Luke Gromen (00:02:28):

Something we’ve been talking about for ad nauseam is I think we’re living through the first bursting global sovereign debt bubble in 100 years. And we think you’re going to need negative real rates, sustained basis, increasingly negative to make global sovereign debt and fiscal positions and entitlement obligations, in the West in particular, sustainable. Third thing is you’ve got what we’ve been writing a lot about over the last year, something that we call peak cheap energy and metals. And you’re seeing, not that we’re running out of energy and metals, but the ore grades needed to address the levels of demand are going to likely require significant upticks in price. You’re going to have a real sort of sustained inflationary impulse from commodity and metals markets in a way that we probably haven’t seen in some time.

Luke Gromen (00:03:09):

Something we started writing about late last year, it’s long been known that the Chinese have water issues, water constraints, that they’ve been talking about it for 10, 15 years. There’s been a number of US policy makers talking about it for 10, 15 years. There’s a lot of signs that have begun emerging in the second half of 2021, that those water constraints in China are becoming acute. And to be blunt, if China has a water problem, China has a power problem. And if China has a power problem, the world has a power problem. And the world has an inflation problem, since China’s the world’s factory.

Luke Gromen (00:03:40):

And that’s something sort of these, “Inflation is transitory,” crowd I think are missing, is that both peak cheap energy and metal and these Chinese water constraints, I think this sort of new Cold War, if you will, that some people are calling it, I think a lot of people are still looking at that through this lens of … I think a lot of the economists are completely discounting it, like it doesn’t exist. A Cold War with the biggest commodity consumer in the world, the biggest factory in the world, the biggest trading partner of everybody in the world.

Luke Gromen (00:04:06):

And it’s just like, “Well, hey.” We’re sort of snapping our fingers and tapping our heels, and the supply chain problems are going to go away. And meanwhile, we’re in this new Cold War, pseudo Cold War, if you will, with that trading partner. And it’s a Cold War that most people I read are still evaluating based on the lens of the USSR, a lot of times I find. “Hey. Well, there was a Cold War, we won that.” There was a reason why the baby boom generation didn’t offshore our manufacturing to the USSR. And we never fought that Cold War once in a position where the USSR had a quorum of our manufacturing. And there’s a great book I was reading over the holiday break by Rush Doshi, or at least excerpts of it, I started it. I think it’s called The Long Game.

Luke Gromen (00:04:47):

At any rate, he highlights that in the last a hundred plus years, all of America’s adversaries, World War I, Nazi Germany, Imperial Japan, the USSR at the height of their power, none of them in singularly or in aggregate ever had an economic cloud such that their GDP was 60% or more of the United States’ GDP. And China hit that level in 2014, so we’re eight years past. So we’re dealing with a different animal, and so the way that manifests, I think these trade issues, supply chain issues, I think probably going to be much stickier than people think. They’re just not factoring in sort of the geopolitical angle of that.

Luke Gromen (00:05:23):

And then I think within all this as well, something that our friend Jeff Booth talks about a lot. Obviously, he made this concept famous in his book, The Price of Tomorrow, which is, if you haven’t read it out there, a brilliant, short, easy read. You have to read it. But it’s into all of this, we have a technology that is moving faster and faster, and forcing deflation on the system, which is a problem because the system is debt backed and needs exponential inflation.

Luke Gromen (00:05:46):

And so you’ve got sort of this cocktail of things that nobody’s ever seen, really singularly, let alone in aggregate, all coming together. You still have a US balance of payments problem. You’re going to have that, because it’s the way the system works. We run these massive current account deficits. Foreigners are not buying enough treasuries relative to what we’re emitting. And so the Fed’s going to try to tighten into this.

Luke Gromen (00:06:07):

And so when I came into this year, and even finishing last year, was really kind of looking at these things and just thinking the Fed’s making a policy mistake, that should not be tightening. They need to let inflation run hot. The politics are getting in the way. Democrats are worried about midterms and the inflation. And I get it, but the Fed’s doing the wrong thing by tightening.

Preston Pysh (00:06:29):

That’s super contrarian to everything you’ll hear out in the markets, that there’s a massive policy error being made with them saying they’re going the tighten. You’re saying they’re making the right decision by doing nothing.

Luke Gromen (00:06:40):

I think they should do nothing. I think they should absolutely let inflation run hot. And the reason I say that is, we know the World War II playbook, right? We saw last time that the GDP got this high, they let inflation run hot, they capped yields from 46 to 51, US debt to GDP went from 110% to 55%. US real rates went as low as negative 14% and were negative pretty much that whole time, or certainly the vast majority of the time. And by taking the debt to GDP from 110% to 55%, what it did is it de-levered the system where the Fed could then normalize policy without blowing things up.

Luke Gromen (00:07:14):

And that’s what needs to happen again, even more so now, because there’s more debt, the dollars, it’s not a gold-backed system. It’s a debt-backed system. You’ve got the Eurodollar system. There’s all these reasons why it’s way more important now for the Fed to let inflation run hot, to de-lever it before … Because if they tighten before they de-lever enough, they’ll blow up markets, they’ll blow up the system.

Luke Gromen (00:07:38):

This is where it gets really interesting, is because if you look, you and I talked about this probably a year ago at this time, real rates have to get much more negative. They did. Debt to GDP, went from a high of 135% in late 2020, down to 122%. So we’ve actually gone from 135 to 122. So it’s not the 110 to 55 that we did after World War II in five years, but we’ve made progress. Now the challenge, the scary thing on some level is going from 135 to 122 took 7% CPI, it broke supply chains, where letting inflation and demand run this hot to try to de-lever the US government’s balance sheet completely broke supply chains, in part, because they’re all so stretched now. Right? [crosstalk 00:08:22].

Preston Pysh (00:08:21):

Did you say that the supply chains broke and caused the 7% CPI print? I see it kind of a little bit in reverse, where I think a lot of the COVID policies and things like that were actually causing a breakdown in supply chains. And then that caused prices to go up, which then gave of you the CPI prints.

Luke Gromen (00:08:42):

I think that’s fair, but I think the key takeaway is it almost doesn’t matter, chicken or egg, which came first, is that running the economy that hot as we did with the COVID stimulus and all this stuff, the supply chains can’t handle it, the system breaks down.

Preston Pysh (00:08:55):

True, true. Yeah, it’s both of those things.

Luke Gromen (00:08:57):

On one level, they need to let this inflation run hot, but the supply chains aren’t working with it running this hot. Now the flip side to all of this that has really started to evolve in my way of thinking, just more recently, last couple weeks is I’ve been watching the dollar trade to down with real rates rising in the last week, week and a half. I’ve been watching gold rise with real rates rising sharply in the US off the lows. And neither of these things should be happening, and I was kind of scratching my head a little bit about why that could be the case.

Luke Gromen (00:09:29):

And all of a sudden it hit me. I had an epiphany. I went back to something that I watched at the time, I wrote about at the time, but last May, Stan Druckenmiller, obviously a legendary investor, and I think, maybe even a more legendary FX trader. I mean, the man is unbelievable at FX, right?

Preston Pysh (00:09:45):

Yeah, yeah.

Luke Gromen (00:09:45):

He gave this incredible interview on CNBC in May of last year, May of 2021. And in it, he lays out the case that once we get on the other side of the pandemic, once you start to have this recovery, he actually … even to back up, he lays out the whole case, “Look, foreigners aren’t buying enough of our treasuries. Instead they’ve been buying US tech stocks, right? So we run these massive deficits, and instead of sterilizing US deficits via treasury buying, they’ve been sterilizing deficits by buying US stocks, and in particular, US tech stocks.”

Luke Gromen (00:10:15):

And his point was that whenever we get on the other side of the recovery of the pandemic and Fed starts to tighten, you’re going to get sort of this traditional recovery, cyclical sector rotation out of tech, into commodities, cyclicals, banks. Value, right? Why pay up for growth, when the underlying economy is going to recover and grow? Classic sector rotation. What Druckenmiller’s point was is that’s going to be terrible for the dollar, because the US is still going to run the deficits, so much of it is structural, and they’re not buying enough treasuries. They almost can’t, certainly not with the dollar valued where it is, but they’re not. And so they have been sterilizing it with buying tech. But if they start moving money out of tech, that means capital flows that are helping finance these deficits, sterilize these deficits, start flowing elsewhere on the margin, and the release valve turns into the dollar.

Luke Gromen (00:11:06):

And so it’s interesting, in just the last week, week and a half, I’ve been watching the dollar trade down when the dollar should absolutely be trading up. Everyone in the world is … and I would’ve been right there with them, myself, a week and a half … The dollar have be going up. Everybody’s along the dollar, everybody’s selling yields, and yet the dollar’s falling aggressively, in the last several days.

Luke Gromen (00:11:24):

And so I think that I’m, really, to answer your question, coming to this year where I’m of these two minds. One is, it is absolutely unlike any other cycle we’ve ever seen. And so you can sort of throw out a lot of the playbooks. But you’ve also got sort of this view of the tech, where the rotation out of tech could be really bad for the dollar and feed on inflation. Right? If the dollar gets weaker, that’s only going to put more upward pressure on inflation, and force the Fed to tighten more, which is going to sort of … It’s a very interesting dynamic.

Preston Pysh (00:11:53):

If Brent was here, Brent would be throwing something at the screen and saying, “But Luke, the dollar’s been up for the last year. This is just a standard volatility move since the start of 2022.” What would you say back to that?

Luke Gromen (00:12:08):

He might be right. It’s too quick to tell, but with all due respect to Brent, if I had to listen to Brent or I had to listen to Stan Druckenmiller on currencies, I’d be listening to Stan Druckenmiller. And when you look at the flows, and I’ve looked at the flows, it makes sense of, you can see the treasuries aren’t being bought. You know we’re running the deficits, you know how much of the deficits are structural. Because so much of it is entitlements, defense, interest, not these things you can cut, and so those are just going to keep growing at a one clip or another. Then you can see not enough treasuries being bought. And then it’s just a question of, okay, if we’re running deficits, we have to balance that in the capital account.

Luke Gromen (00:12:43):

And the way the Americans balanced it in the capital account is via either tech stocks, we sell tech stocks to the world, which is what we’ve been doing, really, since 2010. You can see, there’s a chart in the Fed FRED database that foreign holdings of equities has gone from like 2 trillion in 2009 to 12 trillion in 2020. Right? So, I mean, it’s that we’re buying stuff from China, and China’s buying tech stocks from America. It’s probably not a great trade in the long run, but that’s what we’ve been doing.

Luke Gromen (00:13:11):

And so if you then take away tech stocks, or you start … You’re not going to take them away, of course, but on the margin, if the flows start moving away from tech stocks, and capital globally starts moving towards oil, and it starts moving towards industrials and cyclicals, with the price of oil and cyclicals and gold, and all this other stuff is going to have to rise a whole lot to sort of balance those current account deficits.

Luke Gromen (00:13:33):

And so it’s very possible we’re just seeing sort of a small move, counter cyclical move, and that sort of the Fed is tightening and real rates are rising, and the dollar’s going to go up. That might very well be the case. And that’s why I say I’m of two minds. It’s still early. I think it’s too early to tell. And quite frankly, a lot of it is dependent on what the Fed does, right? I mean, if the Fed comes out and let’s take a real aggressive … Let’s say the Fed says, “All right, we have a $9 trillion balance sheet and it’s going to be back to 800 billion, like it was in ’08, pre Lehman, by the 4th of July.”

Luke Gromen (00:14:06):

Well, dollar’s probably going to go up a shit load, right? I mean, rates are going to go up, dollar’s going to go up, markets are going to go down. And so if that’s your extreme case, of extreme from the means, then it’s too early to tell. But I’m watching these two dynamics very closely. This isn’t just a normal cycle. And then this other dynamic of, “Hey,” if there’s a sector rotation away from tech, the dollar could have a bad year when everybody thinks it’s going to have a good year.

Preston Pysh (00:14:30):

So with all that said, the most popular question out of the hundred plus questions people posted on Twitter for this discussion, this is what people really want to know. How much can the market handle in the fixed income? The sovereign fixed income, US sovereign fixed income. What percent can these yields get up to before we’re going to see another deflationary fit thrown by the economy? So the 30 year today is at 2.09. The 10 year is at 1.75. Throw out one more here. The one year is at 0.48. What do those go to before we start to see things really get wonky, and you start to see equity starting to sell off. And clearly, we are in a deflationary bust at that point. What do you think they’re able to get these things up to?

Luke Gromen (00:15:20):

It’s going to sound like a wishy-washy answer, but it’s not. The answer is, is that it depends on where the dollar is. So if the dollar is here or higher, you’re probably getting close to the levels where … and I think you saw that to a certain degree last week. Last week was an ugly week. Two weeks ago or three weeks ago, whenever it was, we had a round to sell off some of it. And it was weird, because you had some days where it was just sector rotation, oil was up, but tech was getting killed, but there were a lot of days where everything was getting killed. Oil was down, tech was down, yields were up, industrials were down, everything was down.

Luke Gromen (00:15:54):

And so I think with the dollar at 96, at 97, the dollar certainly at 100, we’re probably there. Maybe not quite there, but close. I think that’s what, the wobbles we saw over the last two, three weeks are telling you, that we’re probably getting close. I think, the yield curve where, it’s flattening out is probably telling you that, that we’re getting close.

Luke Gromen (00:16:14):

If you take the dollar down to, I don’t know, 70 on the DXY, let’s say, for a big number that’s not completely non-credible. If you take it down to 70 over the next 12 months, then I think you probably can hit some of these numbers that Jamie Dimon and some of these other banks are talking about. Right? We’re going to start normalizing the balance sheet, and we’re going to raise rates four times.

Preston Pysh (00:16:38):

And just for context for people, to get down and to break 80, we haven’t been below 80 since 2014 on the DXY.

Luke Gromen (00:16:45):

Yeah.

Preston Pysh (00:16:46):

So today, we’re at 94. At the start of 2021, a year ago, the DXY was at 89. And today we’re sitting at 94, kind of got up to … what was the high here? 97.

Luke Gromen (00:16:59):

97, yeah.

Preston Pysh (00:16:59):

Yeah.

Luke Gromen (00:17:00):

And it was all, a lot of it … And really, since May, June of last year, it sort of did enough. But if I remember right from memory, it sort of was range bound from January through May, June of last year. And then the Fed came out and said, “Hey, we’re going to tighten more,” and the dollar had a good second half.

Preston Pysh (00:17:14):

So for the dollar to sell off that much relative to all these other currencies, let’s say the dollar goes to 80, I mean, you’re going to have to see extreme tightening for all these other currencies. So over in Europe, over in China, all these other places are going to have to have extreme tightening in their currencies in order to allow the dollar to become that much weaker. Correct?

Luke Gromen (00:17:37):

You would think so.

Preston Pysh (00:17:39):

It’s a zero-sum game.

Luke Gromen (00:17:40):

It could be the capital flow issue we just identified, right? When we’re in recovery, the pandemic becomes endemic. Who needs tech at 40 times sales, when you can buy Parker Hannifin at whatever it’s trading at right now, 10 times EBITDA. I don’t even know. I’ve not looked at it. All I know is it’s a heck of a lot cheaper than sort of pretty much anything on sort of the NASDAQ. And you’ve seen, obviously, I think some capital flows out already. The average NASDAQ stock has had a really rough four, five months.

Preston Pysh (00:18:08):

The only reason I kind of push back on that, even being a potential is [Lynn 00:18:12] just had a post today where she was talking about how over in China, they’re really kind of creating a much more accommodative policy over there than what we were seeing last year, which was probably the tightest ship being run from a monetary policy standpoint for 2021. So if they’re easing and they’re expecting the dollar … we’re having this conversation about the dollar falling down to an 80 on the DXY. I don’t know, I just don’t know that these international markets could possibly allow for the dollar to fall that far, without them stepping in and saying, “Oh, we’re racing you, and we’re just going to try to debase just as fast and make our currency just as weak.”

Luke Gromen (00:18:54):

So it’s interesting, right? If it’s a capital flow issue, like we just talked about, where suddenly money starts flowing out of tech into industrials, commodities, et cetera, it’s going to be flowing out of the US, elsewhere. The dollar starts to fall. Now, what’s really interesting in all this is, everyone could be loosening in terms of their policy. It’s a capital flow issue that is cyclical, based on the cycle of where we are, and the price investors, global capital’s willing to pay for growth. They don’t need to pay up for growth so they can switch to value.

Luke Gromen (00:19:25):

And what’s interesting in all that is, because I agree with your point that these countries aren’t going to necessarily want their currencies to strengthen per se against the dollar. But what will they be doing to try to fight it? They’ll be buying treasuries, right? They’ll be buying … And what does the Fed desperately need to have happen if they want a taper? They’re selling treasuries, Fed needs a buyer. Fed absolutely needs a buyer. So it fits where if you have this cyclical capital flow, if the pandemic is becoming endemic, you sell growth, you buy value, you buy commodities, you buy emerging markets, you sell the United States, and the dollar falls based on the capital flow issue. Then foreigners are going to start buying a lot of treasuries as the dollar falls.

Luke Gromen (00:20:08):

And you can see very clearly, there’s an adverse relationship between the level of a dollar and how many treasuries they buy. And once it gets too high, they sell a whole lot. And once it gets low enough, they start buying again. And so I think something that could work away from … I think it could be driven by capital flows, rather than relative interest rates. It’s a balance of payments equation. But to me, it’s still very early to tell, but I could see clear to something like that happening.

Preston Pysh (00:20:35):

So your analysis involves a lot more variables and a lot more thinking than how I think about the answer to this problem. And I’m going to put a chart up here on the screen, if people are watching this on YouTube, I think they might be able to see the chart. If not, all I’m doing is just pulling up a bond yield curve and showing Luke the long term trend of the bond yield curve. So here it comes, Luke.

Luke Gromen (00:20:58):

Okay.

Preston Pysh (00:20:59):

I’m putting it up on the screen. So here’s the bond yield curve.

Luke Gromen (00:21:01):

Is that yield curve?

Preston Pysh (00:21:02):

You’ll see this line up top is really kind of the long term trend, the 30 year trend, right? And it’s obviously sloping down, and I’m just showing it off of the 30 year. All the other durations underneath of that would be slightly lower for where they were kind of peeking out on previous mini cycles, or whatever you want to refer them to.

Preston Pysh (00:21:23):

So all I’m doing is I just keep this running trend line of kind of where we’re at across each of the durations. And I’m looking at where they’re intersecting, and I’m saying, “Okay. Well, it looks like you could maybe have an inversion on the bond yield curve out here in July of ’22.” Because that’s where a lot of the lines start to cross over. And then as far as just kind of like, where would it peak out? Well, I guess it could stick with this 40 year trend line that’s up here above. I would see that as a worst case scenario, where the 30 year maybe get up into this range, like a 2.7, maybe where it would maybe throw a fit.

Preston Pysh (00:22:00):

But I’m with you. I follow this analyst from Fidelity, and he puts up incredible charts. And he’s saying something very similar to what you’re saying, which is, you’re already seeing the market really struggle to handle the yields we’re at, even right now. And that you’re starting to see the credit markets really kind of sputter and stall out, which is really interesting. But if you go back to that chart, you can see, we are deeply under that 40 year trend of how high those yields would sell off to, and for people that aren’t familiar with bonds, that as the yields go higher, they’re selling off. People might not realize, there’s a whole lot more to go on that trend line compared to where we’re at right now. But yet, the markets are already acting like they’re going to throw a deflationary fit.

Luke Gromen (00:22:50):

Right, which is the last thing they can afford to have happen. I mean, it’s [crosstalk 00:22:56]-

Preston Pysh (00:22:55):

Which is why you’re saying they shouldn’t raise rates.

Luke Gromen (00:22:58):

They shouldn’t raise rates. They should let inflation run hot. And it’s becoming a political issue, which is … I struggle to remember the last time our politicians were right about anything.

Preston Pysh (00:23:06):

So I don’t see it necessarily as a political issue. Help me understand why you think it’s a political issue?

Luke Gromen (00:23:11):

I think the Democrats are seeing their midterm numbers, and I think they’re scared to death. [crosstalk 00:23:16]-

Preston Pysh (00:23:16):

They want it to stay low.

Luke Gromen (00:23:17):

Yeah, and I think the Republicans are being opportunistic, and saying-

Preston Pysh (00:23:21):

Oh.

Luke Gromen (00:23:22):

“We have something we can hammer on them about.” Look at, I mean, you’re starting to see the Joe Biden, “I did that,” stickers show up on gas pumps all over.

Preston Pysh (00:23:31):

Yeah.

Luke Gromen (00:23:31):

And so I think that it’s very cynical on the part of the Republicans, and it’s politically dumb on the part of the Democrats, because you actually have working class wages rising above inflation for the first time in 20 years. And it’s been happening for three months, and so …

Preston Pysh (00:23:47):

I completely agree with every point you’re making. How inept does this show you the central bank is, that we just had a 7% CPI print, everything on the yield curve is selling off like crazy, and your Federal funds is pegged at zero?

Luke Gromen (00:24:02):

I think they’re doing what they have to do.

Preston Pysh (00:24:03):

But we’ve never seen that before, Luke. We’ve never seen them not move.

Luke Gromen (00:24:09):

We’ve never [crosstalk 00:24:10].

Preston Pysh (00:24:10):

When this blowout …

Luke Gromen (00:24:13):

Not since after World War II, no. And the US is facing a very similar problem that Germany was facing in 1931, which was, okay, without the baggage of having hyper inflated eight years before, they had these very onerous war debts, they had these high debts period. They had spent a bunch of money domestically on things like stadiums and stuff that couldn’t possibly earn the foreign exchange to pay back the notes that was owed in foreign exchange. And they had these war reparations that were in an inflation adjusting currency that they couldn’t print.

Luke Gromen (00:24:45):

And in the same way, the US has all the debt, and it’s got the war reparations, which are entitlements, and a lot of them are … they don’t owe dollars. They owe healthcare, goods and services that the Fed can’t print. And so there’s a lot of similar … we just lost a war, the global war on terror. We saw us pulling out of Afghanistan, and et cetera. You’re in sort of this great power competition with China. The Germans were deindustrialized by war and by war reparations, the Ruhr valley was seized by the French.

Luke Gromen (00:25:12):

We voluntarily shipped a quorum of our industrial base to China, based on a shortsighted mistake in trade policy, ill advised trade policy, shall we say, in the long run. And the punchline is that in 1931, the Germans faced a choice. They could either inflate and basically keep the domestic voters happy, or they could run austerity on the domestic populace to try to keep the external creditors happy, but they couldn’t do both. And the Fed’s in the same position where they should be letting inflation run hot, they should be screwing bondholders, on a real basis, and capping yields.

Luke Gromen (00:25:51):

Somebody has to pay, either the bondholders pay in real terms, or the bondholders pay in nominal terms via austerity and we write the debts down. And ultimately, the Germans did it via austerity. And the political fallout from that, the world paid for it for the next 15 years with the rise of the Nazis and Hitler, et cetera. Anyway, that’s not to say we’re going to sit … but it’s the same dynamic that we’re seeing here.

Luke Gromen (00:26:12):

And I had this thought as I was getting ready for the interview, when you talk about what’s the Fed doing, I really think the measure for people at the Fed, people in Washington should be, do they want the job? And if they want the job, they shouldn’t be allowed to have it, because they either don’t understand what they’re walking into. I mean, it’s going to be a disaster. Or they’re a sociopath, and the fact that they want the job proves they’re a sociopath. What you want are qualified people, want to be like, “I don’t want anything to do with this job.” I mean, they’re literally like “Here. Here’s a stick of dynamite. You’ll make 180 grand, and then you can get rich on lobbying after your service is done.” It makes no sense.

Luke Gromen (00:26:52):

So the Fed is doing what they can. I don’t blame the Fed. The Fed is managing an unmanageable situation.

Preston Pysh (00:26:59):

No doubt.

Luke Gromen (00:26:59):

I mean, they have to do the same thing that Germans in 1930 … I mean, there’s literally a section of the book, 1931, where the chancellor of Germany, Brüning, says, “The plan is, we’re going to tell the domestic audience that we’re not going to pay the war reparations. And then we’re going to tell the foreign audience that we’re going to pay the war reparations and implement austerity.” And the problem, of course, is the internet didn’t exist back then, so you could get away with that for a while.

Preston Pysh (00:27:21):

Yeah, big time.

Luke Gromen (00:27:21):

Now, you can’t tell the bondholder … it’s in the markets instantly. So it’s this fundamental disagreement that’s unresolvable. You have to make a choice. It’s this riding two horses with one ass analog I keep referring to. [crosstalk 00:27:37]-

Preston Pysh (00:27:36):

There’s multiple questions about that, by the way.

Luke Gromen (00:27:40):

And then you overlay the resource stuff, the China water stuff, the Cold War stuff. I mean, who would want to manage through this? You either have no clue what’s going on, or you’re nuts.

Preston Pysh (00:27:51):

You mentioned something earlier that I really want to go back to, because this is something I just don’t know that much about and I’m really curious. The China water problem that you brought up, and then you said it turns into an energy problem. Start, really, take us down the path on this to help us understand. What’s inherently driving this water issue? And if you do have any good resources for people to read up on, because I know I’m curious if you have any recommendations on that. But explain to us in layman’s terms here what’s going on.

Luke Gromen (00:28:20):

Yeah, so there’s a gentleman name Gopaul Reddy who really has furthered my thinking on it. Brilliant guy. We’ve talked a bit. R-E-D-D-Y is how you spell his last name. And he wrote a piece, you can find it online, it’s public. It’s an issue near and dear to his heart. And he is standing on the shoulders of a gentleman whose name escapes me. He’s a British gentleman, I think he’s a former member of parliament, and he wrote a piece as well about China’s water issues in 2018. And my understanding is the British gentleman was, for his troubles, asked not to come back to China for publishing that.

Luke Gromen (00:28:55):

Now, Chinese have written and talked about this. You can find it in The Economist.

Preston Pysh (00:28:59):

I want to read it now.

Luke Gromen (00:29:00):

Yeah, it’s incredible. It’s eye opening. And so the issue ultimately is really, it’s structural. The Chinese, a lot of the population’s in the north, they don’t have a lot of water, the rivers have been drying up. It’s sort of a fundamental mismatch. They don’t have enough water to start with. Climate change or whatever, the water supplies that they do have are shrinking. The aquifers they’ve been drawing on, they have been drawing on way in excess of replenishment rate. When you talk about replenishment of aquifers, you’re talking in terms of tens of thousands of years. So it’s not like you can just sort of stop drawing on it for six months and it fills back up. It’s not how this works.

Preston Pysh (00:29:40):

Huh.

Luke Gromen (00:29:40):

And the issue is … and I’m going to mess this up, so take this with a block of salt. But when you have a power grid, you’ve got base load and you’ve got swing power. Usually, your hydro stuff is really good sort of base load power. As long as the waterfall’s going, the turbine’s going. And so when you start having rivers get too low, you start-

Preston Pysh (00:30:07):

I got it.

Luke Gromen (00:30:08):

… knocking off hydro based loads, so then you have to make up over here. Everyone here is, “God, look at all the nukes China’s putting on.” Nukes use a lot of water. Coal uses a lot of water. And so this water issue had been identified by the Chinese, by this British gentleman, Gopaul wrote a lot about it as well. And I think that the brilliance of what Gopaul Reddy has done has been tying it into recent events where he’s pointing out, “Look in 3Q21, we started seeing the Chinese shut down power plants, ostensibly for environmental reasons.”

Luke Gromen (00:30:49):

They have always been about when it comes to economy and environment, the economy wins full stop, because they’re worried about political issues if the economy slows. And yet, here we have in 3Q21, these oddities that they’re shutting down power plants for the environment. Here 4Q21, we have Apple being asked to shut down factories for the first time in decades in China, for lack of power. They’re having power outages.

Preston Pysh (00:31:10):

You had the Bitcoin mining migration.

Luke Gromen (00:31:12):

And Gopaul made the connection, where he Gopaul says, “Look, I don’t know this, but it’s very possible that this wasn’t about, ‘Hey, we don’t want competition for the central bank digital currency,’ although I’m sure that’s at least part of it. It’s probably at least partly if you don’t have enough electricity, the first thing that gets thrown out are the mining rigs.” Because you can’t shut off Apple, you can’t shut off your factories. You need water for your people. Desalination is extremely energy intensive and maybe slightly positive, and it’s going to be long lead time. You’re having this water is endemic to electric power, and electric power is endemic to China’s economic growth, and China’s a factory of everything.

Preston Pysh (00:31:55):

I know a lot of people maybe that aren’t Bitcoiners that are outside that space, would hear the comment that I made about the power being the issue, and not necessarily the competition in the monetary space, and roll their eyes and think, “Yeah, right.” But everybody that I talk to that are hardcore miners and people that are really connected to what was happening over there from a mining standpoint said it was all about energy. The whole thing for them to move over here was because of the demand that they were putting on the energy grid.

Luke Gromen (00:32:23):

And that makes sense. So then more recently in December, it was Shenzhen and Guangzhou. So you’re the number one tech manufacturing region in the world, and one of the biggest manufactured goods regions of the world. There were articles, you can find them online. They were asking their citizens to start rationing water. And so there’s this sort of monster in the background, right? That’s sort of like Jaws at the beginning of the movie, that has sort of mauled a couple people, and we haven’t seen the shark, but you can sort of see the outcomes of it, or hints of the outcome of it. And to me, I mean, the implication of this, we could take this wherever you want to go. They’re enormous.

Preston Pysh (00:33:04):

I think the big question everybody would have is, what’s Reddy think the timeline is before this really starts to cause major issues? Not just kind of shark sightings.

Luke Gromen (00:33:15):

The short answer is within a couple years. The fact that we saw what we saw in the third quarter, these fundamental inconsistencies, the Bitcoin, the shutting down of factories, Apple. If you’re going to tell Apple to stop running stuff, there’s a problem. Right?

Preston Pysh (00:33:29):

There’s a big problem.

Luke Gromen (00:33:30):

You’re going to tell a lot of people to stop running stuff before you tell Apple.

Preston Pysh (00:33:33):

… tell Apple.

Luke Gromen (00:33:36):

And so again, it’s one of these situations where it depends on how things go. If they get a whole bunch of rain, then this thing could get pushed off for years. If the weather goes against them, this could be a problem in later 2022.

Preston Pysh (00:33:49):

Yeah.

Luke Gromen (00:33:49):

And importantly, and that’s why it’s you can take this a lot of different ways, you can take it to the most extreme, which is interesting and I think important to think about. But for me, I’ve tried to boil it down to something that’s more investible in the short run, which is overwhelming consensus is that we’ve seen peak supply chain disruption.

Luke Gromen (00:34:06):

And if China’s got water problems, there’s zero chance we’ve seen peak supply chain disruptions. Because supply chains are stretched thousands of miles all the way back to China,

Preston Pysh (00:34:14):

Oh, God. Yeah.

Luke Gromen (00:34:15):

We’ve seen how complex they are. You miss one part, and everything shuts down. And China doesn’t have enough water. If China doesn’t have water, these supply chain shortages, they’re going to become endemic. And when they become endemic, you’re going to get inflationary mindset, companies are going to go from running JIT to doing what they did in the ’70s, I’m told, which is you order as much as you can, and actually carrying inventory starts to be an asset on your books. Every quarter, you write your inventory up, because it goes up more. So it’s a very dangerous situation-

Preston Pysh (00:34:48):

Which causes more of the same-

Luke Gromen (00:34:50):

More of the same inflation.

Preston Pysh (00:34:51):

Yeah.

Luke Gromen (00:34:51):

About which the Fed can do absolutely nothing, unless they want to crash the economy. In which case, they still aren’t going to produce more water in China. It’s not going to freaking matter. All they’re going to do is cause political disruption. So that’s why I say if someone wants to be in charge of this parade, they either don’t know what they’re wishing for or they’re a sociopath. It’s really an interesting time, because the Fed can’t tighten enough to fight this without blowing up the bond market with the dollar where it is.

Preston Pysh (00:35:19):

Yeah.

Luke Gromen (00:35:19):

I mean, they’re stuck. They don’t realize how stuck they are.

Preston Pysh (00:35:23):

While we’re talking about China, Evergrande, is there anything new that you’ve seen pop out of that, or any other comments that you think have kind of come to light now?

Luke Gromen (00:35:32):

I’ve not seen anything new particularly, and there’s probably about 100 guys you could have in the hot seat that would be more value added than me on it.

Preston Pysh (00:35:40):

Okay. Hey, so today, ZeroHedge had a comment that they posted. They said, “Some are terrified about balance sheet drawdowns, yet forget that banks have literally handed 1.5 trillion in excess liquidity back to the Fed via daily reverse REPO ops.” And then they said, “Fed can drain 1.5 trillion with zero impact on net flows.” I sent this over to you. I said, “Luke, help explain this to me in an easy and understandable way.” I think everybody who listens to this show knows there’s reverse REPO going on. And I know there’s other very smart macro thinkers out there that are talking about this reverse REPO being able to net out the flows. What the hell does it mean? Explain it in a way that anybody listening to this show right now can understand what in the world all of this means.

Luke Gromen (00:36:33):

There are a bunch of plumbing guys who will be able to know the ins and outs of this way better than me. I’ve been focused on it very much from just a general flow, so I understand sort of it from a T account basis. So here goes, here’s what we were talking about earlier. So Fed creates reserves when they do QE. The Fed gets the treasuries, the bank gets reserves. Once reserves get too high, according to Basel III banking regulations, the banks can actually have too high a reserve, so banks then have to basically cut back on their balance sheet. Basically, once the Fed does too much QE, it actually reduces banks’ abilities to grow loans.

Preston Pysh (00:37:11):

So let’s just think through the logic. So as the Fed is taking a bunch of money and buying bonds off the market, they’re pushing all that liquidity into the hands of the banks.

Luke Gromen (00:37:23):

They’re creating reserves. It’s a swap.

Preston Pysh (00:37:25):

It’s a swap.

Luke Gromen (00:37:25):

I think that’s where people say it’s an asset swap. I think that’s right, is they’re giving the banks reserves, which are basically bonds of … they’re not 0% yield, but it’s reserves and very low yielding, zero duration asset. And the bank and the Fed are putting the treasuries on their balance sheet.

Preston Pysh (00:37:44):

But what they’re doing is they’re capping the amount that they can allow the banks … so if I’m a bank and I’m engaging with you as the Fed in this swap, let’s say you give me a thousand units. We’re just going to keep this really generic. You give me a thousand units, and you’ve capped me at a thousand units, relative to how many loans I’ve lent out. What’s the ratio, this Basel ratio that you’re talking about?

Luke Gromen (00:38:07):

I don’t know the number that that is, but it’s basically the biggest banks in particular, based on the size of their balance sheet, have to have so much capital and reserves count a certain way. And the important gist of it is, once banks have too many reserves, and I don’t know what that is, it’s defined per Basel III, relative to the size of the bank and the balance sheet. Once they have too many reserves, they have to stop growing their balance sheet elsewhere.

Luke Gromen (00:38:38):

So basically, once QE gets beyond some maximum point of marginal utility, there’s actually declining marginal utility for the economy in total. Because at first, it’s taking bonds off the bank balance sheets and freeing up reserves so the banks can make more loans. Taken too far, they end up with too many reserves and they actually have to constrict the amount of loans they make because they have too many reserves. And I don’t know the logic beyond that, other than the Basel III is trying to make the banking system more stable post ’08.

Preston Pysh (00:39:08):

It almost seems like it’s like a flag, or a valve that kind of pops, or like a certain breaker that pops back to the Fed to demonstrate to them that they’re providing too much liquidity into the market. The market can’t handle the amount of liquidity that’s there, because they’re blowing over these thresholds and they have to keep them within a certain amount. Would you think that that’s the rational for having that cap or that limit there?

Luke Gromen (00:39:35):

I mean, it’s almost like a dual corridor system, right? Where you can have two little reserves, you can have too many reserves. And this is my view, I think that what Basel has been trying to do, the Basel III rules, has been basically trying to prevent central banks and the domestic banking system from being used to finance deficits. I think it’s basically sort of … it’s a gold standard of sorts, a hard currency of sorts where, basically, I think they’ve been trying to prevent the central banks, and central banks forcing the domestic banking system or cajoling, regulating the domestic banking system into financing deficits, ad infinitum.

Luke Gromen (00:40:15):

It hasn’t really worked, per se, but it sort of has. Right? Because we’ve seen repeatedly, the REPO rate spike. People say, “Well, that was just a plumbing issue.” No, that was them bumping up against this constraint. And in the same way, this would be bumping up against the constraint. So I guess when you look at it that way, yeah, it would be saying, “Hey, Fed. You can only QE so much. And once you QE a certain amount, we’re going to start penalizing your bank’s ability to lend. It’s going to hurt your economy.”

Luke Gromen (00:40:42):

And then, in theory, you have two options. You can go back to the Congress and say, “Listen, you’re spending too much damn money. You either raise rates to get more people to finance it, or you start cutting spending.” And the reality is, is what Fed did is, they did this reverse REPO program to basically circumvent the whole thing. And so what reverse REPO does … so again, Fed QE is Fed gets a treasury, bank gets the reserves, reserves get too high, banks have to cut back on balance sheet. Reverse REPO temporarily swaps, reverse REPOs the treasuries that the Fed just bought back to the banks. And then the banks temporarily-

Preston Pysh (00:41:19):

profits-

Luke Gromen (00:41:20):

… give the reserves back to the Fed. So literally, just reverses the transaction they just did.

Preston Pysh (00:41:24):

But they’re getting fees on this.

Luke Gromen (00:41:26):

I don’t know fees. I mean, I’m sure there’s-

Preston Pysh (00:41:27):

Not high fees, but-

Luke Gromen (00:41:28):

Yeah, I’m sure there’s a commission on it. Sure.

Preston Pysh (00:41:30):

Yeah, there’s a small … When I say fees, I’m saying yield. They’re getting a small yield from the Fed as they put them on deposit. Correct?

Luke Gromen (00:41:38):

But here’s the bigger deal, is my understanding on very good account from people that know the plumbing issue back and forth, is that these reverse REPOs are not on balance sheet for the banks. So it basically-

Preston Pysh (00:41:52):

Oh, okay.

Luke Gromen (00:41:53):

… it gets rid of the balance sheet constraint. And so this reverse REPO balance you’re seeing … It’s interesting. You go back to when did the reverse REPO start to blow up, the reverse REPO balance started really to blow out last April when the SLR, the supplementary leverage ratio exemption for treasuries that was put in place April of 2020, and that came out and said, “Hey, banks, you can buy as many treasures as you want. It won’t count against this Basel III capital constraint.” Right? So that temporary exemption ended in April of 2021.

Luke Gromen (00:42:22):

And basically, if you look at when that ended and when the reverse REPO balances, when that thing ended, that SLR exemption, reverse REPO balance was at zero. And it went from zero to 2 trillion in eight months, because it was a 2 trillion end. And so this is basically just an Enron-like accounting creation, right? If you go back to Enron, right? When, at the end of every quarter, they would move the barges off their balance sheet, right? They’d REPO the barge to Morgan Stanley. And so at the end of the quarter, it was on Morgan Stanley’s books. And then it would switch back to Enron’s books. So it looked like Enron had more cash and liquidity than they actually did.

Luke Gromen (00:42:53):

This is the same kind of transaction. It’s just when the Fed does QE, they get treasuries, bank gets reserves, reserves get too high, and start to weigh on bank ability to make loans. There can be a capital charge if you get too high, increased capital charge once you get too high above capital thresholds or reserve asset thresholds in terms of the size of your balance sheet. And so then the Fed does the reverse REPO, which temporarily reverse REPOs the treasuries back to the banks, banks temporarily give the reverse back to the Fed.

Preston Pysh (00:43:23):

But it’s, “temporary.”

Luke Gromen (00:43:25):

Yeah, yeah. It’s just, “temporary.”

Preston Pysh (00:43:26):

Meaning, it can come back to the bank again.

Luke Gromen (00:43:28):

And it should, right? It’s a REPO. It’s a reversing transaction, but you just kind of keep doing it.

Preston Pysh (00:43:33):

Well, I guess. Okay. So the terminology, they say is the zero impact on net flows in the short term. It’s net zero for that time interval, that very short duration time interval that you’re looking at, because it went over there and it’s sitting back at the Fed. But the bank can still claw those back if they fall within the balance sheet constraints, so it’s actually still there, right? It’s not like it just disappeared into oblivion.

Luke Gromen (00:44:01):

ZeroHedge’s comment too was in regards to QE taper, where the Fed can taper a trillion and a half before anything bad’s going to happen. And that was my under reading of that.

Preston Pysh (00:44:10):

Yeah. I think you’re right.

Luke Gromen (00:44:11):

I think that’s totally wrong, because if you look at just by reversing the T accounts of it, is that if you reverse the reverse REPO, then the reserves go back to the banks, treasuries go back to the Fed. So then the banks have reserves with which they can buy treasuries. But in theory, there is a constraint under Basel III that is still there. Right?

Preston Pysh (00:44:32):

Yeah.

Luke Gromen (00:44:32):

So in theory, yes, they’re right. They have the reserves, will come out of the reverse REPO back to the banks, and then there’s all this money, these reserves, and in theory, the banks can buy treasuries. However, there’s a constraint for too much reserves. There’s also a constraint for too many treasuries, because that SLR exemption expired.

Preston Pysh (00:44:51):

And you’re assuming supply chains aren’t going to continue to do what they’ve been doing, and you’re going to have all these constraints in physical reality, outside of number entries in the ledgers.

Luke Gromen (00:45:02):

Right. And even just setting that aside, if the Fed came out and said, “We’re going to suspend the SLR rules again, as it relates to us treasuries. Banks, you can use all those reserves and buy up treasuries,” then the ZeroHedge comment that there’s a trillion and a half in liquidity to buy treasuries as the Fed sells them, yes, that makes sense to me. I can’t say it’s absolutely the case, because I would defer to the plumbing experts on that. But from a T account perspective, that would make sense.

Luke Gromen (00:45:28):

If the SLR rules for treasuries are not suspended again, like they were from April ’20 through March ’21, then what ZeroHedge said is, I don’t think, correct in terms of no net flow implication. Because whether the banks have the reserves or not is … they’re not going to buy the treasuries because the constraints on the balance sheet will exist with the reserve levels where they are, even if they’re out of reverse REPO and back on bank balance sheets, if that makes sense.

Preston Pysh (00:46:00):

All right, let’s move on to something else. This stuff is just … you just want to gouge your eyes out. Because it’s just, there’s a loophole that’s created for a loophole, that’s created for a loophole. And meanwhile, you’ve got so many zombie companies that are being created because of these policies.

Luke Gromen (00:46:18):

I think the easiest way to think about it is the US has a balance of payments problem, which is, we’re running deficits, they’re structural, we really can’t shrink them, and foreigners aren’t buying enough anymore. And they are basically doing everything they can to sort of keep the balls in the air of changing bank regulations and liquidity regulations.

Luke Gromen (00:46:37):

And so if you start from this point of balance of payments problem, and they’re going to do anything they can to make sure those balls stay in the air, that’s what’s happening. It’s a classic emerging markets move. You’ve seen it in Argentina. You’ve seen it … any country in history that’s had a balance payments problem-

Preston Pysh (00:46:53):

This is the play.

Luke Gromen (00:46:54):

… that’s what we’re watching. It’s a lot of sexy language, and that’s what’s happening.

Preston Pysh (00:46:59):

Okay, so more sexy language, yield curve control. So when I’m looking at yield curve control, for the most part, it’s not being implemented. We’re watching all the durations sell off in fixed income, except for the Federal funds, which is being kept at 0%. So you could make the argument that the bond market is quasi-free and open, even though they’re doing all these swoopty things that we were just talking about.

Preston Pysh (00:47:24):

But I think if we go through another big deflation … I’ve been calling them deflationary fits, because what happened there in March of 2020, I think is going to be kind of the norm moving forward, is we’re going to have these big deflationary fits. They’re going to step in with just arm loads of quantitative easing. I think on the next deflationary fit, you’re going to see UBI used a whole lot more than what was used in this last round. And I think that when you get into the next round, you’re really going to see yield curve control being used.

Preston Pysh (00:47:55):

For people, for the fancy name here, yield curve control is you’re pegging a yield. Let’s say we wanted the 10 year treasury pegged at 1%. If anybody steps into the market and tries to sell it off and raise that yield above 1%, essentially, bank’s going to step in and be a buyer for every single one of those sell orders in order to continue to keep the yield pegged at 1% or lower.

Preston Pysh (00:48:18):

So I think on the next deflationary fit, that is going to become a very real policy that’s being … I was going to use the word implemented, but I think maybe abused is probably a better word to throw out there. And maybe across multiple durations, if not all durations, are you going to see them really kind of finagling these yields. Do you agree with that, Luke? Or are we way far off from something like that happening? Are we multiple deflationary fits away from that happening?

Luke Gromen (00:48:50):

I think we are. And I’m sure I’ve said it before to you in prior conversations, is yield curve control is the Hotel California, right? Once they check in, they can never leave. And so I think they will do everything they can to avoid yield curve control. I would argue we’ve been in a soft form of yield curve control. Yield curve management, shall we say? They’re happy to let it move around as long as it stays in between … it’s like bumper bowling, right? It’s yield curve bumper bowling is what they’re doing.

Luke Gromen (00:49:21):

And we know that, because we can see how quickly they hopped to it when the REPO rates spiked. Right? That took them 24 to 48 hours. That was the ball rolled into a couple lanes over, and they quickly ran down the lane, grabbed the ball, put it back in the lane. And how did they do that? They did that by growing the balance sheet. They did not QE. In the same way we’re not in yield curve control. This argument that, “Hey, there’s plenty of demand for treasuries,” to me is disingenuous when the Fed’s balance sheet’s sitting at $9 trillion. The release valve has been the Fed’s balance sheet.

Luke Gromen (00:49:53):

And so I think your point is on, in terms of as we get these inflationary downdrafts, whatever caused them, whether it’s over tightening, or it’s some sort of external factor. Or whether it’s a bond market sell off, where it gets trickier is the inflationary side of things. Where if it’s cyclical, in terms of sort of this recovery, if the pandemic becomes endemic and things normalize, okay, that’s one issue. If it’s deep, cheap energy and metals, and Chinese water and power constraints, and so ongoing supply chain issues, which I think are very likely to continue, that’s a different animal, because now you’re going to be talking about CPI that’s probably going to run seven to 10 for the next 2, 3, 4 years. And that’s assuming that we don’t try to reshore stuff.

Luke Gromen (00:50:38):

There’s no inflation associated with ESG and climate change initiatives, which is a joke. There’s going to be a ton of inflation with all those things, right? So they’ve got to do something to keep … we know the bond market can’t withstand interest rate levels at a certain level, at a certain price of the dollar. Will they ever do it? I think, ultimately, they’ll be forced to. I think it will be the last thing they want to do. I think, if I’m in their shoes, I would much rather continue this yield curve management, this yield curve bumper bowling, because it’s [crosstalk 00:51:09]-

Preston Pysh (00:51:09):

The bumpers just keep getting tighter and tighter. Right? Yeah.

Luke Gromen (00:51:11):

They keep getting tighter and tighter and tighter, and eventually, they’re actually going to intersect.

Preston Pysh (00:51:14):

It’s going to be pegged.

Luke Gromen (00:51:16):

Yeah.

Preston Pysh (00:51:16):

Yeah, it’s going to be pegged.

Luke Gromen (00:51:17):

Yeah. And so, how quickly will that happen? It depends on what happens with inflation. It depends on what happens with growth. It depends on a number of factors. That’s how I’d answer that.

Preston Pysh (00:51:27):

Okay. I had a person ask, what if Saudis break petrodollar fully or partially? And then the person online wrote, “They already sold their treasuries.” What are your thoughts on that one?

Luke Gromen (00:51:38):

I think we are already well along that route. I mean, I’ve heard very credible rumblings. I heard very credible rumblings 18 months ago that the Chinese and Saudis signed a deal, that the Saudis would sell some oil volumes to China in yuan, or dollars, China’s choice. I don’t know that that came to fruition, I don’t know that it’s done in any volumes. I mean, there’s a big meeting where all the foreign ministers of the GCC nations are flying over to China next week or something. Now, what do you think … they’re not talking about the Kardashians and who should be a quarterback for the Jets, right?

Luke Gromen (00:52:09):

So the Saudis are ultimately going to have to do what they must to keep their biggest client happy. And their biggest client, by far, is China. And so I think it’s inevitability, and inevitability that you get some sort of concession in terms of China being able to … the Saudis selling oil to China in yuan. Then the question becomes, do we ever hear about it? And if we do hear about it, what are the implications? Because will it show up … in theory, I would expect the Saudi riyal would probably fall pretty sharply against the dollar, maybe. And if the Saudi riyal fell against dollar, then you would expect to see the price of Saudi oil would actually … their cost base would fall, right? Their costs are in riyals, they’re selling in dollars. Those are pegged. But they would be able to even further lower their cost basis relative to the world’s oil.

Luke Gromen (00:53:06):

So in theory, it would be a deflationary impact for global oil in dollars on one hand. On the other hand, it’s hard to know what the market implications would be for dollars. I mean, it would make concrete the multilateral system where, suddenly going forward, the world would no longer need to hold dollars for oil. Certainly not the Chinese, certainly not other big players. They would be able to pay in their own currency. And going forward, that means that as the US emits these deficits, which can’t really be cut again, because their entitlements defense and interest. Primarily, there’d be a lot of dollars being admitted, and there would be a significant step down in foreign demand, because everyone could pay for oil in their own currency. They wouldn’t need to stock pile dollars as much.

Luke Gromen (00:53:53):

And then the Fed would have to pick up the slack. Right? And so as the Fed buys those bonds, we’ve seen … Look, we know empirically, when the Fed buys 60 to 100% of issuance, the dollar goes down. We know that, because we saw it last year. We saw it from March of 2020 through April of 2021. So structurally, it’d be really bad for the dollar. It might actually be good for the dollar in the short run. It might be bad for oil in the short run, but I think it’s an inevitability. I think it’s probably underway, probably has been underway for close to five years.

Preston Pysh (00:54:24):

So back to the Fed, how many high hikes do you think they can actually get through if any at all? They’re going to hike, right?

Luke Gromen (00:54:30):

I think they’re going to hike. Yeah.

Preston Pysh (00:54:31):

I think they’re going to hike too. How many can they get in, in 2022? The forecast right now is, what, four?

Luke Gromen (00:54:37):

I think the forecast is three, but you’ve got people saying four-

Preston Pysh (00:54:37):

Four.

Luke Gromen (00:54:37):

… starting to say four.

Preston Pysh (00:54:43):

I know Goldman was out saying four. I think JPMorgan was out saying that there’s going to be four. And then Powell testified and said, “We got to keep rates low.” All on the same week.

Luke Gromen (00:54:56):

I think they could do the three or four. And if you would’ve asked me this two weeks ago, I would’ve said, “There’s no way.”

Preston Pysh (00:55:02):

Really? See, I agree with you, I think they can. Why’d you change your mind?

Luke Gromen (00:55:07):

Just watching what this dollar’s doing, right?

Preston Pysh (00:55:08):

Oh.

Luke Gromen (00:55:09):

Watching this capital flow angle of if we’re going to from-

Preston Pysh (00:55:12):

Ah, that’s myopic.

Luke Gromen (00:55:16):

It’s increasingly looking like we’re going from pandemic to endemic, and you can see it in the data, you can see it in the political responses. Everyone is backpedaling in Washington on this thing now. And I’m not going to get it into it more than that, because it’s a political hot button, and neither you nor I need that kind of a heat.

Preston Pysh (00:55:32):

That’s so true.

Luke Gromen (00:55:34):

If we go pandemic to endemic, we continue … the capital flow movements I think are going to weigh on the dollar maybe in a very pronounced way. And if they do that, if we continue to see the dollar fall, then the more the dollar falls, the more ability they will have to actually raise rates. And so what’s interesting is, it’s possible that what we’re watching is the Fed not … the way to think about it is not how much is the dollar going to rise when the Fed tightens. It might be the right way to think about it is, what we’re watching with Fed tightening is them slowing the rate at which the dollar falls. It’s basically their foam in the runway for how fast the dollar’s going to fall-

Preston Pysh (00:56:12):

Interesting.

Luke Gromen (00:56:12):

… as we go from pandemic to endemic, because of the capital flow out of the United States into areas and assets that are not big tech.

Preston Pysh (00:56:21):

So I’m just pulling up the DXY chart so people can see what we’re talking about when we’re talking about the dollar. So I have it in a monthly bar, Luke. I think it’s better to look at these things in longer timeframes when you’re talking currencies. And then I have the MACD here on the chart, and you can see that you’re actually getting … it’s looking like a little bit of a rollover here on the MACD. Now, this bar hasn’t closed out. You’ve got another 18 days for that to close out. But you might be right, Luke. You might be right on the momentum there. I just wanted to kind of pull that up so people could see it.

Luke Gromen (00:56:54):

Yeah. So I mean, to answer your question, to me, it really is a function of the dollar. It’s really, the lower the dollar goes, the more room they have. And I think they know that, and so it’s been very interesting to me to see what gold has done. Because if I was the Fed and I wanted the dollar down, if I was the bank of international settlements and I wanted the dollar down … because it’s in everybody’s interest for the dollar to go down. If the dollar goes up, this whole thing’s going to implode. We are going to get a lot more than a deflationary tantrum. We’re going to get an implosion. So everybody needs the dollar down.

Luke Gromen (00:57:31):

Now, if I wanted the dollar down, one way I would consider doing that, I would get someone like the BIS bidding gold every day, right? Which sounds conspiratorial, except-

Preston Pysh (00:57:41):

It does.

Luke Gromen (00:57:43):

… except they have a trading desk, and if you read on the New York Fed website, you can see, and the exchange stabilization fund, the ESF has a mandate to maintain orderly markets and FX by buying foreign currencies and gold. Their words, not mine. Right? So if you get gold just marching up, that can sort of create a framework to sort of try to get the dollar moving in a direction that everybody needs it to go.

Preston Pysh (00:58:07):

Oh. So when you think about the BIS, do you think that that’s one of their main things that they’re … instead of framing it that way, tell us your point of view of the BIS.

Luke Gromen (00:58:19):

I just think of it as a central banker’s central bank. There’s a great article in the Wall Street Journal from 2012. I think it’s December, 2012. And I remember the article, the name of it, it’s Inside the Risky Bets of Central Bank. You can look it up. And it’s a fascinating, fascinating article to me, because I frequently hear, “Oh, there’s not some small committee that gets together, and it’s not the way the world works, and it’s a conspiracy theory.” Okay.

Luke Gromen (00:58:45):

The article in the Wall Street Journal says that every six weeks central bankers, accounting for 55 to 65% of the world’s gross domestic product, get together in a room in Basel, Switzerland with no notes, with no meeting minutes, and talk about in plain language what they want to do. And so I look at that and I go, “Okay, do you think they’re talking about the Kardashians and who should be starting a quarterback for the Jets?”

Preston Pysh (00:59:10):

Absolutely.

Luke Gromen (00:59:10):

Or … Right? And so again, I think it’s cynical and disingenuous.

Preston Pysh (00:59:15):

That’s the pregame, that’s the pregame.

Luke Gromen (00:59:18):

So it’s like, okay, there’s six guys in a room who are … I think they are acting in the best interest of the system. I’m not one of these, “Oh, God. They’re trying to sort of take over mankind and want to rule the world.” I think they are trying to act in the best interests of the system from the standpoint of, look, the system imploding is in nobody’s interest. I think they are trying to basically just manage what has gotten away from them in terms of global economic growth, and the debt, and all this stuff. So I don’t think there’s sort of like this evil committee of the world.

Luke Gromen (00:59:49):

But by the same token, again, read the Wall Street Journal article. There is zero chance that 10 guys in a room, no meeting minutes, that are the central bankers controlling two thirds of global GDP are talking about the Kardashians. Right? They are talking about, “Okay, what happens if the dollar rises? Well, this will happen, and this will happen, and our economy will tank.” “Okay, then we can’t have the dollar rise.” “Okay, how do we keep the dollar from rising?” “All right. Well, we will tighten policy this way. That’s going to make the dollar go up. What are you going to do?” Those are the conversations they would have to be having. They’d have to be having those conversations. That’s how I think about it.

Preston Pysh (01:00:22):

So global cooperation among central bankers is really …

Luke Gromen (01:00:26):

Yeah, and the article kind of says that. It says, basically, they’re in a forum where they can bounce ideas off each other. Not an easy flight, right? I mean, you get on a plane and fly for eight hours to Switzerland. I mean, you’re there for two days and fly back. Again, they’re not going there … they would do the Kardashian stuff over Zoom.

Preston Pysh (01:00:42):

Luke’s got Kardashians on his mind. Final question, what’d you think of Bill Miller’s portfolio this week that came out?

Luke Gromen (01:00:50):

I saw a headline about that.

Preston Pysh (01:00:54):

Now, I’m going to say this. Bill’s a friend. I consider him a friend. I don’t know if he considers me a friend. I consider him a friend. And I would argue, he probably has one of the best risk adjusted returns over a lifetime of a very long time in the market. I don’t know, what’s he up to? Four decades or something in the market. He probably has one of the best risk adjusted returns of anybody that I’ve ever talked to.

Preston Pysh (01:01:16):

For people not tracking the announcement, he said he has two things in his portfolio. He has 50% Bitcoin and 50% Amazon. So, I mean, this is really bold. This was huge. And then we had Ray Dalio who made the announcement that was circulated on our show, on The Investor’s Podcast Network, that he finds it appropriate to have 2% allocation into Bitcoin. So it’s kind of a Bitcoin question, Luke. Any thoughts on some of this stuff? Does it surprise you at all that you have such massive names? I mean, Bill Miller. I mean, the CIO of Legg Mason itself managing 80 billion two decades ago, and that’s what’s in his portfolio.

Luke Gromen (01:01:58):

I mean, to your point, the man’s record speaks for itself. I mean, he’s a legend and he’s brilliant. When I saw it, it speaks to, I think, a greater recognition amongst people sitting in senior seats that realize that the Fed is trapped, that realize basically … There’s always two things in investing, there’s the end game and how you manage your chips along the end game. And I think it’s just a sign that people in senior seats are realizing, A, the end game. And when you see aggressive moves like that, either they don’t have the mandate where they need to manage the chips in a more short term nature, which is the best place to be for something like this.

Luke Gromen (01:02:42):

Because I think that’s what we’re watching, right? If I understood it right, it’s mostly his money, and so he could do whatever he wants with it, and he doesn’t need to write a letter to shareholders in two months, with the quarterly letter and saying, “Oops, we just lost 1500 basis points of your money over the last three weeks in Bitcoin, because Bitcoin’s down 30%.” The fiscal stuff is the fiscal stuff. The balance of payments is the balance of payments, these other issues. So as I look at it, it’s a little aggressive for my taste. It ain’t that aggressive for my taste, based on my analysis of how this is all laying out for the world.

Luke Gromen (01:03:20):

They don’t have a choice. It was interesting, I had a great conversation with Jeff Booth last summer at a conference, and we were talking.

Preston Pysh (01:03:30):

Was this the Bretton Woods Conference?

Luke Gromen (01:03:30):

This is the Bretton Woods Conference, yeah.

Preston Pysh (01:03:32):

Yeah,

Luke Gromen (01:03:33):

Yeah, right. So we’re talking, and the gist of it, someone asked him, it’s like, “Okay. Well, if you’ve got this fundamental disagreement between inflationary currency system, where it’s a debt-backed currency system, so you need inflation to make the debt whole, while Jeff, you’re saying the tech’s got this deflationary impact, Moore’s Law is putting deflationary pressure.” So you’ve got these … it’s the two horses, one ass problem. And this person asked Jeff, this person said, “How are they going to resolve it?” And I interjected, I just said, “They’re going to have to fully reserve the debt.” And Jeff goes, “They’re going to have to fully reserve the debt.”

Luke Gromen (01:04:06):

And for the audience, what fully reserve the debt means is that 70 to $100 trillion Eurodollar system, no one knows how big it is, but everyone says it’s huge, it’s mostly going to have to go on the … fully reserving the Eurodollar system means Fed balance sheets 70 to 100 trillion. And that’s where this is going to have to go, and it’s just the way it is. And so when you say borrowing a productivity miracle, it’s what’s likely going to happen. And I think that’s what people like Bill Miller, when they put 50% of their money in Bitcoin and the other 50% Amazon, I think that’s what that bet is saying. I think it’s like, “Look, it’s my money. They are going to have to fully reserve this thing. And this is how I want to play it.”

Preston Pysh (01:04:43):

That’s banking. Yeah.

Luke Gromen (01:04:45):

I think that’s what he’s doing.

Preston Pysh (01:04:47):

And I mean, he’s been in since 2015, so he can handle a little volatility in the [crosstalk 01:04:51]-

Luke Gromen (01:04:51):

Oh, exactly. No, that’s right, that’s right. Yeah, that’s exactly right. And I think it’s important. I mean, I think it goes back to that chart you and I have talked about before, of what gold did in Weimar, Germany.

Preston Pysh (01:05:00):

Yes, totally.

Luke Gromen (01:05:00):

So as the currency is literally going to zero in gold terms, or gold’s going to infinity in currency terms, there were four or five instances as the currency was hyper-inflating in one of the great hyperinflations of all time, where people were selling gold and buying German Reichsmarks. It was like, “Oh, it’s different this time. They’re going to tighten. The German Reichsbank’s going to tighten rates four times this year, and they’re going to taper QE. They’re going to stop. Oh, sell gold. Oh, God. Give me Reichsmarks.” Well, the math was the math. But what it speaks to is that managing the chips properly. You’re Bill Miller, you own it in whole, you’ve got money. The path was the path.

Preston Pysh (01:05:36):

Yeah, be careful with leverage.

Luke Gromen (01:05:39):

Be careful with leverage.

Preston Pysh (01:05:40):

Yeah. Luke, I could chat with you all night. I love these conversations because I get to learn.

Luke Gromen (01:05:47):

Thank you. I do-

Preston Pysh (01:05:47):

I get to learn in these conversations, and they’re just so useful for me to just really kind of wrap my head around the complexity of all of this.

Luke Gromen (01:05:53):

Thank you.

Preston Pysh (01:05:54):

If people want to tap into Luke’s knowledge, I say this every time we talk, but you have your two books there kind of in the back, The Mr. X Interviews, and both of these books are so insightful. If you really want to try to wrap your head around his sight picture and how he sees the world, both of those books have been extremely helpful for me, personally.

Luke Gromen (01:06:13):

Thank you.

Preston Pysh (01:06:14):

I can’t help promote those enough. Is there anything else you want to highlight, or give people a handoff to? Or …

Luke Gromen (01:06:19):

No, they can always just check us out at the website, fftt-llc.com, and see what we’re up to there, and our different product offerings, et cetera. But no, I’ve got an active Twitter feed. I think everyone that’s listening or most people that are listening probably know that. Check us out there. But no, I appreciate you having me on again. I always learn a lot talking to you. It helps my thought process a ton. I really appreciate it.

Preston Pysh (01:06:45):

Absolutely. And boy, I had fun. Thanks for coming on the show.

Luke Gromen (01:06:49):

Absolutely. And happy birthday to you, my friend.

Preston Pysh (01:06:51):

Thank you. If you guys enjoyed this conversation, be sure to follow the show on whatever podcast application you use. Just search for We Study Billionaires. The Bitcoin specific shows come out every Wednesday, and I’d love to have you as a regular listener. If you enjoyed the show, or you learned something new, or you found it valuable, if you can leave a review, we would really appreciate that. And it’s something that helps others find the interview in the search algorithm. So anything you can do to help out with a review, we would just greatly appreciate. And with that, thanks for listening, and I’ll catch you again next week.

Outro (01:07:25):

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