Grant Williams (00:00:10):
Before we get going, here’s the bit where I remind you that 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. And now on with the show.
Welcome everybody to another edition of Shifts Happen featuring my mate and co-podder the superb Luke Gromen of Forests for the trees. Luke’s work has been incredibly important to me as you’ll hear me say in the podcast, in putting together an awful lot of dots, which at the time I first came across him back in 2014. Didn’t seem that important, but they just sparked so many connections in my head and it gave me a whole new way to think about the world, and that way to think about the world has been incredibly valuable as things have morphed and changed geopolitically and in the financial system over the intervening decades.
So, I’m delighted to have these conversations with them. It’s been a while since our last one because we’ve both been busy and as you’ll see, there’s an awful lot to talk about. So, without any further ado, why don’t I just jump into this and let you hear my conversation with the brilliant Luke Gromen.
Luke, my man. How are you mate? It’s been way too long. It’s been, well, its last year we last saw each other.
Luke Gromen (00:01:29):
I think that’s right. Things are great. How about you my friend?
Grant Williams (00:01:32):
Very, very good. Very good indeed. Yeah, can’t complain. And as they say, “Even if I did, nobody would care. So what’s the point, right?” What is the point? You and I have been trying to put this together for a while now and unfortunately the further we’ve let it slip in the calendar, the more stuff there is coming up to talk about. I mean, it just feels like the world is moving at a faster and faster pace at the moment, both on a domestic financial level, on an international finance level, on a political level. All of it just seems to be just ratcheting up. So you have so much in your work, which is always just so thought-provoking. What’s kind of top of mind for you right now? What’s the thing that you are focused on the most?
Luke Gromen (00:02:13):
It is probably the pace at which, say three things are happening, the pace at which three things are happening. Number one, the pace at which the U.S. fiscal crisis and debt spiral is accelerating. Number two, the pace at which the Fed’s policy mistake, which was not letting inflation run hot enough for long enough in 2020, 2021, is now accelerating, leaving Powell with a choice. They say generals always fight the last war. Investors always fight the last war. The Fed fought the last war. The rules are different with that. The GDP at 120% the way they were when they started raising rates and deficits as high as they were structurally.
So Powell’s choice now is not inflation or deflation. It is how do you want to lose the long end of the curve? You can lose the long end of the continual curve by raising rates or you can use lose the long end by cutting rates. But barring a productivity miracle, that is its choice and that is still a variant perception, but the pace of events that I think are people in that direction is accelerating. And then the last thing is something you and I have obviously talked about for a long time, which is this de-dollarization of global oil markets. I was really surprised when the Wall Street Journal quoted the head of JP Morgan’s Commodities desk at the end of December saying that 20% of the world’s oil traded in non-dollars last year.
It has been missed by many people, myself included, that the Yuan, the E-Yuan, the digital Yuan has traded in the fourth quarter in both volumes of oil and volumes of gold curiously. So that is also of great interest to me. Obviously you’ve had a number of oil exporters join the BRICS. The Saudis have been in the BRICS then, not quite yet, then in, then not quite yet. So who knows, I think ultimately they’ll be there. But this de-dollarization of global oil is moving faster than expected and that then reverberates back into the U.S. fiscal crisis. If you can buy commodities outside the dollar, you don’t need as many treasuries as deficits are rising. Wash, rinse, repeat.
Grant Williams (00:04:33):
Let’s take those in reverse order because obviously that third one, as you said, is going to feed back into number one and probably through number two, so it probably makes sense to take them in reverse order. So let’s talk about this de-dollarization because as you say, it’s something that you and I have spoken about for a long time and you for me, above anybody has been right about this probably the longest. I remember when we first connected back in 2014 probably, we were talking about this and you’d done some phenomenal work on it. At a time when there were a lot of dots to connect and you connected them brilliantly, but they were in a multitude of places and they were very obscured by an awful lot of other stuff going on.
And like I said, when I first read that piece of your was was one of my aha moments that really helped me connect all those dots. So let’s not go back through that whole thing because it’s there for the record. You’ve talked about it a lot and I did a presentation about it after I read your work. But let’s talk about this de-dollarization idea and let’s talk about why it’s accelerating. I think there’s some very important reasons, but I’m curious to get your take on it.
Luke Gromen (00:05:33):
It’s accelerating in my view because China has issues. One of the great fallacies is that de-dollarization is happening because China’s strong and the U.S. is weak. And a lot of times people pin that on me. They’re not listening to what I’ve been saying. It’s not happening for that reason. China has to do it. If China does not de-dollarize, its oil imports, its commodity imports, it will run out of dollars and have a Southeast Asian 1997 currency crisis, economic crisis, political crisis.
So as we see these headlines out of China that things are getting worse, stock market’s down, commercial real estate, blah, blah blah. Yes, yes, yes. And guess what? That increases the urgency with which they need to shift their commodity import bill out of dollars into Yuan. And they’ve been doing that. I think that’s reason number one. Reason number two is two years ago the United States came out and said, U.S. treasuries are only risk risk-free if you forever more agree politically with everything the United States says.
And increasingly the United States geopolitically, economically, socially, culturally has been losing its mind over the last three years, five years, 10 years, 20 years, but in particular in the last two years when we said that two years ago, “Your money’s not safe, we will take your money as we did to Russia. If you don’t go along chapter inverse with what we tell you to do.” And that was gasoline on what was already a de-dollarization of commodity market fire. It’s simply you can’t hold oil surpluses or trade surpluses that you need to use to buy oil in treasuries any longer.
And we can see this in the data 2014, global effects reserves, global central bank effects reserves were $12 trillion. Fast-forward 10 years, they’re $11.9 trillion. So down a hundred billion in 10 years. In contrast, total U.S. debt outstanding went from $17 trillion to roughly 34 trillion. So up $17 trillion and central banks that had bought the prior 10, 15 years, 60% of it, 50% of it bought less than 0% of it over that in swing 10 years. And that is I think the biggest macro gear of what is going on. That is the why of de-dollarization. It’s really too prong. China has to and the US will take your money if you don’t play by our rules.
Grant Williams (00:08:01):
Let’s come back to the second one and second because I completely agree with that. But let’s focus on China first and help people understand why it’s so important for China to do this. The difference once they de-dollarize, the extra levers it gives them to be able to pull in terms of dealing with the multiple potential crises you outline in commercial, real estate, stock market, et cetera, et cetera. And why from a political standpoint they might need to do it.
Luke Gromen (00:08:26):
So to simplify, there’s three big dollar outflows China has, interest expense/debt service, tourism and commodities. Those are the three biggest. Tourism is what it is. Interest expense is what it is. Commodities have some ability to be managed. In other words, Kyle Bass gave a great interview four or five years ago. Think he was with Keith McCullough where he said, “Look, we can collapse the Chinese government and economy as follows. China needs to grow to support the debt. China needs oil and commodities to grow to support the debt in increasing volumes. All that oil is in dollars. They have a finite pile of dollars. So as China’s oil imports go up and the price of oil goes up, they’re going to run out of dollars. And when they run out of dollars, they will have a currency crisis and the government will collapse and the economy will collapse.”
And he’s a hundred percent right. Kyle is 100% right. Unless they start shifting to a currency they can print, which is Yuan, which they have, offering net settlement in gold in Shanghai, Singapore, London. Anywhere they’re trading Yuan and gold side by side is effectively net gold settlement was started in Shanghai and the narrative around this has changed. So when Kyle first said that he would say, “Oh, well no one’s going to take that wampum.” Well guess what? The head of commodity trading at JP Morgan just said, the world’s taken a lot of that wampum. Why? Not because they trust the wampum. Nobody does, but they all trust gold. Everybody trusts gold and it’s not all getting settled in gold of course. Most of it is getting settled in Chinese goods because as it turns out, China makes everything for everybody anyway. They’re the factory of the world.
So what we’re having is this virtuous system out of necessity for China where if they don’t do this, they are going to collapse. And oh, by the way, if China collapses the global economy banking system, everything’s going to collapse like six seconds later, right? It’s like the Michael Lewis, two guys tied together in a boat and one kills the other, throws it overboard and then finds himself being dragged to the bottom. That’s U.S. and China number one. And there are people in the U.S. wise enough to realize this in the administration.
But China has to do it to avoid collapsing. They are doing it, people are taking it, and Russia ends up with Yuan surpluses from selling oil to China and then they take the Yuan surpluses and they buy everything you and I buy that’s made in China, which is basically everything, improving standards of living in whatever country that does that. And if there’s anything left over, which tends to only happen if you’re selling oil and commodities to China, then you settle the net amount in gold and that’s happening at the central bank level as well. So it’s all, enlightened self-interest essentially, or desperate self-interest. But that’s why it’s happening.
Grant Williams (00:11:18):
It’s interesting because as you’ve alluded to there, once they de-dollarize, once they do have this currency they can print, it obviously changes an awful lot of things that they can do too as the U.S. have done to prop up their economy in terms of, I don’t know what the Chinese for TARP is. CARP, maybe. I don’t know. But it gives them the flexibility they don’t have now and it’s so important to realize that they desperately need that flexibility.
And I always remember this. I did an interview with Jeff Gundlach several years ago and he said this to me, “Greed and fear are powerful, greed is powerful, fear is more powerful, but there’s one thing more powerful than both and that’s need.” He said, “When you need to do something, you don’t have a choice.” And it’s interesting you use that word about China, they need to do this and I think you’re absolutely right and they don’t have a choice.
And so whether you like it or not, whether the evidence is compelling to you or not, the direction of travel I believe is inarguable. And because of that it’s beholden on all of us to think about this and work out the changes that will occur if they get to where they’re going to go. And they are profound.
Luke Gromen (00:12:26):
It’s exactly right and critically no matter what happens, even if China were to collapse, which I don’t think is going to happen, it kind of gets you to the same place because if China collapses, the resulting deflationary implosion U.S. tax receipts aren’t going to come close to covering the interest on our debt, in which case they either print it or they default on it. In which case, what do you want to own? Treasuries are gold. The answer is gold. So it’s a Hobson’s choice. There is no choice. The Chinese have to do it. And it’s not necessarily in our worst interest, it’s in the worst interest of certain elements that have done really well in Washington DC over the last 20 or 30 years. It’s not in the worst interest of America.
Grant Williams (00:13:12):
That’s a great point. Look, and coming back to gold, I spoke to Julian Brigdon recently and we talked about gold and I just asked him what his thoughts anyway and he said, “Well, it is kind of done okay. It hasn’t really done much. I can see a case for it going higher and there’s plenty of potential tailwinds, but I think it might tread water a bit.” I said, “It’s really interesting that we are sitting here talking about gold performing okay and it hasn’t really done anything. It’s trading above $2,000.”
And that’s to me, a big signal of the change in the environment here is that people are looking at $2,000 gold as a floor now rather than a ceiling as we did for so many years, and they kind of think that nothing’s really happening in gold and it kind of looks like it isn’t because you have this paper physical markets that don’t reflect what’s happening. But we’ve seen the central bank data the last two years we’ve seen that the gold is moving eastwards. And again, that may not affect things right now, but you’re chipping away at the foundations of the financial system, you’re gnawing away at the beams in the ground and at some point that change is going to be felt. Do you get any sense of where we are in that timeline?
Luke Gromen (00:14:29):
To me, I look at gold at where it was this morning, $2,050. Above $2,000 I think is an extraordinarily encouraging or bullish point because number one, $2,050, in spite of the most aggressive fed rate hiking cycle in 45 years. $2,050, despite the fact that us real rates are positive and in fact gold has completely separated. And to me, I think most investors are misunderstanding or misreading the message of gold having completely separated from U.S. real rates for the first time in at least 20 years started really in September of 2022. Most of them are looking at that chart and going, “Okay, the jaws are going to close by gold crashing because we’re all so battle-scarred over and over and over.”
However, I don’t think that is the correct interpretation. I think the correct interpretation needs the context of where we are in the debt and deficit position of the U.S. because people in Argentina, people in Venezuela, people in Banana Republic’s, emerging markets with debt problems, Turkey, all these places, if you ask them, “Hey, what does it mean when real rates are positive, when rates are going up and gold is going up despite that in your currency?”
And then I’ll go, oh, that’s easy. That’s a debt crisis, that’s a sovereign debt crisis and that’s the variant perception. Gold diverging from U.S. real rates is telling you in no uncertain terms that in September 2022 when the Treasury market dysfunction and Yellen came in and completely offset QT by running down the TGA to weaken the dollar to preserve the functioning of the Treasury market. Gold’s telling you that was the starting date of the U.S. fiscal and debt crisis that everyone thinks is still years away. It’s already almost 18 months old. The acute portion of it certainly. I also think it’s super important and completely misunderstood or missed by most in the gold community, let alone the broader community that when we tie in what we just discussed with Yuan oil and why China needs to do it and that China has done it, China has now set up a Yuan oil price and a Yuan gold price and they need oil to work, then they actually need gold to work too.
They don’t mind gold going up. Gold going up means that their creditors holding gold after exchanging gold for Yuan surpluses. It means gold will go up in Yuan terms, which means their creditors will then have more Yuan with which to buy more Chinese goods in their factories, sending the Chinese kinds a virtuous cycle. So China doesn’t mind gold going up and it needs a lot of relatively cheap oil, but certainly oil in Yuan terms, which means they’ll be shifting more to Yuan over time. This then reverberates back into the gold market because if you have the law of one price as the same good or ratio can’t have two different prices at the same time in two different currencies adjusting for the DFX rate. So if you have a Yuan price of oil and a Yuan price of gold and you have a Yuan gold to oil ratio. How many barrels of oil does an ounce of gold buy? At the same time you have a dollar gold price and a dollar oil price.
Historically the dollar gold price has been managed, shall we say, by the unrestricted growth of unallocated paper derivative gold, unallocated paper gold. So that historically though there was no other currency where there was a gold oil ratio, there was no other currencies where you were trading oil in any volume. And so the U.S. gold oil ratio was the ratio that was it. Well now the gold oil ratio in Yuan and the gold oil ratio in dollars starts to allow China, out of need, they need the oil to prevent what we described earlier from happening, the economic crisis we described earlier. They need the price of gold to rise in oil terms and it’s not paper oil and it ain’t paper gold that they’re dealing in. They’re dealing largely in the real thing in both cases, unlike the west as it relates to gold.
So what the launch of Yuan oil in volume with Yuan gold settlement is doing is it is wresting control of the gold price from the West, London and New York in particular to China because China needs to avoid the aforementioned crisis. That is further driving the separation of US real rates, inverted real rates from gold, which is incredibly important because to the extent that the price of gold goes up, all else equal, that’s a signal on inflation, on price level, on rates. And so this is super powerful. It’s something most miss, which is Russia selling volumes of oil in Yuan to China and recycling into gold to the effect that wrestles control of the gold market from the west. And by the way, you can see this in the data, Jan Noyenhuis had a great piece last year at Gainesville Coins. I think the title of it was The East has Gained Control of the price of gold from the West. And he just shows all these charts for beta going back decades and all of a sudden 2022, the historical relations went on their head.
That is China gaining control of the gold price using Yuan oil facilitated by Russia and others out of necessity to prevent China from collapsing. So it’s extraordinarily powerful. I think the message of gold at $2,050. I couldn’t be more bulled up about it at $2,050 than I am because when I look at these factors, wow. It’s going to be volatile. There’s still a fight going on around it, but I think it continues to grind higher through this year. I think it surprises a lot of people this year. I wouldn’t be surprised if it’s $2,500, $2,800 at the end of this year.
Grant Williams (00:20:49):
Yeah, I don’t disagree with any of that. But the interesting thing though about this, as you said, this wrestling of control of the gold price to the East is fascinating because like the west, they are incentivized to keep the price down, right because they are actually trying to accumulate the metal, which is not what’s happening in the West. So ultimately it explains why people think, “Oh well if the east controls the price is going to go skyrocketing because they want to own the gold.” No, they want the price to be as low as they possibly can because they actually want to secure the physical metal. And that’s such a big change from how the market has functioned in this world where the price has been set in the West because it was all about keeping the price down just to keep the price down. It wasn’t as a means to acquire the metal.
Luke Gromen (00:21:31):
Historically. I agree they wanted to keep it down, but I think it’s gotten very realpolitik now. Right now I think they own a lot, their creditors own a lot, their key creditors own a lot, their citizens own a lot and they’ve obviously been encouraging their citizens to own it forever. So I don’t think they want it to spike per se, but I think what they want it to do is just a nice consistent orderly rise because again, that spins this. Number one, I think what’s going to rise is the gold to oil ratio. So the gold to oil ratio in China I think will go from equal to the U.S. which oh by the way, the gold to oil ratio since China reopened the gold window with Russia in 2014, it was like eight barrels an ounce and it’s like 25 barrels an ounce. So gold has tripled in oil terms in the last 10 years.
I think the gold oil ratio is going to rise a lot more in coming years simply because the oil market is way bigger than the gold market physically. It’s 15 times the size of the global gold market annual production terms. So I think what we’re going to see here is as China prices more volume of oil in Yuan, there’s going to be more Yuan that then end up at commodity exporters. To the extent they do not recycle that into Chinese goods growing the Chinese economy, they’re going to buy gold. And the oil market, the commodity market’s way bigger than the gold market. And as that happens then it’s a virtuous cycle of trade. The gold then grinds higher in price over time as the gold trades higher in price that gold grows in terms of Yuan purchasing power, which means then China’s managing the gold price, they want it managed higher.
And what’s really interesting in this is, I have a good friend of mine, DC, who highlights this 200 day moving average of the price of gold in Yuan. And he says to me, “Luke, this is the lowest Sharpe ratio, most beautiful chart on the board. It is like up with these gentle undulating curves, up into the right, like a 25 degree angle. As you look at your screen and it’s beautiful and nobody has the trade on.” If that chart was the Nasdaq or if that chart was the Dow or if that chart was US housing, if that chart was anything but gold, you would have 16,000 hedge funds and ETFs all plowing gazillions of dollars into it because it’s like the Holy Grail. It is like up into the right 25 degree angle, low Sharpe ratio, buy it, put a little leverage on it, go to the beach and have Mai Tai.
And instead in the West, nobody has it on any real size. There’s a few guys who have it on. The only people who have it on are the PBOC and The Central Bank of Russia in any size. But there it is. And again, none of that matter. The Yuan price of gold on a 200-day moving average or the last 25 years doing that. If oil is not priced in volume in Yuan, then all a rising price of gold in Yuan tells us or drives in the marketplace is a falling Yuan against the dollar because the dollar controls the gold price. But now we have a gold oil ratio in Yuan. We have a gold oil ratio in dollars now, “Hey, the Yuan gold buys me more oil than dollar oil, get my gold out of London, get my gold to the extent it’s there out of New York, take it to a Yuan, convert it, buy me more oil.” Wash, rinse, repeat. Oil is subject to the same beautiful virtuous cycle as everything else and everybody needs oil mean.
We’re over fighting in the Middle East over it for the last 60 years. So it is so powerful what’s happening and nobody’s there. Very few people see it. People say, “Well, it’s decades away.” We’re a decade into it and nobody’s there still. They’ll get there, they will GLD over TLT. The gold ETF over over TLT is up 3X nearly since Central Bank stopped buying treasuries on net and started buying gold in 2014. I think the GLD over TLT will rise 3X again, but I don’t think it’s going to take another 10 years. I think it might happen in the next five years or three years.
Grant Williams (00:25:49):
It’s fascinating because as you talk about that, I’m just thinking back to what you wrote in 2014 and it was a theory then. We are watching it actually come to life in front of us now. These split ratios and the fact that you’ve got them in different countries and there’s an arbitrage opening up, it’s all happening. And it’s interesting what you said there about wanting the price to rise, and I can totally see that and I know that’s the ultimate end game for me. I keep having this flash in my mind that cartoon where you’ve got the U.S. and the Chinese fighting each other and there’s a fence and that Americans are throwing gold over the wall and the Chinese are throwing money back at them. And I just get this sense that there’s this moment in time and I feel like the Chinese must realize this or let’s not make it the Chinese.
It’s not about just them and that kind of reduces the argument. These BRICS central banks that are demonstrably trying to accumulate more gold have this moment in time where people are still throwing the gold bars over the fence at them. And so I’m thinking, “I don’t want it to rise. When they stop throwing it, then I’m happy to let it rise, but I’ve got a window here to accumulate gold at prices that I may not see again for some considerable time. So why not take it?” Because as you say, the supply is finite and it only increases a tiny amount every year unlike oil. And so you’ve just got this moment, why not take advantage of it? Because when that’s gone, it’s gone. And once the game’s up, the game’s up and you are going to be in a complete fight to get an ounce of gold rather than have it thrown over the fence at you.
Luke Gromen (00:27:18):
I agree, and I think it’s really interesting away from the BRICS because they’re doing what they’re doing, like you said, demonstrably they’ve been buying gold, reserving gold, not treasuries. To me, a key moment in this whole fight of throwing cash versus gold, dollar cash versus gold was in December 2022 when the man who is arguably the smartest and most politically connected banker in the room in the United States, Jamie Dimon, he’s the CEO of JP Morgan and JP Morgan comes out in December of 2022 and becomes the second custodian on the GLD ETF, the biggest gold ETF out there, which I look at as simply the biggest freestanding pile of physical gold in the world basically, private physical pile freestanding gold in the world. 18 years after the ETF was launched, right? So GLD is launched in November of ‘04 and for 18 years it was just HSBC.
JP Morgan could not have cared less. In 2019, JP Morgan’s gold desk gets brought up on RICO charges, which serious stuff in 2019. And then we have 2022. I mean there’s some other stuff we can put in the middle. But in 2022 after 18 years, JP Morgan decides now’s a good time to become the second custodian on the GLD making it the only gold ETF as of that time with two custodians. And then three months later, JP Morgan announces we’re going to move some of the gold out of London for the first time to Zurich into New York. And by June of 2023, just six months later, over half the gold that had been sitting in HSBC’s custodial vaults for GLD is now in JP Morgan custodial GLD vaults, some of which is outside London for the first time.
So I look at all of that and I go, let’s say for sake of argument that JP Morgan, the Dimon who was the smartest and most politically connected U.S. banker as of mid 2022, was still the smartest and most politically connected U.S. banker as of summer 2023. In light of all those things that changed, did we just watch JP Morgan go from being on the side throwing the gold at China to the side, throwing dollar bills and taking gold back? And I think that’s what we watched, which is only to say that I agree all these central banks are going to try to buy it as long as they can. But that once you get JP Morgan taking those actions, we’re getting into late innings of this recognition collectively of, “Huh, okay. Throwing gold and getting cash is the wrong trade now.”
Something changed that they suddenly wanted to be part of that. And maybe it’s as simple as, well, they just wanted to collect the fees. Well the fees were there for 18 years, why didn’t they want them then? It wasn’t like gold didn’t do anything over those 18 years. So if they think gold’s going to be in disaster, why go to all the trouble? Unless you think the price of gold that something’s changed, where the price is going to go up over time, and you know what? Those fees might be kind of juicy and let’s do that. To me, it’s interesting.
Grant Williams (00:30:29):
It is. And these are the kind of arcane headlines that come across the wires, adding custodians. People are going, “Big whoop. Who cares.” The thing’s still going to try exactly the same. Moving custody is some of the gold. So there’s a big vault in New York already, the whole golden zero, that’s no big deal. But these are the kind of little details that you have to piece together to try and understand as you say, the wider moves. And they are, again, I’m going to use that word because I think it’s the most apposite and that’s profound. These are profound changes.
Luke Gromen (00:31:00):
I agree.
Grant Williams (00:31:01):
Well, let’s move on to the second part of what we spoke about and that’s this idea of the weaponization of the dollar. Let’s call it the further weaponization of the dollar and this action with the Russian Central Bank that has effectively forced, as you said, every central bank in the world to completely reconsider their reserves policy as a matter of national security effectively. Because as I’ve said many times, you cannot have your reserves at the whim of a potentially capricious government even if you think in the moment, well there’s no way we’ll be on the other side of the Americans. World War II would be a good example to say that that can happen.
So let’s talk about that because it was important at the time and you and I talked about it at the time. We talked about it in the months afterwards without really seeing the data come through, but you are seeing that data now. And it is funny that when you talked about that the percentage of treasuries being held by foreigners not moving, that’s to me I would be the most perfect way to think about this because people show individual countries and they go up and down and they say, “Well, look, China’s buying now or whoever’s buying now or someone may be selling, but it’s all…” But at the end of the day, if the net move is effectively down a hundred billion over whatever period of time as you quoted…
Luke Gromen (00:32:13):
It was over a decade, down a hundred billion over a decade while the debt went up $17 trillion.
Grant Williams (00:32:17):
It’s a huge red flag. So how does this change in the dynamics? How does this newly installed need, again, there’s that word for central banks to think about switching their dollars into gold? How does that affect the pace of this now in competition with all sorts of other people to get this and they’re pricing sensitive buyers? Let’s face it.
Luke Gromen (00:32:39):
The pace of this change that we’re seeing in gold only accelerates the pace of the U.S. fiscal crisis. So we’ve had federal debt in the U.S. went from 17 trillion in 2014 to 34 trillion today, foreign central banks who are price insensitive buyers who had bought… From 2002 to 2014 central banks had bought 55% of aggregate U.S. debt issuance over the prior 12 years. So we only had to find financing for 45% of what were way smaller deficits. Structurally from 2002 to 2014. 2014 to now our debt’s gone up $17 trillion. Central banks have literally bought negative 100 billion of it on net. And so what has followed has been, I think you and I referred to it as the Treasury, the macro version of I love Lucy and Ethel with the chocolates. So the chocolates or the supply, the debt, and they just keep coming faster and faster and faster.
And so at first, Lucy and Ethel can keep up and then they’re not able to, they start stuffing them in their mouths and their hats and their shirts and their aprons. And that’s what’s been happening. Since 2014, we’ve had U.S. banks regulated into buying treasuries, U.S. pensions regulated into buying treasuries under Trump, money market funds regulated into buying treasuries, right? So banks bought about $2.7 trillion worth of chocolates from 2014 through 2021. Money market funds 2015, 2016 regulated into buying about three, $3.6 trillion worth of chocolates at the short end. U.S. pensions, about $1,000,000,000,008 of chocolates at the long end post 2018. And of course the biggest buyer in this time of chocolates, every time that basically Lucy and Ethel so to speak, ran out of room and started puking up chocolates, which is yields going up or treasury market dysfunction, was the Fed, whose balance sheet in that time has gone from, I don’t know, $3 trillion to high $9 trillion and now it’s back to $7.8 trillion and they’re getting victories for, “Hey, QT, great job.”
I was here when Bernanke promised the $800 billion or when we were going back to $800 billion from $4 trillion. So you know what it’s like that meme of the guy’s celebrating and you pan out and he’s like an eighth place or whatever. Nice job guys. Heck of a job Brownie to paraphrase President Bush. So what this then ends up doing is the faster we move away from treasury, central banks move away from treasuries because nobody likes to store money in a bank that steals it from you anytime you say something wrong in the global political arena. Then what that does is it simply adds to the net effective supply of treasury, issuance, our debt on the other side, which is growing exponentially anyway because of our demographics. And more recently because Powell’s been raising rates. So now he raises rates, he sends interest expense up, deficits up, he starts breaking commercial real estate, which is fine.
Hey great, we need to get rid of the bubble. Well guess what? The banks hold as high quality liquid. You regulated them 10 years ago you said buy more treasuries because you need more safe and liquid assets to sell in a crisis. So fast-forward 10 years, the crisis is here, commercial real estate, oops. And now they go to sell the treasuries and they can’t because underwater. So now they either have to take a write-down and/or by the way, they start breaking the treasury market. And we could see this. 10 year treasury yields went up into the SIBB crisis last March until BTI. And so this is now leading to, because you did all these things to stuff chocolates in every nook and cranny of the U.S. economy and monetary system in a procyclical way. Now anytime the dollar gets too strong, especially when you layer on all what foreigners bought over the years, the dollar gets too strong and treasuries sell off.
Treasuries have in the last three, four years began trading like risk-off assets at the long end, not risk-on. And that has very powerful implications for monetary policy and for inflation secularly because if treasuries are risk-off asset at the long end as they are demonstratively, you can see that in the data, you can see that in the correlations. Jeremy Schwartz at WisdomTree, a great chart that we shared with clients a couple of weeks ago, noting that the correlation on a three-year rolling average between a three-year rolling basis between the dollar and US stocks is negative 0.63, which in the real world correlations is nearly perfect. So the dollar goes up too much, stocks are going down. And in the same chart showing that the positive correlation of US stocks and bonds is the highest in 25, 30 years at 0.73, which again, in the real world as perfect a correlation as it is.
So if the dollar goes up based on all these actions we have taken, treasury market’s going to break and stocks are going to break. And then things get really, really simple if you’re Powell, if you’re Yellen. Do we stand aside and let the banking system collapse and all these banks sell treasuries and then money market funds sell bills and pensions, sell treasuries and stand aside, or do we keep supplying more dollar liquidity incrementally and we turn into the stealthy marginal chocolate eaters, which is exactly what’s happened, 2019 repo rates by 2020, et cetera, et cetera? So the critical takeaway is that, again, this is something most people say, “Well yeah, our debt’s too high, but this isn’t a problem for 10 years.” It is a problem today, it is very acute today. We’re already five to 10 years into this problem and it’s only going to get more acute over the next several months and next year and the year after that, barring some sort of productivity error.
Grant Williams (00:38:35):
Beautifully put. And the L word, right? Liquidity. Everything’s become about liquidity And you’ve written often about this kind of shadow third mandate of the Fed, which is market stability. And it’s been interesting to watch the Fed so keen to signal that they were going to cut rates so keen to give the market that all clear. I was talking to someone this week and we were talking about the Bank of Japan and I was explaining that when the Bank of Japan, we were talking about normalizing rates, their language is much more vague, but the nuance therefore is much more powerful. And so the shift in Japan is that our bias has moved to tightening. We’re going to have to find a reason not to tighten now. Whereas before they had to find a reason to raise and that’s a big, big shift. And so for the Fed, as you say there, this idea that liquidity is important, we’ve got a signal to the markets, there’s going to be plenty of it.
And you’ve outlined very clearly how this kind of synthetic QE has worked, which is what we’ve been seeing. So if you can, I’d love you to walk people through that because again, there are an awful lot of TLAs, these three-letter acronyms out there and these cute little programs which are opaque enough that no one needs to really understand what the RRP is and they don’t need to understand what the TGA… They don’t need to understand all this stuff, but trust us, it’s all good. But when you put it all together and you come up with this stealth QE, you realize just how important all this stuff is.
Luke Gromen (00:39:58):
You can look at a number of different things. I mean you go back to 2022, I sort of put myself on a limb and I said the Fed’s going to have to pivot by the third quarter of 2022. And I was wrong. The Fed didn’t pivot, but I was wrong with an asterisk in my opinion, which is to say the Fed didn’t pivot. But what happened was the Treasury market got very dysfunctional, which was what I thought something like that would happen. And I thought the Fed would respond. The Fed didn’t respond, who responded was Yellen. She had a TGA and she ran it down so aggressively, which is to say she injected dollars, saved up dollars, into the economy that more than 100% offset the Fed’s QT at the time. So she was net loosening, that weakened the dollar given the structure of the global economy.
You get the dollar down, you’re going to inject global liquidity for a number of different reasons. That happened, the dollar fell from October of 2022 into early 2023 at a 35% annual rate, which it is hard to overstay in currency markets. A 5% move is frigging enormous. A 35% annual rate decline in the dollar is huge in terms of liquidity. And that bought them time through 2023. We get into late third quarter, 2023, again, even in 2Q she ran down TGA enormously basically to zero because of the debt ceiling charade. So then we get to the end of that, we get the debt ceiling removed, if I remember right, which is a whole separate issue. We get to the third quarter and she extends duration in a surprising amount. And even with inflation coming down, growth started accelerating, she issued more at the long end and we went into the early stages of debt spiral.
To be clear, TLT crashed. Everyone was looking for the crash in stocks or in the banking system. TLT crashed in the third quarter last year it was down 20% in a quarter. This is the deepest most liquid market in the world. It is hard to overstate how important that was. And as soon as it was got the 5% on the ten-year, and as soon more importantly as the move volatility index hit 130 on the upside, which is exactly when Yellen had stepped in 2022 and in 1Q 2023 and SIVB, when Powell stepped in with BTFP. Mid-October, it hits 130 on the upside. And for reference, the creative index, Harley-Basman said anything over 140, 150 is the Fed losing control of the bond market. So that’s why that’s important. It hits 130 on the upside and mid-October, in the next nine trading days, seven Fed governors come out and say, “The bond market’s done our job for us.” Jawboning the dollar down. That’s jawboning rates.
Then Yellen comes out and surprises all the people that are very focused. There’s a whole bunch of very smart people, very tied in people who’ve been watched the quarterly refunding. They were almost too, a man and woman surprised by what Yellen did on November 1st, which is shift issuance out of the long end into the short end and bills, which then taps the pool of stored up QE, but there to for sterilized known as reverse repo. And they began running down sort of historical QE that had been stored away in this and that pile of chocolate. So when you talk about synthetic QE, QE, the effects in the market are dollar down, liquidity up, long end rates contained because duration supplies are reduced on a net basis and bank reserves go up. Okay, that’s QE. Those are the effects of QE. When you go into fourth quarter and you look at what Yellen did by shifting issuance to the front end; reduces supply of duration, check; injects all liquidity and weakens the dollar, check; increases bank reserves, check.
Why? Because it’s coming out of reverse repo being spent by Yellen and T-Bill, and then the money shows up in a bank somewhere from a T-Bill or reserves go up. There’s no functional difference in the two. So it was synthetic QE. Why was it done? It was done because the Treasury market was malfunctioning. And that is the absolute most critically important thing because in a time where everything seems nuts, every single time since 2019 when the Treasury market malfunctions, Powell and/or Yellen hop to it instantly to supply dollar liquidity. It’s as close a thing to a macro North star as we have now. And it’s for a simple reason. They’re not going to cut benefits to boomers and they’re not going to cut the Fed’s spending. And if they can’t do those two things, then they have to inject all the liquidity and constrained rates.
Grant Williams (00:44:26):
It’s interesting because the Treasury’s role has completely changed. The Treasury is not there to be the financial arm of the government anymore. It’s there to maintain market stability again. So now we’ve got our two best fire trucks at the scene of the blaze, right? We’ve got fireman Sam and Fireman Janet or both there pouring the hoses and everything and forget everything else. It doesn’t matter what else is happening in the world. We can’t take any other calls. We need to stand here and make sure this pile doesn’t catch fire again, which is terrifying. And that brings us neatly to the first thing that you mentioned, and that is this fiscal crisis that the US has and the possibility that they lose the long end of the curve, which would change the world dramatically, let’s put it that way.
So let’s end and talk about this fiscal crisis because again, your work on this has just been stellar and the way you couch these big ideas, but then lead people through the trail of breadcrumbs very, very precisely is just world-class, man. Honestly, I’m a big fan of your work and I’m not just saying this.
Luke Gromen (00:45:25):
Oh, I appreciate it.
Grant Williams (00:45:25):
The way you do it is exemplary and there’s a lot to be learned from walking people through this. So let’s explain the nature of the fiscal crisis first and then let’s walk through how it unfolds so people know what to look for.
Luke Gromen (00:45:38):
The nature of it is pretty straightforward, which is too much debt, too much deficits, not enough buyers, not enough price sensitive buyers. And not enough price sensitive buyers is not a problem as long as the aggregate amount of debt is not too high because then price can go up and you can find where the buyers are. That’s what happened in the seventies. The Volcker, screw it, take them to 20, okay? He took them to 20 or 15, and the US government was never at risk of insolvency because that the GDP was 25, 30%. And our economy, our receipts were nowhere near as interest rate sensitive as they are now because we’ve financialized for the last 40 years. The problem comes when you financialize your economy for 40 years, so your DVO one or sensitivity to a increase in rates is very high, and when you let your debt, the GDP balloon to 120% doing stupid stuff geopolitically and economically over the ensuing 30 years because you believe your own press clippings about I can do whatever I want forever.
Now, when you lose your price insensitive buyer, you have your price sensitive buyer show up, but if the price sensitive buyers price based on fundamentals is above the rate that you can afford because of your debt and deficits, you’re done. And anytime it goes above that, you’re going to have treasury market dysfunction. You’ve got to come in. And that’s what we’ve been seeing. And that’s in essence the crisis is the debt is so high and they’re the most price sensitive buyers. Number one, central banks. They haven’t bought a treasury in 10 years on them as the debt has doubled up $17 trillion. They say, “Well, don’t worry. We can get the Japanese insurers.” Yes, sort of, except that’s a function of the dollar. If the dollar gets too high as it currently is, by the way, for their like. You can look at FX hedge 10-year treasury yields. To a Japanese buyer, right now it’s at negative 2.5%. The cost of hedging the dollar is so expensive.
They’re not going to buy it unhedged, because you clipping a 4% coupon and it drops 30% a year, you lose your job. So price sensitive buyer A) is central banks, B) are these pension funds and the dollar’s too high for them to buy in enough amounts. Okay. Price sensitive buyers you get into now, which are pensions. Okay, pensions are fine. They can buy some, insurance companies can buy some because there’s a duration matching, a liability matching aspect. They’re nowhere near big enough. We’re spitting out $2 trillion a year deficits. They don’t have that demand. Okay, the banks. Well, the banks can buy for a while, but at some point the price sensitive rate starts to blow up the bank’s loan books like commercial real estate. Uh, oh. Now I got to take losses on these. I can’t keep buying. I need to sell these.
This then gets in foreigners. Hey, why won’t foreigners, former foreigners can buy some more, but again, it’s dollar level sensitive. The foreigners have borrowed $13 trillion in offshore dollar denominated debt over the last 15 years. They’re short dollar. They’ve bought $18 trillion on net of dollar denominated assets. Seven and a half trillion of that is treasuries. So again, if the dollar goes up on them, you sell what you can, not what you want to. What do you sell to raise dollars to address your dollar short that you’re getting squeezed on the dollar debt? You sell treasuries. So the dollar, and this goes back to why Jeremy Schwartz’s chart shows you this nearly perfect negative correlation between the dollar and all stocks and bonds and treasuries. Why treasuries are trading like a risk-off asset. We have spent the last 10 years after Central Bank stopped buying treasuries, stuffing everybody around the world in the private sector with chocolates while they continue to borrow in dollar terms, shorting chocolates on the other side.
And now anytime the dollar goes up too much, they sell, everyone sells. And this is why what the fiscal crisis ends up looking like. So this leaves Powell, based on the evolution of this over the last 10 years, leaves Powell with a simple choice. His choice isn’t inflation to deflation. It’s do I want to lose the long end by raising rates or by cutting rates? And what I mean by that is if he cuts rates here, I mean, let’s knock that out of the way because that’s a short version. Go to anybody on Wall Street Fed cuts rates with nominal GDP running six wage inflation at four and a half. What happens to the long end? And they’re like, “Oh my God. It gets sold.” Okay, that’s easy. The part that most of Wall Street doesn’t understand in my opinion yet. They started, they got a brief glimpse of it 2023, is if Powell tightens like today, good jobs number, great. Tighten.
Okay. Now the dollar goes up, dollar’s up today. Foreigners, they’re short $13 trillion debt. Dollars going up on me. What do I sell? Treasuries. Banks, commercial real estate’s already a shit show. Okay, so now if rates go up, it’s definitely going to start hitting. They got to start reserving losses. What do they sell? Treasuries. Corporates, as the dollar goes up and emerging markets, economic growth gets squeezed. Multinational corporations, uh-Oh, our earnings starts slowing. Okay, well what do we have? We have cash sitting in money markets. Okay, great. What do they own? T-Bills. Okay, let’s bring some… Oh. Pensions. People start laying people off. Okay, great. I’m going to take early retirement. You got to pay out pensions. What do pensions own?
Grant Williams (00:51:08):
All together now. Everybody join in with the chorus.
Luke Gromen (00:51:11):
Treasuries. There’s this debate, and again, it’s mis-framed in most places I see online. Most people say, ‘Oh, who’s going to buy the Treasuries up?” Again, the issue is not who’s going to buy the Treasuries. The question is who’s going to buy the Treasuries at a given level of the dollar, which implies a given level of rates? And can the U.S. government afford that level of rates given their level of debt and the current level of the dollar? The answer is nobody. And then the answer becomes, okay, well then rates have to go up because deficits are going up until we find that buyer. But since 2019, we’ve increasingly been seeing the Treasury market break before we find buyer in requisite size. And that buyer more frequently has become Powell, Yellen or some combination thereof via various machinations we discussed earlier. So that is the fiscal crisis that most people are saying, “Don’t worry, it’s two years, it’s five years.” It is two today. The symptoms are everywhere. And we’re 10 years into it. It started when Central Banks said, we’re done here, in 2014.
Grant Williams (00:52:25):
You made the point in your most recent piece about the surprisingly high tax receipts. And this again brings us back to this idea of why the market, particularly the stock market, is so important because without those tax receipts, the problem is even bigger. And it’s one of the, I mean, it sounds ridiculous to say this, right, but it’s one of the few and easiest levers they have to pull because animal spirits are easy to generate and they know that and they’re doing that. So thinking that through, and I’m always on guard when I hear a thesis as perfect as that. Here’s why cutting rates screws them. Here’s why raising rates screws, and it makes perfect sense. So let’s think about how that could not happen. Is there a way, absent just a full on, open your mouth wide and stuff, as many chocolates as you possibly can, which obviously causes problems elsewhere. Is there a way that this doesn’t play out or they can delay it long enough to give them some hope?
Luke Gromen (00:53:23):
Yeah, there’s a few different ways ranging from the feels really good and is probably fine depending on how you’re positioned, to the really, really unpleasant. So let’s start with the happy. The happy is you create a new everything bubble. You juice stocks, everything and receipts rise sharply, which means issuance falls sharply, which means the Treasury market stabilizes. How do you do that? Powell and Yellen, one way or another, need to get the dollar down enormously. They need to kill the dollar. They kill the dollar down, you take DXY from whatever 103 to 90 to 95, which no one on Wall Street is positioned for. I don’t even believe it’ll do it until I see it, but that’s what needs to happen. To avoid calamity we just described. You take DXY down to 90, 95 for a start over the next six months, that buys them a lot of time.
That buys them probably a year. It certainly is going to make October in this country feel great for the incumbent. Hey, yeah, CPI is back to four, but the S&P is at 6,000, 6,500 and Gold’s at 2,500 or 2,800 and Bitcoin is at 90,000 and commercial real estate is stabilizing a little bit and house prices are up 20% again and vote for Biden. Woo-hoo. That’s sort of the happy outcome. Again, ain’t going to feel happy for you at treasuries. You might actually make money. The long bond might actually rally on that because of the mechanics we discussed earlier, this dollar of liquidity. Remember long-term treasuries are now risk-on assets, not risk-off assets. So the 10-year treasury yield and all of that might go from four today to 3.8. It ain’t going to two, not with inflation at four and all of that going crazy, but it might do okay. It’s going to get killed relative to stocks, gold, Bitcoin houses, commodities, everything. But that’s like our happy outcome.
From there, the outcomes get more unpleasant. You can try to raise taxes dramatically in an election year solely on upper income earners.
Grant Williams (00:55:29):
Not this election year. You can’t. Forget that.
Luke Gromen (00:55:31):
This election year you can’t do it. Even if you could, we have experience doing this that people forget because again, people put these, they label something and as soon as you label something, it hurts your ability to think about it. Don’t look at things for what they’re called. Look at things for what they are, right? Synthetic QE, whatever. I don’t care what it is, it’s liquidity. In 2014, Obamacare was a tax increase. Supreme Court even ruled it was a tax increase. Wall Street Journal said it was designed to reduce deficits, push the government’s big cost of healthcare on the consumers to reduce deficits. Whoa. Wall Street Journal reduced deficits.
Okay, great. 15 months later, the deficit, the GDP was higher. Why? Because the future pays for it. It’s out in the ether. Unicorns and pixie elves pay for it when it’s on the government’s off balance sheet. When you take it off, off there and push it onto consumers as a tax increase to pay for the future, it impacts stuff today. And as it turns out, I as an independent business owner whose premiums went up 40% and a lot of other business owners could buy healthcare or we could go to a restaurant or take our kids here or there or buy another car or buy a new car. So we had to pay for our healthcare. That’s much higher up on the hierarchical needs. So consumer spending slowed, economy slowed, and when you slow something down in a high leverage economy, guess what happens to your deficit? It goes up.
And that’s what happened. Deficit to GDP went up. Despite a tax increase to reduce deficits, leverage is higher. My point here is that a tax increase might work for like a second and then the deficit is going to go up as growth slows and you’re done. That brings us to option three, which I bring up as simply being… Well, let’s get option three and then I’ll go to option four. Option three is some sort of productivity miracle that is scaled and at just the right pace such that it doesn’t create too much unemployment, but it takes the top off of the debt spiral we talked about before, caps it and it is threading the needle. Best case. Option four, which I bring up simply because I want to be an objective analyst looking at where I could be wrong. It’s not something I am wishing for, but if I look at what the biggest costs of the government are, they are entitlements.
And if you look at the various data, a quorum, the entitlements in the US are subject to a Pareto principle where some good percentage of spend is done in the last six to 12 months of life for very sick people. If something happened to those people quickly and cheaply where they passed away, mechanically on an accounting basis, social security costs for them goes to zero, health and human services cost to them goes to zero, and your deficit, your issuance goes down a bunch and you buy yourself time. I’m not wishing for that. I’m not hoping for that. I’m not seeing any signs of that. If that happened I would be dead wrong. And that’s why I keep an eye out for that because I don’t like being dead wrong. So I don’t think it’ll happen, but that’s another way it could happen and it’s extremely unpleasant.
Grant Williams (00:58:46):
I’m going to apologize to you, but you brought it on yourself. We’ve been talking for about an hour and I can already see the one headline that comes out. This Grumman says Bitcoin to 90,000. I can see that’s going to be the headline. And you did it yourself. You walked into trap my friend.
Luke Gromen (00:59:00):
I did. I did. I did.
Grant Williams (00:59:06):
Listen, Luke, I loved having these conversations with you, whether they’re online or offline. And for me, the more people that get to listen to you think out loud and get to read your work the better because it’s been very important for me and I think it’s going to be very important for a lot more people going forward. So just let everybody know how they can contact you and find out more about the Forest for the Trees and all the great stuff you put out.
Luke Gromen (00:59:27):
Oh, sure. Thank you. They can find us online at FFTT-LLC.com. And as you know, I have a fairly active Twitter feed at Luke Gromen. L-U-K-E G-R-O-M-E-N. I guess it’s an X feed. It’s an X feed now, not a Twitter feed. Sorry.
Grant Williams (00:59:42):
It’ll always be Twitter. I can’t bring myself to call it X. Sounds ridiculous. All right, my friend. Well listen again, it was great seeing you. Thanks for spending the time and let’s do this again sooner rather than later before all this stuff piles up on us again because it gets out of control.
Luke Gromen (00:59:53):
Absolutely, I’d love to.
Grant Williams (00:59:53):
All right buddy, take care.
Luke Gromen (00:59:53):
You too.
Grant Williams (00:59:56):
All right, well if you don’t have enough to think about after that hour, then I don’t really know what to say to you. That was extraordinary. Another absolute masterpiece by Luke, the way he walked us through that stuff. And again, I’m such a Luke fanboy because not only is he a great analyst, but he’s a super nice guy. He thinks differently, he writes differently, and he looks at things from a different perspective. And whether he is right or wrong, it will make you see the world and think of it with a slightly different perspective, and I think that’s always important. So my thanks to Luke for joining me. Again, my thanks to you always for listening. Again, you can read Luke’s work at FFTT-LLC.com. And he’s on Twitter, very active on Twitter, far more active than me at Luke Gromen.
That’s it from me. I’ll be back with another podcast in the not too distant future. In the meantime, thank you all so much for listening.
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.
