The End Game Ep. 2 – The Lord Of The Dark Matter

Episode 2 of The End Game sees Bill and Grant unmask The Lord Of The Dark Matter – a man who has been providing invaluable insight into financial market plumbing to Bill and his readers for many years.

Once the mask is ripped off, James Aitken proceeds to demonstrate just why he has been such an asset to those fortunate enough to have had access to the inner workings of his mind through the financial crisis and into the recovery.

James takes us through his thoughts on passive investing, inflation, the Japanese JGB market (and the chances for some kind of debt jubilee therein) and explains why Central Clearing is the place he’s focused on when looking for the next possible tripwire for markets.

Grant Williams:

Welcome everybody to episode number two of the End Game. Joining me, as is now customary after one episode, the fantastic Bill Fleckenstein. Bill, hi mate.

Bill Fleckenstein:

I’m happy to be here today, especially mate, because I’m dying to do the interview we’re about to do.

Grant Williams:

Yeah. We have got a very special guest joining us this week as part of kind of our quest to try and figure out what the End Game looks like. Bill and I drew up a hit list of the people we really wanted to ask these questions to. And this guy I think was at the top of both our list and surprisingly, and we’re very grateful for this, he’s agreed to come on and do this. So Bill, why don’t you just talk a little bit about our guests, that you’ll backstory with him? Cause I think it’s important.

Bill Fleckenstein:

Okay. For those that don’t know me, I ran a short only fund from 1995, till the beginning of 2009. And when I was trying to figure out catching the end of the stock bubble was difficult, of course, but I knew what I was trying to do. When we got to the real estate bubble, it was harder because I could never figure out where all the bad paper was. I knew there was obscene amounts of borrowing going on by people who could never pay it back. And I knew prices were ridiculous in the housing world, but I did not understand who was funding it. And I kept trying to figure that out. I was lucky enough to find somebody who was in the mortgage origination business and he helped me put some of the pieces of the puzzle together.

Bill Fleckenstein:

But I stumbled upon our guest who at the time was working in AIG’s structured products division before he moved on to UBS. And because of his tremendous intellect and ability to put things together, he was able to share with me things that were going on in the mortgage plumbing world if you would, who knew about the credit stacks, but more importantly, he knew about the SIVs and SPIVs, which is where the stuff was hiding. And he helped open my eyes to what was really going on, which helped me understand how it was going to break and how badly it was going to break. And then after that in the recovery period helped me keep perspective on things were getting better and more importantly, things that I didn’t have to worry about. And he was just starting his consulting business in early ‘09, which has become an extraordinary success.

Bill Fleckenstein:

And when he was working at the other two places, he didn’t want his name to be used because he worked for big houses. And when he was starting his new business, he didn’t really want his name to be used. So in the ‘05, ‘06 period, I came up with a nickname for him, which I thought described his ability to synthesize ideas and explained incredibly complex things that were going on in the part of the netherworld or the aether we couldn’t see. And so I nicknamed him the Lord of the dark Matter, which is probably the most appropriate and best nickname I’ve ever come up with for anybody. And he’s been kind enough to come on with us today because, you obviously know him Grant, and everyone’s going to get to find out who that is today. And I’ve got some people that read my column for long, long time, and they’re all dying to know, not that it really matters. So today’s going to be a big reveal. In addition to being incredibly thought provoking, like I said, I’m extremely excited to be able to do this.

Grant Williams:

Well, it’s funny, like all your readers, I was fascinated with the identity of the Lord of the Dark Matter. And funny enough, I didn’t realize who he was. I didn’t realize that I actually had known him, Lord of the Dark Matter, whom it was for a while before I realized he was the Lord of the Dark Matter. And of course, when it’s one of those instances where you put the two together, you just go, “Well of course he’s the Lord of the Dark Matter.” Because he knows more about this stuff than anybody I know as well. So how could it be anybody else?

Bill Fleckenstein:

And just one thing, I wish this was a video, so we could actually show this it’s. I think it was about 2010, he put together the schematic of how the plumbing, the financial plumbing, all really worked. And it literally was probably on something that was a good, maybe three and a half feet by three and a half feet had diagrams everywhere. I mean, how you can even think of that to keep it straight, to be able to put it together. Anyway, he’s an extraordinary guy, plus he’s a great guy and this is going to be loads of fun.

Grant Williams:

He is a great guy. He’s Australian-born he’s London -resident. So let’s welcome to the podcast, the Lord of the Dark Matter himself, James Aiken. Welcome to the podcast. Great to have you with us.

The Lord Of The Dark Matter:

Good to be with you, mate.

Grant Williams:

I have been a subscriber to Fleck for well over a decade now, so for me, this is a huge day to uncover, to take the mask off the face.

The Lord Of The Dark Matter:

Oh. I bet, by the end of this, some people were wishing it had been kept on.

Grant Williams:

Well, the good news is you still got the mask so we can slip it back on and Bill could just change your name, in fact, give you a slightly less impressive nickname if it does not work out.

The Lord Of The Dark Matter:

Right. I apologize to anyone unfortunate enough to be watching us all. That I forgot to put my tinfoil hat on, but I can get it if you wish.

Grant Williams:

No, no. You are okay. They are only going to be hearing us. We are all good.

Bill Fleckenstein:

You can imagine my relief now that I do not have to worry about doing a reveal by accident some time. Now that you are out of the closet. Maybe we should get started.

The Lord Of The Dark Matter:

Let’s go.

Bill Fleckenstein:

All right. I have a handful of what I think are important questions that I would love to hear what you think about them. But I think perhaps the best way to start in is, In your last “Notes from a Small Island”, you mentioned the possibility of inflation. And it’s not something I can recall you ever really even making a throwaway comment about. I have had my hair on fire about inflation for quite some time because I am convinced the statistics do not capture it, but that is a different issue. For some reason you are more sensitive to it now, it would appear. I thought your strategy of Mouton ‘19 futures was interesting. In any case, I will let you answer the question because I would like to know how you are thinking about the inflation process.

The Lord Of The Dark Matter:

Let’s say we’re going to text some of that and we’ll break it down into sub-components. But I think Bill, one of the reasons I have been fairly sanguine about inflation for the past dozen years, or since quantitative easing started, is because, firstly, we had one heck of a bust, in 2007 and 2008, it was a heck of a bust, demand collapsed, nobody was buying, the inflation expectations and everything, obviously, collapsed. That’s not a surprise. So first and foremost, it was an enormous bust which central banks around the world tried to offset. And unfortunately, as we move through the back end of 2009 and into 2010 and 11, fiscal policy was turned off. And I thought to myself, if we look at what the central banks are doing, the money printing, the law money printing, buying all those assets, at some point, you’d think, notionally that would be inflationary, but so large was the overhang of what a lot of these economists call the output gap from 2008.

The Lord Of The Dark Matter:

And then Fiscal policy was not available either. So I was fairly relaxed about any persistent surge higher in realized inflation. I don’t mean market expectations. I mean realized inflation. I know from time to time, headline inflation popped up, but really, because monetary policy, ironically, has been the only game in town, there has not been any fiscal policy. Indeed up until 2017 fiscal policy was unavailable in Europe. We have austerity in the UK and, of course, we have the Tea Party in the United States. So that’s the reason I’ve been fairly relaxed about it. Pivoting to the present moment. I mean, look up the one level… I think a child just snuck up behind me but I will keep going.

The Lord Of The Dark Matter:

I am working from home. I have only done it for 11 years. You should think I have figured out how to lock my door. By the way, while I have you both. I recommend to anyone listening that they get themselves one of these when they are working at home and I will show you why. For the last time, no, no, no. N-O. no, no, no, no, no, no, no, no, no. You get the picture.

Bill Fleckenstein:

That is priceless, mate.

The Lord Of The Dark Matter:

Let me shut the door.

Bill Fleckenstein:

Okay. Okay.

Grant Williams:

That’s gold.

The Lord Of The Dark Matter:

That will probably fall on the “editing room floor”.

Grant Williams:

No, no, no, nooo.

The Lord Of The Dark Matter:

No, no, no, no. Who knew that inflation could be so much fun?

Bill Fleckenstein:

And we haven’t gotten started.

The Lord Of The Dark Matter:

Oh gosh. Now, what have we got today? We have this enormous global disinflationary shock. So to even think about inflation in a global economic shock, such as unlike anything we’ve seen since perhaps the 30s, is a little bit strange. But let’s think about what we have. We have the most rapid reaction functions from central banks ever. In the case of the Fed, what took two years in 2007 and 2008 took about two weeks this time. As we saw this week, Bill, he’s committed to just keep going and going and going. And he makes Mario Draghi looked like a bit of a souk, right? This is whatever it takes cube or something like that. And that applies in most jurisdictions around the world.

The Lord Of The Dark Matter:

Of course, there’s two differences now, we have fiscal policy available, and then some. Right? We probably have one last bill coming in Washington. Probably starts to get discussed in late July or August. Mitch McConnell says it is another trillion. I mean, oh my gosh. On top of what we have already got? We have got all these bonds out there to which we will come to in a moment, I am sure. And then you’ve got this other event, which is a supply side shock. Now calibrating, it is very difficult, but it’s been a long while. 2008 was a demand shock. This event is elements of a demand shock over the heck of a lot of supply shock. So to finish this point, ultra-easy monetary policy, we know that, fiscal policy all-in and even still being turned up, we know that. And then a supply side shock to work our way through which as the world comes out of hibernation, we’ll run into bottlenecks and supply delivery delays and all sorts of things.

The Lord Of The Dark Matter:

While I remember it there’s one last component. We might have a very unusual situation later this year where the unemployment rate, let’s just stick with United States, remains very high, relatively speaking. So let’s say 10, 12% maybe. And to get workers back in the job, companies might need to pay up for labor, which we haven’t seen for a long, long time. And look, I could go to a few other details, but to leave it there, we have a combination of events there for policy stances and developments, which make me think that the probability of realized inflation, not inflation expectations, but realized headline inflation. My sense is, the probability is higher than it’s been in a long, long time, but it will start to go up. And when I say start to go up, look, there’s no algorithm in the world that has parameterized anything other than inflation being somewhere around two, two and a half percent in perpetuity.

The Lord Of The Dark Matter:

So what I’m thinking is what’s the probability that for some period of time, maybe a sustained period of time, we start to see CPI outcomes and core inflation, which is the fed laws, start to inch up from a 2% range to two and a half to a 3% range. And most bizarrely of all, we start to see average weekly hours going up and stuff like that. So that’s why I’m wondering about, to be very clear to anyone listening or watching in, lads, it’s not to say inflation will happen, it’s to say, it’s not priced in markets, and yet we have this backdrop that makes me wonder that the probability of it might be higher than markets are thinking about right now. And hence, I want to look at a few things that we might do on the back of that notion to be tested by events.

Bill Fleckenstein:

Would it be fair to say that in some, the preconditions to actually getting it going have kind of come together in a way that they haven’t really, as you’ve already just articulated?

The Lord Of The Dark Matter:

Yeah. They’re slowly coming together. We’ve got the fiscal and monetary policy all in, you would imagine that with the money supply growing at the rate it is, that it would be astonishing if we didn’t see higher nominal growth in the second half of 2020. And then I will be watching wage outcome, supply bottlenecks, all those other things, trying to calibrate or estimate the extent of the supply shock to see how much headline inflation can pick up. And frankly it might not. But I’m wondering about it a lot.

Grant Williams:

James, do you think that this time around, cause you normally get the ability to see expectations, pick it up, if you’re a bit of a lead, do you think this time around, we might get the tail wagging the dog and we might see Southern surprise inflation and then expectations play, catch up.

Bill Fleckenstein:

Just let me add a thought to that, because that was where I was going to go and we can put our two questions together because I think they’ll work. One of the things that I’ve observed in my 40 years doing this, the guy that was my original mentor used to say to me is, what really matters is inflation psychology. And so people have been saying one, maybe for a lot of the reasons you have, you stated as to why the last 10 years QE didn’t lead to it. So I’ve always thought that you had to change inflation expectations, not the market’s inflation expectations, not what you derive from tips and stuff like that, but people’s.

Bill Fleckenstein:

And so I wonder if things like a shortage of toilet paper and things like that, that make people think, “Oh, maybe I can’t just get this.” Or, “Okay, prices have gone up now because of disruptions.” What we’re doing at restaurants, you pay more and things like that. If we haven’t put the seeds also in place to shift psychology, such that when these events start to occur differently, they hit a fertile patch so to speak, which is sort of, I think that fits in with your question Grant that’s like, how might this coalesce?

The Lord Of The Dark Matter:

It’s a bit like Hemmingway’s aphorism on bankruptcy. Isn’t it slowly then all at once. And you’re right. And here’s an actually an interesting anecdote, again for people listening or watching in, I remember buying Adam Ferguson’s book When Money Dies in 2010, I bought three or four books on inflation because I thought, well, I don’t think there’s any inflation, but how might it happen? And then, books like that really invaluable. And they were popular, Bill you recall and driving in 10 and 11, and everyone was falling over themselves to do curve cap trades in rates because inflation had to happen. And it just couldn’t because the overhang was so immense from our weight and there was no fiscal policy. But I do think there’s something in your psychological perspective that people just decide, it’s costing me more to do X. I’m really to notice this.

The Lord Of The Dark Matter:

But I would say as an important caveat, I don’t see how you can anticipate any higher realized inflation saying in consumption baskets, unless you have a concurrent or perhaps proceeding rise in wages, which after 128 months of expansion, ultra-easy monetary policy was barely able to achieve. So I think the psychology takes hold if ironically, there’s unemployment insurance that everyone’s being provided with kind of boosts their income. And then they get insurance for a long period of time. They got back to work and they’re able to get some kind of wage boost from their employer. And then you sort of start spending a bit, and then there’s bottlenecks, and then you notice that the prices are going up. I regard I can’t answer that in a scientific way, but I think the point you’re making about a switch going on is probably correct.

Bill Fleckenstein:

So it would seem then that we have the most pregnant conditions to get some inflation that would be disruptive, even if it’s not a big, absolute number.

The Lord Of The Dark Matter:

So there’s two things I forgot to mention. Sorry to interrupt. Just look, I’m well aware that two enormous components of US inflation are actually housing costs and health. So you’d have to imagine that you’d never get a sustained increase in us headline inflation. Let’s just call it headline inflation, as opposed to realize inflation, unless you started to see housing costs and health costs really taking up a lot.

Bill Fleckenstein:

But the ironic thing about that is that as you know, and probably some listeners do, but not all of them, is how contrived, for lack of a better word or to be politically correct, the CPI is. Because when you allow substitution and hedonics and a way to calculate owner’s equivalent rent and all of those things, they don’t, and everyone’s own personal basket is different depending on your age and economic stratification. It occurs to me that people might start experiencing, they might finally get upset at the fact that healthcare inflation is as strong as it is or tuition. And then the fact that the CPI never registers it could actually cause them to lose more confidence because they say, they’re they’re lying to us about it. That’s a couple of steps down the road, but…

The Lord Of The Dark Matter:

I think there’s a couple of steps prior to that. And let’s think about them. I mean, if we’re trying to think about what do we do if we think the probability… The probability of inflation going up is higher than are willing to consider today. I’m afraid that, and I don’t mean you’re doing this, but I see it elsewhere that people get wound up about the hedonics and the CPI. The market’s only going to respond to the CPI that they see printed as opposed to breaking down the components. So I could look at the Billion Prices Project at MIT and state street, which is actually very useful. And frankly, so far, it’s not showing you anything terribly different to what we’re seeing in the traditional CPI prints in the United States. But there is one important other step here, which is that in cycles gone by when inflation was forecast by a central bank to be picking up a central bank would act to knock it on the head.

The Lord Of The Dark Matter:

And monetary policy, so let me be clear, policy rates as they used to be, work with a long and variable lag, asset purchases are instantaneous, right?

Bill Fleckenstein:

Yeah.

The Lord Of The Dark Matter:

But monetary policy rates still work with the long and variable lags. So it cycles gone by the fed would have settled. 15, 18 months out things are probably looking a bit tight. We should tighten today. And eventually that’ll trickle down damp and consumption and everything else and inflation will calm back down to target. Not now, these people have been trying for 12 years to create inflation and to get it meaningfully bad, using the US example again, that mystical core CPI of two points called PC, I should say, of 2.0%. The point being, if it starts to come in a bit hot, they’re just going to be immensely relaxed about it.

Bill Fleckenstein:

That’s it.

The Lord Of The Dark Matter:

And you got to let it run. And they’re going to let it run. And in the history, inflation regimes changing, it’s Hemmingway. It’s just like, “Oh, it’s here.”

Bill Fleckenstein:

Yeah. That is an excellent point that you make about, they’re going to let it run hot because they believe they need to make up for past shortfalls. So the reason why I wanted to tackle that first is because in accordance with the theme of this show, i.e. The End Game, one of the questions, burning questions in my mind, which is what I’ve been dying to talk to you about, it’s kind of a two-part question, how does the money printing regime come to an end? Because I think we all know that this can’t go on forever. As you know, my phrase has been, at some point, the bond market will take the printing press away from the central banks. And while I fervently believe it, I’ve never been able to come up with a, I’ve never really thought we were close to having it happen yet. I want to say that.

Bill Fleckenstein:

And what I would like to know is, in your opinion, have you thought about how this might end and do you have an opinion on whether it will end and they’ll take the printing press away, and I think how they would respond, if it look like that was happening, could you kind of use your imagination and tell me how that looks to you?

The Lord Of The Dark Matter:

Let’s think purely in intangible terms, how would central banks lose control of the bond market? And first and foremost, we need to think about the float, the free float. Let’s take the very, very unfortunate case of Europe and the ECB and Bunds and Schatz and Bubbles, which is, let’s just think of it as the German government bond market. And surprisingly, the ECB is buying a lot of these things, no surprise there. And I remember a speech given by a fiendishly clever man called Benoit Coure. And he was at the ECB for a long time. Very smart, worked at the French treasury, knows his fixed income markets back to front. And he’s now at the BIS. And Bill, he gave a speech, I think, I’m going to say three years ago, talking about the efficacy of quantitative easing. And of course nearly all these central bank speeches about the efficacy of asset purchases that they’re doing post rationalization.

The Lord Of The Dark Matter:

“Oh, well, we did that and Hey, it worked great.” But he might’ve point, he put up a chart of the AC based purchases of German government bonds. And here’s the tragic thing for any of us who still believe in price discovery or any bond market sell-off that might result in the context of higher inflation, because you would imagine, all the textbooks tell you that if inflation does show up, there should be a much higher inflation risk premium in long-term government bonds. Not according to Couere because he put up a chart, and this was three years ago before the ECB ramped up their purchases again. And he showed that the free float, the free float of the German government bonds, all of them in private sector hands, was approaching 20% and falling.

Bill Fleckenstein:

Yeah.

The Lord Of The Dark Matter:

Now that’s the conundrum when we think about outcomes. Because investing 101, macro investing 101 bill tells you that if you anticipate higher inflation, you just sell the long bond, obviously, right? You just get rid of duration and you stay short. But if in this day and age, the European central bank is trying to create inflation by holding long-term bond yields down and they own 80% plus of the float. Where’s the false seller.

Bill Fleckenstein:

Right.

The Lord Of The Dark Matter:

And that’s the conundrum of what to do about any of this. So to come back to your point, when does the bond market take on central banks, or when does central banks lose the bond market? Well, the answer might be when they need to sell or when they stopped buying. And again, unfortunately when they need to sell, well they’re all committed to once they finish the current spurt of asset purchases, to rolling over maturing securities, to keep the size of their balance sheet constant.

Bill Fleckenstein:

Yeah.

The Lord Of The Dark Matter:

I mean, look, we could rile against it and we should rile against it for a long time to come. It’s almost unfair, but I’m afraid that’s the game we’re involved in.

Bill Fleckenstein:

Sorry James, would the analysis change, and that was brilliant, would the analysis change if we looked at the US government bond market, because it’s so much bigger and it’s growing fast, might that be, could they, is it the same dynamic? I never thought of it that way before.

The Lord Of The Dark Matter:

No, it’s, it’s a good point. Obviously the fed is doing their very best to gobble up the free flow of treasuries, mind you, but they’ve got a long, long way to go before they own the treasury market. Put it this way, the fed has not nearly cornered the treasury market as the ECB has cornered the bond market or Bubbles and Schatz and stuff like that. We’re not remotely at that point. The other thing I’d just point out while I remember, is that when the fed was doing their first round of quantitative easing, 10 year treasury yields and the long bond sold off, because people were believing in reflation, it was the signaling effect of the fed buying all these bonds. And the point being at the time, the fed would have wanted a steeper yield curve to allow banks to land and to signal that reflation had arrived and all those good things, but in the United States, let’s think that through.

The Lord Of The Dark Matter:

We have as of Wednesday, the central bank, that for the foreseeable future is going to be buying 80 billion of treasuries and 40 odd billion of agency MBS per month. So they’re going to be soaking up a lot of collateral and they’re going to be not selling anything, re-investing stuff. It’s back to where we were, unfortunately in 11, 12 and so forth. I don’t think any leveraged investor is going to want to take them on. But then we flip the argument around and let’s think of it as a pre-mortem. What would a bond market accident look like in treasuries? And it’s so reflexive because I think it would be a simultaneous combination of…

The Lord Of The Dark Matter:

Because I think it would be a simultaneous combination of inflation pops up, the exit from lockdown turns out to be much smoother than any of us imagine, then we head back towards trend growth in the US which is what? Roughly 2% real? [crosstalk 00:30:18] Something like that.

The Lord Of The Dark Matter:

And then people go, well hang on a second, the Fed is allowing this to run hot, but they still want to hold rates low and then the dollar starts to slip. Now, I do not know what the right probability is to handicap all of that. But Bill, if I was to imagine a situation where the long end of the US treasury market was under a lot of pressure and global investors were repricing it, I would have to imagine it would entail something going wrong with the dollar.

Grant Williams:

James…

The Lord Of The Dark Matter:

Which is strange because Grant, as you know as well, that the dollar has been broadly doing nothing for a long time it’s just range trading.

Grant Williams:

Well that is really interesting because as I was listening to you there. The thought that was occurring to me, Japan just stealthily and very quietly cornered a big part of its bond market. The ECB have cornered a big part of the bunds interestingly, because they are the only things worth it there, right? If they can hold things steady by calling the bund market quietly and watch the Southern European countries react along with it but leave as many of those in private hands as they can, at least they have got a relatively, money good, asset on their balance sheet. But if you think about the way they go with that and they gradually corner that market and reduce the free float, I am thinking to myself, well, this must mean that the pressure valve has to be the currency in some way, shape, or form. People have to look at what’s happening and react to the currency.

The Lord Of The Dark Matter:

You would think so, but there’s another caveat. I mean, it must sound like to some of our listeners that I am trying to talk my way out of my own view. I’m just trying to calibrate all the moving parts of this and frankly lend, so I am trying to imagine, how am I going to lose money if I turn out to be wrong? What am I going to have overlooked or missed? If I say, “Yippity-do, inflation is coming.” I want to be the clever fellow who shortstop on bond. I short the dollar versus something where we build my level to think of one asset on the other. We will maybe debate it offline it is tricky Bill, it is tricky.

Bill Fleckenstein:

Yeah I know. Let me…

The Lord Of The Dark Matter:

Look…

Bill Fleckenstein:

Sorry, go ahead.

The Lord Of The Dark Matter:

I was just wanting to make sure that we think about another technical point here and Grant brought it up about the bank of Japan. The bank of Japan, bless them, have destroyed the JJ bay market. It’s not even a market. It’s just two numbers on a screen that sometimes trade, and the bank of Japan claims that the reason their yield curve control has been so effective because it’s hovering around zero give or take 10 basis points, and they have had to buy so little is because they are so credible. No, they have killed the market.

Bill Fleckenstein:

Well, let’s hold that thought, okay, because there is a segue from what we are on which we are about done with that I want to get to that exact topic. So if I may just kind of interject for a second. No, this is great. I wanted to touch base one more time about the difference between the ECB and the thought process and the US. Despite reasons to be bearish on the Euro and the ECB and the problems that are endemic to trying to unify and all that stuff, one thing I always said in defense of the Euro was, “Okay, all those things are true, but there’s one thing that they are doing. They have rules about the percentage size of the budget deficit vis-a-vis GDP”. Even though they fudge the daylights out of them and they change to whatever they need to…

Grant Williams:

Yeah.

Bill Fleckenstein:

they at least have some rules, which we do not.

Bill Fleckenstein:

Therefore, I think it’s easier for a central bank to corner the bunds particularly, then the problem the FED has. So, that may play into it, so it may be that the problem can’t really start in Europe. If it was to start, it would start here, but the other place-and you can finish that and start the next one-is I wanted to go to Japan because what I really want to know is since they have cornered that market and it doesn’t exist and they own so many, what if they decide to go down the cold fusion route?

The Lord Of The Dark Matter:

Right. .

Bill Fleckenstein:

The reason I asked the question is because sometimes in trying to understand things that are nearly imponderable, I try to take it to the farthest extreme. So let’s say a Central bank could buy up enough of the country’s debts to then say to the treasury, “Okay, I’ll give all the debt back to you for a 200 year piece of paper at one basis point.” In effective they’ve torn it up, but they kept it on the balance sheet. What would markets look like on the other side of that? I’ve always thought if I could figure that out, I would learn something. I can’t figure it out, but I’m hoping you can. There you go. There’s the hot potato.

The Lord Of The Dark Matter:

Well, thanks for that hospital pass there I wish I could give a sensible answer. But look, your point about Europe… I think is broadly correct- because now they’re trying to do things they’ve been postponing for decades. Whether it works or not, time will tell, but they’re trying to complete banking union, capital markets union, there’re elements of joint and several liability, Euro bonds and stuff like that. It’s absolutely not a Hamiltonian moment as so many people are spinning it, but trying to do something different and on balance, that’s probably no bad thing for European growth prospects for the first time in, goodness knows, how long. It’s probably no bad thing for European equities either, which has been out of favor for all the right reasons for a long time. But you’re right about if you’re managing a bond market rupture, assuming of course Madame Lagarde doesn’t open her mouth on BTPs, Europe is probably not the place to be looking.

The Lord Of The Dark Matter:

On Japan as much as they try to say it with a straight face Kuroda san who’s that little imp? “Oh no, no, no, no, no. This isn’t monetary financing and there’s no, no, no. There’s not debt repudiation”, and stuff like that. I mean, Mr. Magoo can see that the idea, the bank of Japan is going to be a net seller of JGBs or otherwise sell wind down their portfolio is just not plausible at some point, which is the critical thing. There’s a reckoning for the Japanese. I’m just not sure what that trigger is. And that’s my conundrum with it, Bill. I watch what’s happening in Japan. I say to myself some days, gee whiz. I wonder if Japan’s the template for all of us. I don’t know, but I very much regret. I apologize to listeners that I don’t know how to think about the end game other than some kind of repudiation at some point. And it may yet be decades away.

Grant Williams:

But does that James,[crosstalk 00:37:45] that once again, lead us back to the currency if they come up with this scheme? [Crosstalk 00:37:47] All I can think is that the currency has to take it somehow.

Bill Fleckenstein:

But [crosstalk 00:37:52] let me just, let me add this to Grant’s question.

The Lord Of The Dark Matter:

Yeah. .

Bill Fleckenstein:

As he asked, as you pointed out, there’s no way to know when that might happen, but if in fact they did it, let’s just say they did do it. Then what, what Grant asks I think is, then after they did it, would the yen go up or down, would the new JGBs be priced somewhere differently? What, would happen afterwards would you guess? We don’t have to know when it would happen, but I think trying to understand what would happen afterwards might be useful.

The Lord Of The Dark Matter:

Let’s then think about who gets hurt if Japanese- I don’t know what happens if they’re written off or repudiated- do they clear at zero or did they clear at par? Is it money good? Or is it money bad? Right?

Bill Fleckenstein:

I don’t know, that’s why I’m asking you.

The Lord Of The Dark Matter:

So let’s think about two scenarios here. We’ll think about a scenario where the bank of Japan and the ministry of finance, who ironically own the bank of Japan’s reserves come to a deal where the JGBs owned by the bank of Japan. They strike a line through them, I assume now that if you’re putting a big X through something, you probably take that as meaning it’s worth nothing, it’s gone. But for the people who actually own some of the similar JGBs that the bank of Japan owns what happens to them? What happens to the Japanese insurance companies who have to look at their own JGBs for liability management purposes?

The Lord Of The Dark Matter:

What does it mean for Japanese pension funds? What does it mean for the large remaining owners of JGBs? Now maybe that’s the wrong question because you’d imagine it, there was some kind of repudiation in Japan by that time, the bank of Japan would own 90% of the judge base anyway. But I do think it’s critical in terms of trying to imagine a scenario for the yen, because on the one hand, if you wipe out the JGBs and say, they’re basically vanished, that probably has negative consequences for Japanese domestic holders. If they would try to recover the losses on the JGBs, they hold these Japanese insurance companies, guess what they would do? Sell a lot of foreign assets. So in that scenario, you could possibly see the analog higher, but I think realistically, the signaling effect of a repudiation of JGBs are a wash, a rinsing of JGBs-whatever, I don’t even know what the right term is-but I think the signaling effect when you’re destroying a debt burden that can’t be met, I would’ve thought that’s colossally inflationary.

Bill Fleckenstein:

Yeah.

The Lord Of The Dark Matter:

Japanese equities would go to some ridiculous number. My best guess is that the yen, more likely than not, would weaken very substantially, but you know, we’re not, not there yet, but that’s purely best guessed scenario.

Grant Williams:

That was my thought process too. I figured if they can get to a percentage of the bond market in their own hands, and then they move for Bill’s cold fusion scenario. Let’s say they get 95% of, and that’s the magic number, the remaining 5% presumably will be held by the pension funds and the Japanese bank for life insurance companies. They would have to essentially print the money to buy them off those guys at par. How else do you deal with that? Right? I mean, at this point they printed money to buy everything else. So I would imagine that would be the sense, the sense of, oh, this is where it, and we’ll we’ll we talk about that as being sensible.

The Lord Of The Dark Matter:

Yeah.  Here’s something we can watch before we are anticipating that something was about to happen in JGBs-and it’s not JGB futures or 30 year swaps or even dollar yen-I think you’re both aware, as I’m sure many listeners-are that one of the biggest risk-free short-term trades in the world over the past several years has been what I call this JGB repack trade. Because of discontinuities and certain relationships in these giant cross currency basis, swap markets-which we won’t go into-but there’s an opportunity for anyone with a lot of dollar cash to lend dollars in exchange for yen invest it in Japanese government T-bills and enjoy a healthy pickup over the equivalent US T-Bill that are looking at the corner here.

The Lord Of The Dark Matter:

All sorts of people have done that trade on an enormous scale…The People’s Bank of China…this is all public domain, mutual funds around the world, family officers, anyone basically with a large dollar balance has swapped their dollars into yen, put it into Japanese government T-bills and effectively created a synthetic US T-Bill with a yield pickup and in a low rate world, those extra few, sometimes more basis points. Well it’s more than a few-it’s very useful. So why does that matter? Foreigners now are 70% of the Japanese government T-bill market. Now…

Bill Fleckenstein:

Wow.

The Lord Of The Dark Matter:

Yeah.

Bill Fleckenstein:

Wow. I did not know that at all.

The Lord Of The Dark Matter:

It’s all because of this opportunity to lend your dollars. And of course the Japanese authorities know this. There’s some very strategic global players who have this position on. I think there’s number of sovereign wealth funds and central banks and others. It’s a liquid risk-free tribe. Well, generally risk-free, as long as you choose your counterparty wisely, but the reason I mentioned that to you fellows is because it would be an enormous tip-off if all of a sudden foreign holdings of Japanese government T-bills started to fall down a lot, because that to me would be a tip off that something is coming. Because I’m not going to be told we’re not going to be told.

Grant Williams:

No. Right.

The Lord Of The Dark Matter:

by the People’s Bank of China.

Bill Fleckenstein:

Okay. So that is really interesting. That would help on the sensing something is changing.

The Lord Of The Dark Matter:

Yeah.

Bill Fleckenstein:

What I wanted to share with you how I thought about the cold fusion, how it works. See if it logical-it makes sense-because it winds up with a similar outcome. When I look at it, of course, I’m going to spin it bullishly because they will. They’ll say, “Look, we know we were just changing one asset for another in this world of, of inflation canaries.” So they swap with them off-the, whatever, the hundreds of trillions of yen it is-and they have a new asset that yields one basis points, it doesn’t cost them anything-the government that is. Now they swapped an asset for an asset. There would be nothing derogatory about the JGBS that are left.

Bill Fleckenstein:

The ones that are left behind now are more credit worthy than ever, because they’ve managed to take their horrendous debt to GDP down by two thirds. So it seems to me then finally, in the land of deflation fears, you would have taken the deflationary outcome off the table. The debt collapse cannot happen.

The Lord Of The Dark Matter:

That’s right. .

Bill Fleckenstein:

Therefore, we don’t need to worry about it. If the epicenter of all things deflationary-that being of the last 20 years being Japan, so to speak… were to no longer have that threat that would feed back into a general change in inflation psychology that we were talking about. I think JGB yields, while the credit would incur would be better, the yields might go up because people might say, “Well, we should get more.” On the other hand, there wouldn’t be very minimum around. So I don’t really know how the debt mark would work. I could make an argument that the end could go in either direction in the wake of that fund.

The Lord Of The Dark Matter:

Yeah. Let’s think about it. It’s something that just occurred to me. From time to time, you hear people say, whether it be cold fusion or something else, okay. Let’s talk, take the entire stock of JGBs and swap them for zero coupon, perpetual JGB. We’ll have one bond with infinite duration. Hang on a second? Isn’t that the worst asset in the world if inflation arrives?

Bill Fleckenstein:

Yes.

The Lord Of The Dark Matter:

So you’re basically saying, “look, I know you’ve got all these seven year and nine year and 10 year JGBs, but I’m sorry. We’re now going to give you a zero coupon perpetual.” Nope. I don’t want it because what happens next? You issue or swap a, let’s say at the time it’s a seven year JGB, whatever it is… At par with a zero coupon perpetual and inflation shows up, you’d think that zero coupon perpetual instantly goes to 62, which generates tremendous losses for whoever’s unfortunate… misfortunate enough to hold that paper so you can…

Grant Williams:

Let me just let me play devil’s advocate on that then, because the scenario Bill has put forward and we’re debated here has cleaned up the bank of Japan balance sheet nicely, right.

The Lord Of The Dark Matter:

Oh beautiful.

Grant Williams:

Done a great job. So let’s say then…

Bill Fleckenstein:

The governments as well, right?

Grant Williams:

So let’s say they bought 85% and there was 15% outstanding. They’re all offered a perpetual and they’ll say, hell no, we don’t want that thing with the bank of Japan. And then start all over again, expanded their balance sheet…

Bill Fleckenstein:

Exactly!

Grant Williams:

Pay 90 cents on the dollar 95 cents on the dollar for it and take the remaining 15% in. Right. You would you think, which is why I just think, well, it has to come out in the yen because who the hell would want to own a Japanese asset if this is the way the whole thing works?

Bill Fleckenstein:

Well on the other hand that if it made the Japanese stock market go up and punters in China and everywhere else want to flow, I mean, they could rally other than the fact that all those people that own those T-bills, that you’ve just mentioned, they might want to take their dollars and go home, [crosstalk 00:48:34] so that would put downward pressure on the yen.

The Lord Of The Dark Matter:

By the way, actually hold that thought for one second. But, there’s another important asset that the bank of Japan owns, which in the event of the yen going down a lot, which would generate tremendous returns on the bank of Japan balance sheet, which is US dollars and treasuries. So dollar yen went from a hundred and 107-44 to 207-44. Well, in yen terms, the bank of Japan’s balance sheet looks pretty good. But just on this-and this is a little bit technical-but when those global investors decide to swap their dollars for yen, more often than not, they’re swapping those dollars with Japanese banks who re-invest the yen into Japanese bills. And that’s a very key source of dollar liquidity for Japanese banks. So the People’s bank of China lends dollars to Mizuho. Mizuho helps them swap it into yen, they buy Japanese government bills. The People’s bank of China creates effectively a US T-bill with a yield pickup, but Mizuho can use those dollars and recycle them, and invest them in US dollar high yield.

Bill Fleckenstein:

Well, that brings me to a slightly different topic, but I think it’s a good segue for it. I would like to get your thoughts on the concept- there’s a popular concept in the world today-that people that borrow dollars-sorry- issue debt, are short dollars.

The Lord Of The Dark Matter:

Yeah.

Bill Fleckenstein:

I always rail against that because, having shorted a few things in my life,  I like to point out that, well, gee, when I short something A. I have to put a deposit up and maintain that margin.

The Lord Of The Dark Matter:

That’s right.

Bill Fleckenstein:

B. I don’t get the proceeds from the debt sale, and there’s a clearing house that gets in my way. While I’m sympathetic to the intellectual analogy in practice-not even close. Having said that there’s a lot of smart, smart people who think that there is this large embedded short, because of all this debt. Would you walk us through how you think about that?

The Lord Of The Dark Matter:

It depends entirely if the debt’s ever going to be repaid.

Grant Williams:

Yeah.

The Lord Of The Dark Matter:

This is a mistake I’ve made over the years, hopefully not too often… We talk about corporate bond markets and we talk about corporate bond issuance. And from time to time, people will buy back their paper at a discount or whatever. But the stock of corporate debt outstanding really declines because most people simply refinance. Especially now when interest rates right or wrong or perceived to be lower for longer. Again, all those corporate guys are incentivized, the corporate treasurers, to appease their shareholders. “Oh, you need to lever your balance sheet. You need to optimize your balance sheet.” Look at the issuance of US corporate Bonds since the FED wave the magic wand! I’d say precisely zero of that is likely to be redeemed. I mean, it doesn’t mean it won’t try to par that, I don’t mean that, it will be rolled and rolled and rolled and rolled. As long as you can attract people to help you refinance at a relatively attractive pickup to the lenders benchmark, maybe we can keep this ridiculous game going.

The Lord Of The Dark Matter:

Now in the narrow question of China and foreign currency borrowing in China, because I think that’s the one that people think about a lot. And it is true! China’s corporates have borrowed an awful lot of dollars. Some of them we saw last year. There was quite a pickup in defaults on certain Chinese property developers who had borrowed in dollars, but I’ve just remind listeners that everything happens in China for a reason. There are no accidents. People get pushed aside, if you know what I mean. Just an anecdote for you all-we all remember the renminbi  devaluation, which still strikes me as around those pointless things that have been done in late 2015.

The Lord Of The Dark Matter:

We were all obsessed with the amount of outflow from renminbi and the way Chinese citizens and corporates, and whatever we’re switching from, renminbi to dollars. Well I did, but it never left the Chinese financial system. This is the magic trick. So much of those, renminbi were converted the dollars were redeposited with Chinese banks in dollar accounts in China.

The Lord Of The Dark Matter:

I mentioned that because I met some treasurers of the big Chinese banks in February 2017, in Beijing. We’re sort of chatting away as you do about how they do their job, and it’s a hard job. Then they casually started to talk about their offshore branch balance sheet. One guy just said, “Oh yeah, we’ve got $300 billion in the Hong Kong branch.” Wait, what do you do with them? “Oh, well we put them into treasuries. We put them into MBS. We put them into bonds, we do this… And we put them into dollar bonds issued by Chinese corporations.”

Grant Williams:

Yeah, of course they do.

The Lord Of The Dark Matter:

So we’re  supporting the home team. Now. You get the odd wobble  in the Evergrande paper and all those other things, which are tottering towers of indebtedness. But unless someone in Beijing gets on the back phone and says, “Right, take him down.”

The Lord Of The Dark Matter:

So many of these Chinese corporate dollar borrowers or foreign currency borrowers, let’s call them. They’re going to be rolling and rolling and rolling for a long time to come.

Grant Williams:

So what does that mean? One of the big ones that went down was China Minsheng right. Which was Li Ka-shing’s, sponsored finance company. And I looked at it, I thought, well, that’s a political message. That is being sent more than anything else. It seems to me…

The Lord Of The Dark Matter:

Grant, help me remember, where did Li Ka-shing make all his money?

Grant Williams:

Yeah good point.

The Lord Of The Dark Matter:

Who was his political sponsor?

Grant Williams:

Yeah.

The Lord Of The Dark Matter:

Jiang Zemin

Grant Williams:

Jiang Zemin, yeah, exactly.

The Lord Of The Dark Matter:

Right.

Grant Williams:

Yeah.

The Lord Of The Dark Matter:

Yeah. Right. Nothing, nothing happens by accident in China’s financial markets. Nothing.

Bill Fleckenstein:

So if I summarized what you said, would it be fair to say that the angst over a massive dollar short position precipitated [crosstalk 00:55:56] is exaggerated? Yes.

The Lord Of The Dark Matter:

I think it’s the number one financial Twitter scare story that-”Oh my gosh, the world is short dollars.” Bill you and I, in particular, we’ve had this discussion over the years and it’s a scenario that must be evaluated. There’s a lot of dollar borrowers out there that we might have to roll. There’ll be people that get into trouble, global dollar shortage. I’ve argued for a decade. There’s no global dollar shortage. There are dollars everywhere. It’s just that from time to time, they get stuck. That’s the problem.

The Lord Of The Dark Matter:

People either for unfortunate regulatory reasons or de-leveraging reasons, or we could go down the list, I can’t get the dollars or the capital and the dollars and this, that, and the other. So they scrambled into markets and they pay crazy rates. Then again, we’ve just seen another demonstration of the power of central FX swap lines , right?

Grant Williams:

Yeah, absolutely.

The Lord Of The Dark Matter:

I joked with someone the other day-not really a joke-I just observed that we now have the federal reserve Tokyo branch… We have the federal reserve Singapore branch, the federal reserve Sydney branch… Frankfort branch, London branch, Berne branch… I could go on, but you get the gag.

The Lord Of The Dark Matter:

I’ll just stop. [crosstalk 00:57:30] Hang on. I got to be careful. I was just thinking I’m turning into Cramer this is, I’m just going to throw that out the window.

Bill Fleckenstein:

I have one more easy kind of quick question. Then I’ve got another imponderable for you to finish on. Okay.

The Lord Of The Dark Matter:

Oh, good.

Bill Fleckenstein:

The short, easy layup. I think for you, particularly is, I’m starting to notice chatter again about potential CLO problems. And whenever I see that chatter the fact that I haven’t seen you say anything about it in forever, makes me think it’s kind of a non-event, but since I have you here, I thought I would ask the question.

The Lord Of The Dark Matter:

Like all securitized markets, what makes them work is not necessarily the people willing to take risks at the bottom of the capital structure, although that’s very important. What makes securitization markets work is the ability of people to take capacity at the top of the capital structure, okay? That applied a much as CDOs as it doesn’t CLS RMBS. So what’s the triple eight pace? What’s the size required, assuming loss assumptions that-I’m paraphrasing and trying to simplify it a bit..I’m trying to illustrate. But the reason that part of the reason the U.S. CLO market just chugged along for as long as it has, is in part down to very strong Japanese support from my old mates at Norinchukin and the government pension investment fund, they’ve been very keen buyers of AAA CLO transfers because it gives them a yield pickup or has done.

The Lord Of The Dark Matter:

They’ve been buying European CLOs as well. Insurance companies are obviously very interested in these things and assuming one’s done their credit homework and read the prospectus, one should generally feel up the top of the capital structure. That one’s pretty safe. Now, the problem going forward with CLOs and leverage allowances… Look, it would be astonishing if we didn’t have some very serious problems and the leverage loan market compared to other parts of US credit markets that have been blessed by federal reserve magic has definitely been a legged. If we were to sort of imagine a part of the US credit market, that would be really troublesome, it would be the CLO market, but I’m thinking about it from a different perspective. If I’m a hedge fund or private equity guy…

The Lord Of The Dark Matter:

If I’m a hedge fund or a private equity guy or any of these debt funds, and you say to me, “Look, the Fed’s probably going to be at zero for a long time to come. I’ll give you 10%.” Very hypothetical number. “I’ll give you 10% on the BB piece of a CLO tranche, and you can do the analysis and we’ll work together.” People are probably going to keep finding that relatively attractive, okay? So there’ll be some car crashes, but broadly, people will find that attractive.

The Lord Of The Dark Matter:

Given the fed’s now at zero, the yield available on the AAA tranche of some of these newly minted CEOs is probably not going to be as attractive to the Norinchukins and the GPIS and some of these other people, right? That’s part of the problem here, is that the returns on the biggest piece of these securitizations, who’s going to take them? Unless the US dollar goes down a long way. And then in local currency terms, for a yen-based investor or-

Bill Fleckenstein:

There’s your pick up.

The Lord Of The Dark Matter:

Right. You get compensated via a weaker dollar. So all in all, Bill, I am watching CLOs. I know there’s a fair bit of chatter around and all that kind of stuff. And we definitely should watch it. It would be extraordinary if there were not any defaults in the leverage loan market in the United States, but I’m reasonably relaxed about it and thinking longer term about who’s going to replace Norinchukin.

Bill Fleckenstein:

Okay.

Grant Williams:

Bill, if you’ll…, let me just ask one more question on this change, because it’s always in the plumbing that this stuff starts to get wobbly.

The Lord Of The Dark Matter:

Sure.

Grant Williams:

We saw this in ‘07. We had the repo market last year when the people who watch it said, “This is important.” Everyone else said, “Well, nothing to see here.” And they tamped it down a little bit. When you look at all the various aspects of the plumbing, is there an Achilles heel that you think, okay, if something’s liable to blow, it’s likely going to be over here. The repo’s okay. The CLOs, I’m watching them, but they’re okay. Is there anything that you’ve got on high alert?

The Lord Of The Dark Matter:

Central clearing.

Grant Williams:

Okay.

The Lord Of The Dark Matter:

Central clearing. But we had another pretty stern test in March and April, and the daily margin calls were very large. But we have never had a sustained margin call, a sustained reversal of trend that’s lasted months. And there’s an awful lot of people out there who have an awfully large amount of long dated interest rate swaps, for example, all of which needs to be collateralized.

The Lord Of The Dark Matter:

Now, it did get pretty hairy there as we saw in the treasury market and long-dated swaps market in March. I mean, some of those gyrations. But they didn’t last terribly long. So there were some margin calls required. But think, for example, about the gigantic liability-driven investing sector here in the United Kingdom. Hugely important chunk of the UK financial system, which combines pension funds, long-dated interest rate swaps, derivatives, and repo. And by definition, a pension fund does not have cash. So if you get rung up and said, “I need XYZ margin.” Well, you better hope you have a lot of gilts or treasuries available to post.

The Lord Of The Dark Matter:

So we’ve had a couple of good tests. Up until now, the system has worked well. But I do wonder about the ability of the pipes on the back end of central clearing, and with … I don’t mean to say less sophisticated, but less technologically advanced participants that rely on central clearing. If their systems are not up to scratch, I worry about that.

The Lord Of The Dark Matter:

But I will make a key point, or … Not a key point. I will make the overriding point that I think everyone’s known me for a long time as the plumbing guy, which is always good fun. But you can’t be just the man with a hammer. And frankly, Grant, most of the things I’ve written about the plumbing, with the exception of last September, and of course, March, over the past five years have nearly been all from the perspective of, I know everyone’s talking about it, but that’s not true. Here’s why. And even today, I mean, there is so much garbage written about the workings of the financial system, repo markets, cross-currency basis swap. There’s conspiracy theories everywhere over Twitter. And because it’s complicated, everyone goes, “Oh, yeah. That must be why.”

Grant Williams:

That must be it. Yep.

The Lord Of The Dark Matter:

Cross currency basis swap.

Bill Fleckenstein:

Can you spell that, please?

The Lord Of The Dark Matter:

I’ll get back to you, friend.

Bill Fleckenstein:

So I saved this question for last, because it’s not really in your specific wheelhouse as everything else I asked you was, but I know you must have thought about this and it’s … Again, it’s an imponderable about the end game. I regret that I’m probably the last guy to know about this, but I’ve recently become familiar with Mike Green’s work.

The Lord Of The Dark Matter:

Yeah.

Bill Fleckenstein:

And you and I had an online chat about that. But so, since we talked, I’ve paid attention to it and he was kind enough to forward a paper, and I’ve read all that stuff. And as a, I don’t want to say a student, but when you run a short book for a long time as they did, you have to learn to be able to read the tape to some degree so you know when to add or cut back and blah, blah, blah.

Bill Fleckenstein:

And I would very much like to talk to Mike himself about this, and we’re going to endeavor to do that. But since we have you-

The Lord Of The Dark Matter:

Uh oh.

Bill Fleckenstein:

Obviously, passive investing can only go so far before it distorts the market. From his writings, I think he has pretty much acknowledged that we’re past that now, at least to some degree. Whereby prices aren’t really being set by the informed behavior of thousands or millions of people who are processing the information. I think the flows are … It’s like 70% is passive. I don’t want to say the stats because I’m going to get it wrong. But it’s enough to where, for the first time in the last couple of weeks, when I look at my screen it makes sense now, because I can see that it’s … We’ve evolved into one giant voting machine, and the weighing part doesn’t happen.

The Lord Of The Dark Matter:

That’s a very good description. Yeah.

Bill Fleckenstein:

And so, it’s just knowing what I’m up against … And I’m not trying to short, but even if it doesn’t matter what you’re involved in, whether it’s gold mining stocks or XYZ. Knowing why the tape is as distorted as it is helps. So my question to you is, do you have a thought on how that may end? Because, again, it’s one of these things that makes my head hurt when I think about it.

The Lord Of The Dark Matter:

Yeah.

Bill Fleckenstein:

They’ve already gone too far, probably, but they’re not going to stop anytime soon. So how does it end? Or can it end?

The Lord Of The Dark Matter:

I think it’s a … Can I tell you, Bill, how disappointed I am to see CNBC on in the background of your office? I would never have imagined that.

Bill Fleckenstein:

Oh, my god. Melody! My wife was in here … I was out getting an MRI this morning and she came in here and turned that on.

Grant Williams:

Dude, what’s going on?

The Lord Of The Dark Matter:

It’s a prank.

Bill Fleckenstein:

Holy smokes. I’m so embarrassed.

The Lord Of The Dark Matter:

You’ve been pranked.

Bill Fleckenstein:

We have to cut this off the tape. I’ll never live it down.

The Lord Of The Dark Matter:

I was going to say something, but I didn’t want to interrupt.

Bill Fleckenstein:

Oh, my god. I’m horrified. By the way, we call it bubble vision. Not CNBC. I’m not going to hold it against you.

The Lord Of The Dark Matter:

No, that’s okay. Respect. Mike is one of the most extraordinary thinkers I’ve come across. All of that research and digging, he did himself. I remember him stress testing his conclusions against a range of investors around the world, basically saying, “I want you to prove me wrong.”

Grant Williams:

Prove me wrong. Yep.

The Lord Of The Dark Matter:

And nobody could. And then he’s repositioned himself in his new business, and I think he’s doing really well. And he’s someone to whom I pay enormous attention because he’s an iconoclastic thinker who does his own work, which is very unusual.

Grant Williams:

Yeah, very rare.

The Lord Of The Dark Matter:

And I think the broad point he’s making, we can think about it passive versus active. Or we can just think about the float, like we were discussing earlier about the German curve. And this is something that’s come up with my own clients for four or five years, now. JP Morgan did a survey, I think, 2016 or 17 about global turnover. Who is what? And they came to the conclusion that as much as 80 to 90% of the turnover in global exchanges on any given day was non-discretionary float. So it could be principal trading firms. It could be these giant factor machines, which I’ve talked about a lot, Bill, over the years. It could be the passive flows. It could be the retail … Well, not retail pundits.

The Lord Of The Dark Matter:

But basically, if 80 to 90% of the flow is systematic or set and forget, or whatever, and you as the discretionary investor, the active investor, the fundamental investor, are only 10% of the float on any given day or flow, you could be the greatest analyst of your chosen stock on the planet. You could have known the stock for decades. You could know management. You know every moving part of their business. But if you mistime it on any given day, it sounds strange, but it’s important these days even for value investors. If you mistime it, you are just going to get run over by the systematic flow. And that systematic flow can just keep going and going and going and going.

The Lord Of The Dark Matter:

And I think the factor machines, as we’ve seen, there’s another factor smash up in equities this week. I mean, extraordinary moves in momentum versus value versus growth versus quality versus size. All these different things. And the amount of money allocated to that is enormous. Maybe it’s too much. But Mike’s making a good point about systematic flow more generally and how it distorts markets.

The Lord Of The Dark Matter:

But there’s an important rider on top of all of this and that is incentives. And there’s some reflexivity to this that I really wish I’d thought about a long, long time ago. And it’s not central banks, although they’re a part of it. But if I’m an asset allocator, sovereign wealth fund, foundation, family office, etc. And I’m imagining the world over the next 5 or 10 years. And you come to the conclusion that your investment committee, their policy rates are going to remain low, inflation might remain roughly at averages, bond yields down, this gun the other. Then your expected rate of return is quite low, obviously.

The Lord Of The Dark Matter:

But for the allocator, there’s another conundrum. Because if my expected rate of return is low, then the fees I pay on my external investments are a very large and rising part of my expected returns. And therefore, I think, I’ve known that manager for a long time. I know that sector. I know that product. But if I’m expecting on a global absolute return bond fund that I might make, and this is a very stylized example, 100% per annum … Sorry. 100 basis points. What am I saying? 100 basis points per annum. I’m not going to pay, BlackRock, 75 basis points for that. I can’t. And you create these incentives where more and more money is allocated on a systematic basis. And it’s effectively an embedded short volatility position, right?

The Lord Of The Dark Matter:

So you’ve got this giant pile of money that’s not discretionary. It’s set and forget on the assumption that if everyone else is doing it, I should do it too. And I’m not sure what the reckoning is. I mean, we could be dramatic and say, “Well, in passive owned, 90% plus of the global stock markets,” and well, let’s face it. We should probably add the Swiss National Bank to this discussion, and the Bank of Japan. And then all these other fellas.

The Lord Of The Dark Matter:

The point is, Bill, it’s really, really, really hard to be a stock picker. It’s really hard. Hang on. I’ve just got to take profit on my Hertz. One sec. Sorry. Gotcha. Gotcha. But it is really hard, but there’s some light. If this inflation view turns out to be correct, you’re going to have higher headline inflation, higher core inflation, steeper long ends of government bond curves, somewhat steeper. And Grant, given the flatness of all those curves … I mean, a five-year treasury at a whopping 32 and a half basis points. Every curve trade is just a bet on duration now because the front end is flat. But if you imagine high realized inflation, some kind of higher inflation premium in the long end of, let’s say, the US curve, you’d imagine that would be accompanied by higher realized interest rate volatility, which would be negative for credit because credit is short an option. It would be negative for equities. And you’d imagine it would be finally, finally, finally, after a long painful decade, very good for value as a concept.

The Lord Of The Dark Matter:

But, Bill, I’m afraid, in terms of structural flow I don’t think there’s a great deal of good news for the very patient, capable, process-driven value investor. I’m afraid this passive conundrum and these systematic flows are going to continue to dominate markets for some time to come. And if I was to be the Dr. Evil of this, I would say that the real test comes if, for any reason, the computers aren’t able to talk to each other, which was the case on some days in March. I’d push a button and nothing happens. Oh, it’s down another 5%. I push another button. I go to pick up the phone. I haven’t done that for 20 years. I pick up the phone to a Citibank desk. Your call is important to us, please hold. And so, that’s, really, Bill … I’m afraid we have to assume that Mike’s point, it’s not an easy one to address. It is what it is, and we have to factor it in to the way we think about navigating equity markets more broadly.

Grant Williams:

Bill, I just think about it as, we’ve basically created a beast that feeds itself.

The Lord Of The Dark Matter:

Yes.

Grant Williams:

And once you to do that, you have to rely on it basically eating too much and making itself sick. And that’s how I think about it.

Bill Fleckenstein:

That’s a good way to think about it. The sad conclusion … Or, not conclusion, but sketch of where we are is, we have bond markets where the prices are administered. The bond markets don’t really exist anymore for G7 countries, at least in the government sector. And now, we have a US stock market that is on autopilot from the passive flow sector. So basically, we have two of the most important markets on the planet that aren’t really markets anymore to a large degree.

The Lord Of The Dark Matter:

So this is where it gets really interesting and we think about potential. Not the actual, but potential scenarios and tactics. I wouldn’t say I totally agree with the idea that G7 bond markets are locked down, because I mean, even over the past week we’ve seen a little bit of a flurry of activity in the treasury market, which relatively speaking is unusual. I mean, it went from 60 basis points to 90 basis points to 70 basis points. Wow. It happened, right?

The Lord Of The Dark Matter:

But when we imagine a world where the systematic, the passive, the non-discretionary flow into equities just keeps going, and we imagine a world where central banks, as intended, end up dominating the free float of high grade government bonds in their jurisdiction. And yet, we dare to imagine a different world of higher inflation or just, for whatever reason, higher volatility and different outcomes than everyone’s parameterized. You think to yourself, well, if the stock market’s just going to do its thing and wobble around a bit, but the passive machines are just in all day, whatever, okay. Maybe there’s some specific parts of equity markets, obviously, that get very interesting. If the bond markets, if the central banks are going to fight me tooth and nail for every basis point of P&L in bonds or rates.

The Lord Of The Dark Matter:

But what about foreign exchange? My bet would be, in that hypothetical world, the pressure valve for so much of this would be foreign exchange, which is the biggest market of them all. And tonight, or this evening here in Wimbledon, we had a bit of a flurry in foreign exchange realized and implied volatility in March, April. Of course we did. It’s all come back down because interest rate volatility has come down, because central banks have basically said, “We’re not going to let that happen.” And of course, currency volatility can’t move too far if interest rate volatility is not going to move too far. Or more accurately, if forward curves in different currencies don’t really change that much, they’re static, then the currencies themselves are not going to really gyrate.

The Lord Of The Dark Matter:

But if you imagine different circumstances in the world, if you imagine equities are just going to … Everyone’s going to say, “Yeah, I know. Everyone’s excited about XYZ, but I’ve got to keep allocating because rates are down and there’s an equity risk premium I need to harvest.” And the bond markets are shut down to speculators, or people make it difficult for speculators to generate profit. Then my sense would be that the pressure valve for so much of it is foreign exchange volatility, currencies more generally, and of course, Bill, commodities.

The Lord Of The Dark Matter:

Now, the thing that is so instructive, I think, for all of us about March, April. There was only one market that cleared. Oil. And it cleared in a way that no machine could have predicted. It had all sorts of stupid instruments that were tracking it. It had the dumbest ETF, which told everyone when they’re going to roll and built up positions, and people hadn’t read the prospectus. There were people gaming it. And you had a barrel of oil trading at a negative number. It traded negative. What does that tell us about the ability of, let’s call them, euphemistically non-administered markets to surprise us?

The Lord Of The Dark Matter:

And it does not mean to anyone who’s listening, “Oh, my gosh. I got to go to interactive brokers, or heaven forbid, Robin Hood. I got to open my currency trading account.” Doesn’t mean that at all, because retail and even institutional, it’s very, very hard to actively trade FX risk. As you both know, it’s very, very difficult to do well consistently. And part of that’s because, with a couple of notable exceptions such as Brazil and Turkey and Sterling, which has been a special situation due to Brexit, currency markets have been incredibly range-bound for what? Half a dozen years? And people get so wound up about every basis point and nothing’s really happening.

The Lord Of The Dark Matter:

But it’s something to reflect on if the world changes, scenarios change … Outcomes change, I should say, not scenarios. Realized outcome change. It could be inflation. It could be some other dislocation. It could be round two of COVID. We don’t know. It’s just to think about, what should I do to be less wrong? Is it the gold stocks? Which still by every measure seem to have done nothing in response to a higher bullion price. And the three of us could differentiate between the very, very speculative ones and the ones that could survive a few cycles.

The Lord Of The Dark Matter:

And you think about, what other instruments are out there that are relatively liquid that could help me be less wrong than others if there’s this big dislocation? And I think you tend to … You’re probably worthwhile wondering about, what do I understand about commodities? What do I understand about commodity companies? The big ones with good balance sheets. You know this, Bill. Do I understand some of these oil companies in March, April, that are probably going to make it and are trading at a discount? How do I think about these alternative ways of hedging against volatility if I’m not going to be allowed to make much money combating the systematic flow in stocks and the central bank bid, etc. in bonds? So I’m wondering about that. What’s the pressure valve? And I think it’s commodities and foreign exchange.

Grant Williams:

But it’s interesting, James, because that brings us back full circle to this idea of inflation, because that’s what it really takes, I suspect to get these things going in a way that you can make some money out of them in a reasoned, rational way.

The Lord Of The Dark Matter:

Yes. So everything I’ve said, to be clear, is conditional. I’m imagining what I might need to get involved in if the world becomes disruptive again.

Bill Fleckenstein:

Yeah. But don’t you think, I mean, to be a decent risk manager in whatever it is you do, you have to think about all kinds of different possibilities, even if they seem bizarre. Because that’s what fuels the process and gets you to not be cut-

The Lord Of The Dark Matter:

I’ll tell you a story. One of the greatest macro investors I’ve worked with, who’s invisible, and he’s done so well for decades. And he was a mentor to me long time ago. And he said, “Look, it’s not about right or wrong. It’s about constant scenario analysis. Reading, reading, reading, thinking, understanding what happened in the past, using charts to take the temperature of markets. But reading, thinking, reading, thinking.” And you build up a portfolio of what he calls fault lines. Now, fault lines doesn’t mean bearish. It just means cracks. Cracks in the narrative, cracks in the consensus view, market structure, whatever.

The Lord Of The Dark Matter:

And he does his research. He puts it on the shelf and he’s so diligent in watching markets, which as you both know, requires enormous effort and discipline to just turn on your Bloomberg the same time every morning and look at the same things and just notice if anything’s different or what the market’s telling you. And then, inevitably, he’ll see something and go, “Hey, wait a minute. I know this.” And he’ll pull it off the shelf and go, “Right. I’m going to do this in your add on features. Something’s changing here. I’ll put one risk unit on. Oh, hang on. No one’s told me about this, but this is going now. I’ll put two. And then I’ll put five.”

The Lord Of The Dark Matter:

And he’s done that time and time again in currencies and rates, and occasionally equities and certain emerging markets. It’s an extraordinary skill. But to embellish Bill’s point, part of the challenge for all of us is to find that time, to just carve out hours to read and think and evaluate. And it’s perfectly okay to say, “You know what? I know everyone’s talking about this. I know everyone’s got an opinion. I don’t understand it. I’m not going to do anything.” That’s okay. I don’t know I’m going to let it go until I see something that I do understand.

The Lord Of The Dark Matter:

And I’ve had some pretty intense conversations with him about inflation as well, and he’s not betting on it yet because he doesn’t see it. He can conceptualize it, but he doesn’t see it. And he doesn’t think the markets are smelling it. Although, he’s obviously got an interest in gold and especially silver, Bill, which I think looks perhaps more interesting than gold. But that’s another conversation.

Bill Fleckenstein:

Well, just since you brought it up, mate. You want to finish and I’ll just give you some-

The Lord Of The Dark Matter:

We came to the conclusion that, as much as we think Milton Friedman tells us … Well, he did tell us. Monetary inflation is always and everywhere a monetary problem. I wonder if it’s always and everywhere a political choice. What’s the path of least resistance?

Bill Fleckenstein:

For sure.

The Lord Of The Dark Matter:

Let’s just turn it up a bit.

Grant Williams:

Yeah. But that’s why it’s so frustrating right now, because they’re trying to turn this damn thing up. They’re making a choice, but they’re unable to-

Bill Fleckenstein:

Well, perversely, all of the years of lack of success. I’m putting up sneer quotes now. On generating enough inflation, ie. the 2% that they made up was their target. You can almost see, when Jay Powell does his press conferences, that he’s frustrated that he hasn’t been able to hit the target. They are going to jump for joy, in my opinion, when they hit that target, and they’re going to let it run hot. And I’m not saying it’s ready to go. All we’ve managed to sketch out here are preconditions that didn’t quite exist till now, both due to variables and psychology, perhaps. And that would, based on our conversation, if we start to see that, that would change a lot of things, and it might create some new things that guys like us who are more value-oriented and less momentum-oriented might be able to muck around in.

The Lord Of The Dark Matter:

You remind me of something I ought to have said way back when we were thinking about inflation and everything else. And firstly, these central banks will never quit.

Grant Williams:

No.

Bill Fleckenstein:

No.

Grant Williams:

No.

The Lord Of The Dark Matter:

Second. The fed is clearly having a big debate about not if, but when to do yield curve control. Combined with, perhaps, average inflation targeting. So now that we’re all in, let’s do more cowbell. Right?

Bill Fleckenstein:

Right.

The Lord Of The Dark Matter:

So even more cow bell. What a great skit that is.

Bill Fleckenstein:

Yeah. No kidding.

The Lord Of The Dark Matter:

Keep in mind that the view of central banks is that easier financial conditions create jobs and create inflation. Now, right or perhaps wrong, the canonical view of every central bank in the planet is that you need to work to keep financial conditions loose, if you ever hope to meet your self-anointed, 2% ish inflation target. It’s financial conditions or nothing. And that’s unfortunately the way they think.

The Lord Of The Dark Matter:

But the other key part of all this central bank activity over the past decade plus has been to ensure that real interest rates don’t go up too much.

The Lord Of The Dark Matter:

Sure that real interest rates don’t go up too much. In order that we continue to take risk. In order that lower real discount rates support equities and risk assets, of course, and most of all, get real rates trending down and staying down. So we bring more and more and more and more and more consumption forward from the future. That was the game. Why? To avoid a liquidation event. That’s what the game is. To avoid a liquidation event by keeping real rates down and, in the future, further down. And this is where it gets really interesting. If you assume that the Fed is going to do you curve control, which you’d imagine somewhere out to the three year, maybe five year part of the curve, involves the Fed acting, to begin with, to push the very front end of the Earth’s curve down to effectively zero.

The Lord Of The Dark Matter:

And the expectation would be that the forward curve flattens as well. That would be their expectation. Retains a bit of steepness for the banking system and regional banks. But their expectation would be that it feeds through to the entire curve. So long-term rates come down as well. Oh. What does that mean for real interest rates? If not the front end, but all of the treasury curve ends up being parked at a really no nominal yield. Either because of the Fed or spillovers from other central banks or the world’s not confident about growth. The world gets disinflation in their head.

The Lord Of The Dark Matter:

So what happens to real interest rates if the world’s risk-free curve, which has treasuries, is locked at a very low nominal yield? And we can’t create inflation. Real interest rates go up. Now that wouldn’t be good. Now we’re a long way from that, but that’s what I’m wondering as I contemplate the world of latter this year. I think it unlikely that the Fed does your curve control before December, but they’re working on it and we’ll probably see the smoke flare go up just as it always does at Jackson Hole.

Bill Fleckenstein:

Won’t they need a catalyst though? To bring that out of the closet. I mean,

The Lord Of The Dark Matter:

No. Well, he said it at the press conference.

Bill Fleckenstein:

Yeah I know. It was like a planted question. It had already been in the journal earlier in the week.

The Lord Of The Dark Matter:

Right. I don’t need a catalyst. They just need to reach consensus. And then they need to think about how to implement it. And by the way,

Bill Fleckenstein:

But, you lost me there for one second because, as you were doing the buildup to that, I kept thinking, “Well wait a second,” you’re setting the scenario for creating even more negative real rates but you concluded with; ‘Real rates would go up.’ So if I lock rates at some minuscule number of basis point and inflation starts to rise.

The Lord Of The Dark Matter:

Yeah. That’s my point. No, no, that’s my point.

Bill Fleckenstein:

Okay.

The Lord Of The Dark Matter:

It wouldn’t be a deadly combination if you had very low nominal rates and no inflation. If you couldn’t create it.

Bill Fleckenstein:

Oh. Yes. Right.

The Lord Of The Dark Matter:

That’s what I was trying to say. So there would be even more pressure-

Bill Fleckenstein:

So that’s what’s in their mind. Is to make them want to push harder. Cause that’s what they’re worried about.

The Lord Of The Dark Matter:

That is what they are worried about, and they have been worried about that for 25 years Bill.

Bill Fleckenstein:

Okay. So, perversely, that feeds back into them doing more cowbell, so to speak, to create the scenario that we’ve kind of come into talking about that could, might blossom prospectively.

The Lord Of The Dark Matter:

The Fed this week, Jay Powell out-doved Bernanke and Yellen by a mile.

Bill Fleckenstein:

Yes. I Thought the exact same thing when I watched that.

The Lord Of The Dark Matter:

Now, a lot of people, just to think about tactics, have said, “Oh, he’s responsible for the market sell off.” Well, I think the three of us would probably agree. Things were extraordinarily frothy going into the Fed. They had trailed that he was going to be dovish. The dollar was under pressure. You know, it’s not as if people were, sort of, shorting stuff. So we were due a correction but he was adamant about what he and his colleagues feel they will need to do. Their forecasts over the years of the Earth’s economy have not been great. But on inflation they are absolutely determined to do at least as much as they’ve done thus far. At least as much. And for the chairman of the Fed and his colleagues to say that we really don’t think we’re going to be touching policy rates this side of 2022.

The Lord Of The Dark Matter:

And when their September statement of economic projection comes out, they’ll probably say, “We’re not expecting to do anything with rates until 2023.” I mean, you could probably put in an algorithm to handle every Fed press conference from there on. “Ladies and gentlemen, we have nothing to say. We would just direct you back to our previous statement.” And just recycle that every month or so. It’s extraordinary to see just how dovish she was this week. Just how dovish. And as much as I teased them and many other people teased them you know what? Are those people punting all this stuff on Robin hood? Are they irrational? Are they irrational? Or are they responding to the incentive that money is free?

Grant Williams:

They don’t have any previous biases like we all do. Right? We know how it’s supposed to work.

Bill Fleckenstein:

Think about it. You essentially. You guys won’t agree with this exactly I’m sure but, we’ve had 25 years of, what I would say, moderately irresponsible to massively irresponsible monetary policy. And in that period where they’ve done all these things, all these crimes against financial sanity, the price to be paid for market participants, equity market participants particularly, has been about 15 months from in 01’, late 00’ into maybe early 02’. And really about a year of really severe pain in 08’. And most recently, 15 minutes of pain.

Bill Fleckenstein:

And each time they create bigger and bigger messes. But now that they have taken ownership of the markets to heart because, to me, they think that the stock market is just the portfolio balance channel dial they turn to create jobs. We now have two and a half generations of people who’ve not seen anything wrong with these policies. So, I’m not even slightly surprised to see the kids of these people playing on Robin Hood and they’ve been taught and they’re being incentivized so, their stock selections may not be great, but I understand why they’re there, which is the point you’re making I think, James.

The Lord Of The Dark Matter:

And on top of that Bill, the magic of zero commission trading, which is the key point. Another point that Mike Green has been making, that kicked in, in November 2019. Why not? I mean, let’s make it as easy as possible to turn the entire financial system into an online gambling machine.

Bill Fleckenstein:

Right.

The Lord Of The Dark Matter:

That’s what we’ve done. It’s like sports betting on steroids in nearly every instrument. Well, that’s not quite right, but certainly in stocks.

Bill Fleckenstein:

Stocks for sure.

The Lord Of The Dark Matter:

Who cares? Who cares If Hertz’s paper or Chesapeake’s paper is trading at 5 cents? Oh, I’m going to trade it up a storm.

Bill Fleckenstein:

Honest to God though, didn’t you both think that, when they filed the shelf last night for the Hertz, that thing was going to go crashing to zero? Last I looked, it was up 50% a day.

The Lord Of The Dark Matter:

As you saw earlier, I’ve been really involved in that one. But, it’s like, why not? Who cares? What world are we in, when a bankrupt car rental company, with a share count of 142 million shares outstanding, as of last night, can issue 247 million shares? And up it goes. What kind of madness is that? But to be fair to them all, is it mad? Or, and this might be a bit of a stretch. Does it tell us about the animal spirits out there and the inflationary tendencies that are just starting to bubble up? I really don’t know but, to be fair, it’s tempting for the three of us to say, “Oh yeah, wouldn’t happen in my day, you know, we bought stuff, we read prospectuses and, blah, blah, blah.” So oh. These people are stupid. Well, again, given the incentives provided to them,

Bill Fleckenstein:

If I was young, I mean, when I was young.

The Lord Of The Dark Matter:

Bill, Bill, just for the record. Bill, Bill Just for the record. You’re young mate.

Bill Fleckenstein:

Oh, that’s right. When I was younger, when I was these guys age, I’m sure I would have participated because I would have thought “I’m smart enough to do this.” I wouldn’t have been, but I would’ve thought I would have been. And what young person doesn’t think they’re smart? You only find out how dumb you are as you get older. Right? So,

The Lord Of The Dark Matter:

Sorry? What?

Bill Fleckenstein:

I totally get it.

The Lord Of The Dark Matter:

What are you talking about?

Grant Williams:

Let me ask you one more quick question in terms of where your talent is. We’ve talked about some of the choices that the central banks are making. So let me ask you both this. You too Bill. Is anything the central banks do these days a choice? Or are they now at the point where everything they do is predetermined? They do what they have to do. Nothing is a choice.

Bill Fleckenstein:

Go ahead. You first, James.

The Lord Of The Dark Matter:

I think it’s probably largely been the case for a decade plus. Not zero choice, but little choice. I’m Ben Bernanke. I can just hold a press conference and say, “Ladies and gentlemen, we did our best. It’s over.” And then, that’s the end of the Fed as an independent central bank. And they’ve got these, literally, legally binding mandates, written into law in every part of the world and, when you sit there in one of these big roles, and when you join, you sign a bit of paper that is legally binding. And I think that does tend to focus the mind of all these central bankers. So they conform(inate?), and many of them privately do. It’s rotten that we’re the only game in town. However, we have to do this.

Bill Fleckenstein:

I naively thought when the, I thought when the equity bubble burst, when it was, I knew it was going to burst and I was running short money, of course, and tried to capitalize on that. I thought, for sure, after that bubble burst, we would look at what we did, learn our lesson, clean it up and set ourselves up to do better. I naively held that view and I don’t know whether it was the fact, in my book about the Fed, I said it was because of 9/11. Changed the narrative. It was 9/11 that caused the problems. Then they passed the first bubble off as just a .com craze when it was more than that. So, after, when they started doing it again, heading in and, I could see they were starting to create a housing bubble.

Bill Fleckenstein:

I realized I had been naive and that they would stop it but, I really thought that because, then they hosed the public again, I thought when the real estate bubble burst, I was certain that they would get religion. And I think, and of course I wrote the book and thought I was going to make a difference and that was laughable too. But, when they started QE, I assumed it would never end and we’re cemented on the path. There’s nothing they can do to get off this just like they can’t leave (Nurpenzur?).

Bill Fleckenstein:

So, they maybe could have done some things along the way. Perhaps if Bernanke would have stopped in 2010 and said, “Okay, boys, I saved a system. Now you’re on your own. It’s going to get bumpy but if we keep doing this kicking the can stuff, we’re going to have all kinds of problems, blah, blah, blah.” Maybe they could have gotten out of it but they have no choice. I mean, they have a choice but they really don’t have a choice. They are on, they have no choice. They’re doing what they’re doing and they’re going to keep doing more of it. That’s what I think.

Grant Williams:

But for me, if you look at the chart and the balance sheet and you look at the runoff, which was watching paint dry. That was the last vestige. The speed with which that went from going down gently to vertical. Past everything. That to me was like, okay. Now it’s-

Bill Fleckenstein:

It’s proof positive that can’t stop these programs now.

Grant Williams:

That’s it. There’s no choices to be made.

The Lord Of The Dark Matter:

Just a sidebar which I think is quite relevant and, I’ve been very, very fortunate over the past 13 years now to get to know some of these key central bankers and, the number one takeaway is, they’re just fellow human beings with families and everything else and I don’t want you to, sort of, put the background music of violins and harps or anything like that. But when you get to know them and you sit down with them, you appreciate how hard the job is when you are, most unfortunately, the only game in town. And, arguably, too many of them are still obsessed with their models and tweaks and thumb dials and everything else. Most infamously John Williams, who, without any manifest understanding of financial markets, was made President of the Federal Reserve Bank of New York, which is the most important central bank in the world. Or at least, district. Extraordinary. And I think that has cost the Fed a bit.

The Lord Of The Dark Matter:

But why do I say all that? In my experience, Jay Powell is as savvy on markets as any central banker you will meet.

Bill Fleckenstein:

Oh yeah. Read those minutes. I mean, he gets it.

The Lord Of The Dark Matter:

He is so good on the plumbing. He understands every moving bit of the financial system. And what I’m trying to say is; as much as people say the 4th quarter of 2018 was a big mistake. And arguably in December it was. That last time. I’m not sure all of that was an accident. Right? And he’d been building up to that for some time. He seemed to be a little bit ahead of his colleagues at the FOMC. And then you may recall, he said at Jackson Hole. And I’m paraphrasing a tiny bit. “Yeah, yeah, yeah, all this ‘R star’ stuff.” You know? It’s impossible to forecast and you can see John Williams jaw drop out of his head and everything like that. But it was an important signal to the world that we’re going to keep going. And then he chucked on top of that, ‘long way from neutral.’

The Lord Of The Dark Matter:

Now that’s pretty gutsy, to say the least. When you’re Chairman of the Fed and you’re acting, to try to take some wind out of asset prices. Now, unfortunately he was too successful and then he got some pretty bad earnings from the Facebook’s and other guys and all of a sudden, what started as a correction, started to get ahead of him and for reasons that may yet emerge, they locked themselves into the December, 2018 rate hike. Now I’d have to think at least some FOMC members realized, “Oh gosh, we can’t dissent because that would be worse. All right.” And then this back-and-fill spin was that, Jay Powell and his colleagues got together over the new year period in 2018 and did a handbrake turn and dot.dot.dot. But the reason I raised that is because, I’m not sure he’s getting as much direct market intelligence today, given how much is in his calendar, then he was when he was just a member of The Board of Governors of the Federal Reserve System because you have a bit more time in your calendar.

The Lord Of The Dark Matter:

But again, in my experience, there are few more savvy central bankers in the world, when it comes to how things work, than Jay Powell. And, then I watched the press conference this week and I’m like, he’s never going to do that again. He’s never going to do it again. And that’s a function of where the world’s got to.

Bill Fleckenstein:

Do what again? I’m sorry. I didn’t know who we mean.

The Lord Of The Dark Matter:

He’s never going to try and pop an asset bubble.

Bill Fleckenstein:

Oh, right. Right. Right. He basically stated that this week in the press conference. Basically.

The Lord Of The Dark Matter:

That was a confirmation of what we knew but, gee-whiz. For a central banker, for the Chairman of the Board of Governors to say that is quite something. It’s quite something. Unreal. But yeah, look, Bill it’s, the “Shoulda Woulda Coulda.” the hindsight, reflections and everything else, I’m afraid was so far beyond all that. And while I remember, part of the reason the March smash-up was so bad. It was not just because of COVID-19 and shutdowns is that, it was, in January everyone was “Cash is trash.” Or, “Get any more illiquidity, duration, leverage. Get me more punting capacity. I need to lever up. I need to do more of this. I need to do more of that.” There was no margin of error at all in the system.

Bill Fleckenstein:

No.

The Lord Of The Dark Matter:

Which exacerbated the response to the rolling lockdowns. Right? And the Fed and every central bank was forced to operate as the market maker of first resort.

Bill Fleckenstein:

Yep.

The Lord Of The Dark Matter:

And how you get out of that. I don’t know.

Bill Fleckenstein:

Oh, I just assume, we’re so far past the point of no return that the only question is; “Does something stop them?” which is where we started this conversation and, I know something will because, these things can’t go on forever but I don’t know when and how long they’ll be and, anyway, that’s why I was, and we were both so interested to talk to you about these topics because, we don’t know what’s going to make it end or the timing but, at some point it will but, for now, it’s clear that they are, you know, “Damn the torpedoes, full speed ahead. We’re not wavering.” For a few years. That’s what they’re planning.

The Lord Of The Dark Matter:

Yeah, and I think if I was to think about an overarching framework for this discussion. It’s like, okay. If inflation, again, a hypothetical. So let’s just say higher inflation than we’re used to is a thing, we’re probably not going to see it first in the traditional things, which is, the long end of the bond curve.

Bill Fleckenstein:

Right. Right.

The Lord Of The Dark Matter:

Right? Or breakevens or even zero-coupon inflation swaps. I mean, quite frankly, why does something like that even exist? A zero-coupon inflation swap. Isn’t that just like a punting mach..? I shouldn’t get into that but, we’ve got to imagine, where should we be looking for signs that something’s changing? And the answer, of course is, in non-administered markets. I won’t call them suppressed. I’d call them ‘non-administered markets’ that are generally clearing and that leads us to currencies and in particular, commodities. And look, it’s not just that gold is doing what it’s doing and I think, all things being considered of late, it’s being very resilient. Right?

Bill Fleckenstein:

Yes. Yes.

The Lord Of The Dark Matter:

We should be thinking about silver, which is a bit of a laggard. Bill, we should be eyeballing for potential breakouts. I mean, there’s a bit of reflexivity perhaps but, looking for breakouts in baskets of junior gold stocks, which have been trading up, trading up, trading up, as you know, but if suddenly there’s a bigger move and no one can explain it, that’s really important.

Bill Fleckenstein:

Yes.

The Lord Of The Dark Matter:

And then I look at copper and I could go down all the checklist and it’s just to keep an eye on all those things that might be changing because as Bruce Kovner said, many years ago, in that wonderful Jack Schwager book Market Wizards.

Bill Fleckenstein:

Yeah. Great book.

The Lord Of The Dark Matter:

All of them are great. Breakouts, for reasons that nobody can understand, are normally terrific risk/reward trades. And that’s stuck with me for a long time.

The Lord Of The Dark Matter:

So look, I know I can’t be definitive on inflation. Yet. I’m imagining different scenarios. I’m thinking about where we’re at with monetary policy and what’s still to come. I think about fiscal policy, which I very much doubt will be dialed back. I’m thinking about supply-side shock. I’m thinking about supply chain disruption, delivery delays. I’m thinking about the struggle to get people back from over 100% unemployment insurance to actually physically back doing their job and, will companies have to bid up?

The Lord Of The Dark Matter:

And then of course, something we didn’t talk about. The ability of companies to pass through. Higher prices if they’re forced raise wages. So there’s a whole series of hypotheticals and I’m trying to keep an eye on it and trying to think about it. Over the next six months of 2020. Because, quite frankly, if we cannot create somewhat higher inflation with all that, in the next six months, then when we will we? Right? So there’s another side to this.

Bill Fleckenstein:

Amen to that. That’s very well said.

The Lord Of The Dark Matter:

And it’s not like, Bang. Crash. Wallop. This is the scenario. It’s like, hang on a second. It’s like, if we get to October and we’re talking to each other again and going, gee-whiz, you know? Where everyone’s back online. The world’s picking up. Somehow. And there’s still no inflation.

Bill Fleckenstein:

Great point. Well, maybe that’s a good place to end it. We can come back in October and discuss this again.

The Lord Of The Dark Matter:

There ya go. We’ll do it whenever you like, it’s been very pleasant. All right mate. Have a good weekend.

Bill Fleckenstein:

Thanks for that. Thanks a lot.

The Lord Of The Dark Matter:

All right guys. Bye.

Bill Fleckenstein:

Bye.

The Lord Of The Dark Matter:

Off I go.

Bill Fleckenstein:

Wow!

Grant Williams:

Fantastic.

Bill Fleckenstein:

Wasn’t that? Oh, I mean,

Grant Williams:

Well, Bill. I’ll tell You what, as I said at the top of the show, James is at the top of both our wishlists to kind of dig into this topic and everybody that’s listened to this now understands why.

Bill Fleckenstein:

Yeah. I don’t even think we need to sum up what he said because it speaks for itself.

Grant Williams:

Yeah. I Mean, yeah. There was one thing that really struck on me that I wanted to just have a very quick chat with you about, and that was, the point he made when he was talking about Mike Green and the point he made when he was talking about this mentor of his, who was clearly a big influence on James. And that was the commonality in both the approaches that Mike Green is a smart, original thinker that does all his own work. And the same with this guy. He’s a smart, original thinker that isn’t afraid to do his own work and then just put that away. The work’s done. I don’t need to do something with it. I don’t need to act on this now. I just wanted to understand it better and, by understanding it, it’s there.

Grant Williams:

And when the dots connect and the synapses fire at some point down the track and you realize what it is. Like he said, you pull that off the shelf and you’re just ahead of the game at that point with people and for me, James is someone that I consider, every chance I get to talk to him. That’s part of my learning process, right? I will make notes on this conversation and a lot of the things he said. I will be finding a way for when that inflation does return and plenty of other instances of, that you and I can probably imagine when, what we’ve learned in these last couple of hours are going to be extraordinarily valuable to us.

Bill Fleckenstein:

Yeah. I think sometimes you don’t really know what you picked up that’s going to be useful or when you might use it but, I thought it was particularly worthwhile to hear his viewpoint on how, if inflation is to become an issue, how it might coalesce and what should we be looking for and all of that and it might not be something we need to consider immediately but, it was liable to be one of those things that’ll be, as he said, to quote the phrase “Suddenly, and then all at once.” I’m pretty sure if that turns out to be an issue, it’ll kind of go like that.

Grant Williams:

Yeah. I completely agree. Well you’ve had the chance to listen to James now. His firm is Aitken Advisors. He is on Twitter. You’ll find him, but it’s a locked account so you’ll have to ask him nicely and we can’t promise that he’ll allow everybody to follow him but, if you can get into that exclusive VIP area, trust me, it’s a good place to be.

Bill Fleckenstein:

Amen to that.

Grant Williams:

All that remains is to thank you for listening to episode two. To thank Bill for doing this with me. You can find me on Twitter, should you wish to do so @TTMYGH

Bill Fleckenstein:

And I am @fleckcap

Grant Williams:

@fleckcap.  . Thanks so much. We’ll be back with another one of these in the, not-too-distant future. Thanks for listening.