it’s good to finish on a note of optimism because this has been, as always, one of those fascinating conversations where we kick around some ideas that people just aren’t really for the most part, comfortable with thinking through. But you are, and I thank you for your willingness not just to do that work and think about it, but to communicate it in such an effective way. So mate, thank you as always for doing this.

And before we close, for anyone listening out here who doesn’t already follow your stellar work, just let them know how they can do that, because as I say, it’s best in breed.

Luke Gromen (53:36):

Oh, thank you. Anyone interested in learning more can go to fftt-llc.com, or follow me on X, I finally said it right, @LukeGromen, @LukeGromen, L-U-K-E-G-R-O-M-E-N.

Grant Williams (53:50):

You heard the man. Follow him on Twitter, @LukeGromen, G-R-O-M-E-N. All right, my friend, listen, let’s do this again sooner rather than later. I really enjoy these chats and it’s been far too long since the last one.

Luke Gromen (54:00):

Likewise, I really do too, so absolutely we’ll do that.

Grant Williams (54:03):

Thanks, buddy. I’ll talk to you soon.

Luke Gromen (54:04):

Sounds good.

Grant Williams (54:15):

Nothing we discussed should be considered as investment advice. This conversation is for informational and hopefully entertainment purposes only. So while we hope you find it both informative and entertaining, please do your own research or speak to a financial advisor before putting a dime of your money into these crazy markets.