Preston Pysh  01:13

So Luke, we’ve chatted two times on the show since the summer, the beginning of the summer of 2019. Back at the start of the summer, which was about, you know, seven, eight months ago, you warned our listeners about the concern of the spread inversion on the excess reserves compared to the federal funds rate. Then this fall, you came back on the show, which was a very valid concern. I’m just going to throw that out there. So then, you came back on the show in the fall time frame, and you talked about this repo blow out. So I’m kind of curious, what’s on your radar today at the start of 2020? And maybe it’s just those same concerns, but at a larger magnitude, or is there something else that’s evolving at this point that you think is a extremely important macro theme and idea.

Luke Gromen  02:04

Yeah, I think the thing I’m, I’m probably most focused on at this point is trying to get a sense for…I, I guess maybe two things, right? So the first is watching for Fed responses to all of this. And then, secondarily, and, and maybe more importantly, the recognition amongst when are we going to hit a quorum of investors, who realize what the Fed’s doing, which is effectively financing US deficits through the banking system; which is effectively what began in September of last year. When you compare the Fed’s balance sheet growth in September to the United States federal debt growth since September, they are remarkably close to being the same number. And so, you know, it’s this dynamic of understanding, okay, the Fed has effectively been forced into, you know, what we called–when we talked last, you know, ceding control over the quantity of money or the size of their balance sheet in order to control the price of money, which was repo rates. And basically, there’s, there’s no limit on what they can do there. Their balance sheet is theoretically infinite. But it’s a question of when do more investors start to realize that this can’t really stop without very severe consequences until either the dollar falls sharply or unless global central banks start buying a lot more treasuries again, or the Fed slashes spending, or excuse me, the Federal Government slashes spending in an election year, which is probably highly unlikely. So I’m really trying to, to focus on that.

Stig Brodersen  03:43

You hear a lot of people saying in our space that countries can make their balance sheet grow because they are a country, so it’s not like you and me. If we go down to the bank, we can’t borrow indefinitely. What are your thoughts on how big these balance sheets can grow, and what is the relationship to the interest rates?

Luke Gromen  04:02

So John Hussman did some really great work about nine years ago, where he looked at–it was effectively the amount of base money per unit of GDP in the US economy. And it was basically the economy’s willingness to absorb base money or for lack of a better word, Fed money printing, right? If they’re going to grow their balance sheet, that’s base money. And his point was that there’s a very concrete relationship; a very solid relationship between interest rates and the amount of base money per unit of GDP the economy’s willing to absorb. And basically, the relationship is the lower rates are the more base money per unit of GDP and vice versa.

So back in 2011, when he wrote this, his point was that for the Fed to raise rates without it touching off a severe bout of inflation, they were going to need to shrink their balance sheet. They are basically going to have to shrink the balance sheet, and then, they can raise rates. And of course, that’s what they did. And that worked for a while. Obviously, we, we ran into issues with that. All that I, I say by way of background of…the Fed is now growing their balance sheet at a rapid rate and rates are well above zero. And what’s interesting is when Hussman wrote in 2011, global central banks were still buying large amounts of treasuries; even China. And so, one of the things we’ve highlighted in our work is that when you look at once China and global central banks and total stop buying US treasuries in 3Q14, the US went through a series of steps that basically were used to stop gaps to help fund deficits. And the first was, you know, HQLA bank reforms. The bank started buying more treasuries. And the second of those was arguably money market fund reform, where money market funds were regulated into buying more treasuries, and they did. They bought between treasuries and agencies from 2015 to late 2016. They bought, if I’m quoting the number right about a trillion 3 in treasuries and agency, so it was basically, a trillion 3 in QE.

The Fed didn’t have to call QE because it was money market funds supplying that liquidity; crowding out other dollar borrowers around the world. We saw libro rising very rapidly in that timeframe as a symptom of that. The point is that I think people may be looking at, but, you know, they, they may be fighting the last war in that they think they need rates to go to zero before they really start growing the balance sheet. And this time, they’ve taken rates to one and a half, but they’re growing the balance sheet really rapidly. Hussman has said that that should be inflationary; very inflationary on a lag. And the relationship there is, is very solid that he lays out. He’s, he’s always great with the data. And the last part of that is, is I’m not sure the Fed can cut rates to zero this time or close to it because remember, they used money market funds as a stopgap. And so, if you take rates to zero money is going to flow out of money market funds. They’ll have to sell treasuries. And oh, by the way, money market funds are supplying liquidity into repo. And so, cutting rates to zero to try to address a liquidity problem through repo may actually make the problem worse. And so what I, what it suggests to me to answer your original question, which is, you know, is it just take the rates to zero and we get inflation, I, I think we may actually get the inflation. A lot of people, myself included, once upon a time, thought we would have gotten from 2008 to 2013. I think this balance sheet growth with rates well above zero, we may actually start to see it show up in another, you know, three to six to nine months. And that may be a big surprise as we move through this year. But that is probably a longer winded answer that maybe you were looking for. But that’s why I mean, why it’s very…there’s a number of different moving parts associated with that question.

Preston Pysh  07:48

So that’s really fascinating that you say that because one of the things that I think some folks are starting to see labor rates are creeping up, and it’s getting much more expensive for businesses to operate and function with that expense. So, are we already starting to see some of those signs that you’re suggesting might get amplified here in the months ahead?

Luke Gromen  08:09

We might be, we might be. I mean, there was a headline towards the end of last year. It was “Year of Your Nonsupervisorial Wage Rates; Year of Your Growth was Above the Mortgage Rate in the United States for the First Time Since,” I think, “1972,” which I thought was fascinating, right? Because now you’re talking about mortgages being effectively a negative, a negative real rate instrument. You know, is that a one off? Is it not? But to me, I think these are the types of things anecdotally, I think we’ll start to see over the coming, you know, months. And that’s only gonna put them more in a box ’cause they’re already in a box. They can’t raise rates. They probably can’t lower rates because, you know, they’ll, they use money market funds to sort of help pay per over deficits five years ago. So, you know, they can grow the balance sheet, but then, you’re going to need inflation. They–they’re sort of stuck.

We’ve seen numerous times since at least 2014, and maybe earlier that, you know, the 10-year yield over three, three and a quarter, the US economy doesn’t really work with that kind of a rate. That’s really the US policy rate, you know, the real like the real for the real economy, right? When you’re looking at mortgages and, and what have you. And we’ve seen it over and, you know, several times. 10 years get to 3-3 and a quarter, and the US economy really slows down. And so, you can see where I think this is all going is, yeah, I think we’re going to see a pickup in inflation. And I think it’ll catch him by surprise, and I think the bond market will start to sniff it out. And then, you know, I think I would direct people back to Ben Bernanke speech of, you know, the famous deflation speech from November of 2002, making sure it doesn’t happen here. And, you know, he cites specifically the example of World War II, where he said, “Listen, the Fed bought 90% of this, of short-term issuance, and we pin the, we pin the three month at three eighths of a percent, and the middle of the curve we pinned at seven eighths of a percent; 10 year we pinned it two and a half percent. And so, you had a positively sloping yield curve, so banks can make money at that.”

You know, if you went down a little further from here, your bondholders would nominally make some money. But, you know, you’re talking about what’s basically a Frankenstein yield curve. I mean, it is, it is not being set by the market at any point along that curve. And you know, the S&P rose 5x from 1942 to 1951. And so, you know, if you were putting your money in treasuries, you, you know, you were, you didn’t lose anything nominally, but you fell behind both inflation, but, and you fell way behind equities. Now, with that said, world war, there’s nothing more inflationary than world war. So when you’re pinning negative–I’m, I’m not saying the market necessarily need to rise 5x, but where I think this is going is, the Fed’s going to be forced to turn the yield curve into a Frankenstein yield curve like it did during World War II in some way, shape, or form.

Stig Brodersen  10:45

It’s very fascinating how you see this. So look, you have this quote, “Many market participants are beginning to realize the Fed is involved with financing US deficits, but most don’t yet realize the Fed is actually committed to finance US deficits.” So please explain what you mean by that to our listeners.

Luke Gromen  11:06

Sure! So we wrote a report about a month ago. And there’s a, there’s a famous saying or maybe it’s pseudo famous, but it’s, “The chicken is involved with breakfast, but the pig is committed.” And so, you know, there’s starting to be a dawning recognition that the Fed is involved with financing deficits in some way through the banking system. And there’ve been a number of…very astute analysts highlighting this, but I don’t think there is a realization yet that the degree to which they’re committed to this. So basically, unless you either get central banks coming back and buying very large amounts of treasuries, which seems very unlikely, you know? If not, even if we set aside geopolitical things that are going on, when you look at that China’s trade surplus is shrinking; global trade surpluses, basically across the world, shrinking. Maybe with the exception of Germany, maybe. There’s not the firepower. They aren’t generating the surpluses nowhere, nowhere near needed in, in sizes, size is nowhere near needed to, to recycle into treasuries. And so, unless global central bank start buying again or unless, you know, the, the F…FX hedging costs fall, which would probably require a weaker dollar as more dollar liquidity is supplied or balance sheet is supplied, then foreign private sectors is, is not gonna be able to buy treasuries in the, in the size they had been historically.

You’re left with okay, is the Federal Government gonna cut treasury supplies? Are we going to cut spending in an election year on what amounts to entitlements defense, or interest expense, or sort of, you know, big three that we’re spending money on? And I don’t think that’s gonna happen. And so, I don’t think people realize that sort of, you know, unless you have central bank’s joining that–they’re growing their balance sheets significantly again; the dollar weakening significantly; or the US government slashing spending significantly. The degree to which the Fed is really committed to basically growing their balance sheet on what they call “less fall on organic basis,” but it’s, I think you’re going to see them growing their balance sheet, you know, pretty close to dollar for dollar with the size of US debt growth.

Preston Pysh  13:08

So how long can that last? Because, I mean, everyone in the market, as far as I’m concerned, understands that. Any person who’s managing a large tranche of bonds, they get it. I mean, we see these conversations on Twitter as if they’re just a fact. It’s not even debatable, right? But it doesn’t seem like you’re seeing the dollar losing value relative to the other currencies in any kind of major way, or like it’s very obvious that that sell off has occurred. Why now? Is it now? Which your thoughts on the timing of some of that?

Luke Gromen  13:45

That’s a great question. I think it–some of it is tied into and speaks to, you know, the dynamic of this dollar shortage that exists, when you look at that you hear talked about so much in terms of the dollar denominated debt that’s outstanding. When you talk about a slowing economy; that when you talk about, you know, euro dollar markets. All these things, so there’s–it’s not as if there’s just the Fed doing, you know, what they’re doing with one hand. What you’re really looking at, or you know, this other hand, which is a, a dollar shortage pushing the dollar up. And so yeah, I would say you have sort of two tectonic forces pushing against each other to a relative standstill at this point. And, you know, at some point, you’ll get slippage one way or another. And you know, you’ll get I–in my opinion, our view is that you’ll get slippage, too. You know, stronger dollar if the Fed backs off too much, and you know, sort of stronger dollar risk off higher short term rates in the United States. And you know, to the other side, I think is the slippage would be caused by, you know, a weaker dollar. Slippage will be caused by, I think, a greater recognition–just to how long they’re on the hook for this. That basically this is gonna, gonna continue until the dollar is weaker.

Stig Brodersen  14:54

So keeping that in mind, would you say that the expectation is that there’ll be a lot more fiscal spending, so basically the government’s spending money on public institutions? Would that result in a weaker dollar?

Luke Gromen  15:07

It’s a great question. I, I think it’s going to have to be just sort of realization, sa–you know, and, and some of it can even be a recession, which would throw people, throw people for a loop because historically, recessions are dollar positive, right? People scramble for safety dollar rallies. You know, in this case, you’d be looking at issuance rising nonlinearly, and the Fed would basically have to sort of take all of that down. And so, you know, the sense I get, is there still a strong belief that, you know, we get to the end of March, and you know, what, we’re not gonna, they’re not going to have to continue this. I mean, there’s, I’ve seen people definitely saying, “Okay, this is going to have to spread from the bill market to the coupon market.” I just don’t get the sense that people fully believe that this is going to last, you know, basically, you know, for a long time to come. Now, the question is, is you know, it’s a recurrencies a relative game. And you know, what’s happening in Europe? What’s happening in China? What’s happening with the trade deal? You know, all of these things. I mean, you know, I, I think I saw an interview of Kiril Sokoloff. And, and when they asked him, he said, “But that’s why gold’s easy. Because you know what, you’d, you don’t have to, you know, you can tell they’re all going down. And you know, fiat currencies are all devaluing in, in varying rates against each other, but they’re all gonna have to fall against gold.” And I think that that might be the most eloquent way of putting it.

Preston Pysh  16:25

So would you–the way I would describe it, I’m kind of curious if you like this analogy, is you have, let’s just call it the yen; you have the euro; you have these major currencies; these massive in size currencies that have literally a bond market yielding nothing. And so, then they’re applying the pressure, almost like a pig pile on top of the dollar. And now, you’re starting to see just the blood squirt out, out of the nose, call it the repo market here in the US of being on the bottom of everybody chasing that yield in the US because that’s the only place that they can capture it. So you’re saying that you’re talking to people that are saying that this repo is just going to start solving? It’s just going to go away in a couple months? I mean, if, if anything, it seems like it’s accelerating.

Luke Gromen  17:13

Yeah, the thing I think, you know, it, it’s almost like if you, if you ask a fish to describe his environment, the last thing he would list would be the water. And, you know, to me, the thing that jumps out as I’m watching, so I think there’s a greater realization. Okay, the Fed is buying a lot of this. They’re, you know, they might they’re probably going to have to move to coupons. The thing that sort of that we refer to as Voldemort, right? The, the, the crisis that cannot be named, you know, from the Harry Potter series. The thing that I’m still seeing virtually nobody talk about is that the genesis of this is the US fiscal side. That there’s just too much treasury issuance; that, you know, the US issued eleven and a half trillion gross last year in treasuries; 71% of that was issued at six months or less. And when you look at that issuance, the thing I think people are missing is that the United States government is issuing 71% of eleven and a half trillion gross at six months or less at a time when the bid for duration is the strongest it’s been in 5000 years. And so, you can only come to the one of two conclusions, which is number one, US Treasury doesn’t know that the bid for duration is the strongest in 5000 years. And that’s strange credulity. We know that’s not true.

So the other option is the bid for US duration is not nearly as strong as it needs to be for the US to go out and term all this debt out. And so the reason they are crestling, replacing, and rolling the eleven and half trillion dollars gross was 71%, but six months or less, is because, yeah, Austria can do 100-year bond, and you know, even Argentina can do 100-year bond, and, and, but the United States is placing $40 billion every single trading day, and next year, it’ll be 45 billion, and the year after that, it’ll be close to 50 billion, right? So there’s this dynamic that is just this side. That’s the elephant in the room that I think people are ignoring the data to, which is, “Why is the US issuing so much to short end, when demand for duration is so good?” And the answer is the demand for duration isn’t sufficient. And so, they’re having to roll it at the short end.

More and more with, you know, there was a BIS report in early December, saying that, you know, a lot of what was happening in repo had to do with hedge funds buying, you know, treasuries on a leveraged basis. So you think about that, you go, “Gosh, all right. We’ve gone from, you know, in 3Q14, five years ago, global central banks were buying treasuries, and then they stopped. And it was, you know, global private sector was buying treasuries, and that’s still a very good creditor, right?” You’re talking about German and Japanese pension funds. Then, you know, FX hedge treasury yields went negative last year in the, at the end of the third quarter, and that forced more of the financing burden of the US government under the US private sector. Three months after that, we saw Fed funds rates go over IOER. Three, six months after that we saw repo spike. And that to me is the, this dynamic.

Now, you’re seeing the BIS say on the other repo spike was partially due to leverage hedge funds buying treasuries, and you go, “Alright, we’ve gone from financing at 30, 10 and 30 years with global central banks, who, you know, buy for political reasons; don’t mark the market; have infinite balance sheets. And five years later, we’re financing at the short-term under six months with leverage hedge funds.” And like that’s the trend to me that I think continues to be maybe the most important one that you’re not allowed to say that yet. And that is to me that realization of okay, yes, when the bulge bracket start telling me the US has a balance of payments problem, and the Fed is going to have to finance it all until the dollar falls, then if the dollar still isn’t falling at that point, then we’re going to need to you know, maybe revisit a bit, but I suspect gold will probably be a bit higher, when, when that realization hits.

Preston Pysh  21:00

Yeah, I just want people to know, when you were here at the beginning of the summer of 2019, one of your only recommendations was gold. I don’t know how much it’s up since then. But it’s done quite well. One of the ideas I want to talk to you about–so with this, all these repo operations that have been happening that are just accelerating, the primary lenders are gobbling up all the demand for this. And if it’s over, subscribe, lo and behold, the Fed comes out, and says that, “Well, we’ll just offer you more tomorrow.” Where I think the, the glue separates from what it’s trying to hold on to here is when you look at the relationship between the primary lenders and the secondary lenders because although the primary lenders are getting all they can take or all that they are demanding, that’s not necessarily trickling down to where the rubber meets the road for the rest of the economy. And so, are we seeing this adhesive slipping away from reality?

Luke Gromen  21:58

I, I think it’s a fair characterization. I mean, I think if you look at, if you look at the growth of treasury holdings, and you know, primary dealer balance sheets, you know? Compare it to long growth more broadly, you can see that, you know, loan growth to the US government is pretty strong, and loan growth to everybody else not so much. And so, that used to be called “crowding out,” and it was never an issue for the US. It’s an issue for the US now, and some of those Basel III regulate, you know, regulation, you know, related, and that’s probably something I should have listed before as look, that’s another way out of this. If the US either exempts itself from Basel III regulations, or somehow does implement some sort of regulatory fix that, you know, gets them out of having to abide by these, then, then that too could be affixed.

When you look at how this is, is basically, you know, the amount of, you know, at some point mathematically, the…if the rest of the world basically stopped buying treasuries, there is a some point, where the marginal financing capacity within the U–US economy to finance US deficits; the marginal us deficit, you run out of capacity. And that–when you, when you then go back and say, “Okay, theoretically that should happen. That’s just math.” Where would it show up? You know, where, where would the release valve happen? And understanding that eleven and a half trillion gross issuance; 71%, six months and under. The answer’s, well, if there’s a, a supply demand mismatch, it’s going to show up at the short end. And you know, so when, when you see repo, go from two to ten, that was a huge sign that basically, there’s a supply-demand mismatch. And when you look at the buyers of treasuries among the banking sector, it’s been very unevenly distributed. So you’ve had, you know, JP Morgan, Citigroup and Bank of America basically financing a quarter of the deficit last year, effectively. That’s just based on numbers as old tempos are highlighted in terms of how many treasuries they’ve taken down and dividing that by the total debt issue or total debt growth. So it’s–your point, I think, is right on that there’s basically this mismatch between sort of where they’re funneling the liquidity in and, and how it’s getting through.

Stig Brodersen  24:04

On that idea, Luke, could you please talk to us about the idea of inflation? What most people does, whenever they talk about inflation is to look up the definition that is tied to a basket of consumer goods like groceries, oil, corn, and so on. But if you look at how the average American are allocating his or her expenses, the big ones are medical, housing, education, which is different than the textbook examples. Now if we return to financial assets, we’re seeing the price of assets, and the correlation of the monetary policies is heavily correlated, and I guess you could argue the causality is quite clear the two be–because all the money that’s being pumped out might not be reflected in the official inflation numbers, but one could still argue that it’s driving up the unofficial inflation. That is a game for the owners of the financial assets; be haves if you like, but it’s still felt by the have nots in inflation, whether it’s recorded officially or not. But what are your thoughts on that and the idea of inflation?

Luke Gromen  25:10

So I think, broadly speaking, I think inflation is under measured. And I think it’s under measured on purpose for political reasons. And the reason I said is the United States government’s the biggest debtor, particularly, when you add up things or the cost of living, you know, attachment or adjustment to them, right? Social security, etc. So, the United States has a very vested interest in understating inflation because the lower inflation is the lower the interest rate they’re gonna have to pay to float all that, and we’re now at a level where they can’t float anything beyond a de minimis rate. And so, basically, what I think you’re seeing is, is, you know, Warren Buffett, there was a great quote he gave in 2012 in his annual report, where he said, “Look, back in the early 80s, treasury bonds are a great deal, but now bonds should come with a warning label.

Then, you know, they can’t possibly come close to compensating you with coupon for the amount of monetary, you know, base growth that has to occur.” And I think it’s–that, that’s exactly right. And so, the question is, and you know, A yeah, I think that that’s happening. I think they’re wildly understating inflation, you know? B is, why is it happening? And, and you know, the answer, in my view is it’s, you know, in service to the bond market, it’s basically in deference to the bond market, broadly speaking, the US government bond markets, specifically. You know, this, in turn drives asset inflation because if you’re understanding inflation, then, you know, your revenues in corporate America look better; your borrowing costs are low because the government has to have low borrowing costs. And so what does corporate America do? They go, “Well, great! We’re gonna, we’re gonna to borrow a bunch of money at low rates, subsidy, and we’re going to buy back a bunch of stock.” And of course, this is exactly what we’ve seen over the last, you know, 10 years. I saw a chart, I think, it’s a Deutsche Bank chart from Torsten Slok, showing, you know, basically the only buyer of equities over the last 10 years on net has been, has been corporate America buying back their own shares with borrowed money. And as a shareholder, that makes perfect sense. So it does.

So I think what you’re seeing is this dynamic, where to this point it is primarily showed up as asset price inflation. Something I’ve said in the past, I haven’t said it recently. But I would, I would say, you know, when you look at the history books, you know, political populism has historically been driven by inflation; falling standards of living on a real basis. And so, when you see populism rising in western social democracies all over the world, you know, to me, I think that is on some level marking the market of, of real inflation at the ballot box. People are just–they’re angry because they can say there’s no inflation, and they get their 2% wage increase, but the reality is, is tuition’s up nine, and health care’s up. I mean, my health care premiums, when I started FFTT were 450 a month, and last for 2020, the initial quote I got was 1200 a month, plus a $12,000 deductible, right? You know, I’m very blessed. We’re at–but we have no change in healthcare status, knock on wood. You know, we’re, we’re young and young family; healthy family. And they’ve just quadrupled, you know? For, for, or tripled for, for no reason. So, you know, people are seeing this inflation at the grocery store. You know, a pickup truck, you know, now costs $55,000. You know, they hedonically just that away because it got a softer ride, and it’s got a really nice screen inside, and, and, and.

I think there’s a number of different ways that they have played this game. But as with all, I don’t want to call it a fraud because it’s too strong a word. But anytime you sort of play this game, where you just basically are, you know, robbing Peter to pay Paul, sooner or later, it catches up to you. And I think that’s what we’re seeing with political populism. I think that’s what you’re seeing with some of the frustration. If you know, it manifests in wealth discrepancy that we’ve seen, which are at record levels as well. So there’s, you can sort of see it if you know what to look for. But if you don’t know what to look for, just take it at face value, you can duration match, and you know, collect your 2%, but you’re losing money on a real basis over time, you know? If you look over probably I’d say five-year stretches, you’re going to lose probably fair amount of, of purchasing power.

Preston Pysh  29:01

For anybody that follows you on Twitter, they probably have seen you say this, or they, they’ve seen you reference this. And what I’d like you to do is just explain it as simply as you possibly can because I know this can get very complex. Here’s the question, explain dollar shortage.

Luke Gromen  29:18

So dollar shortage, there’s, I would say there’s two main ways that this occurs. The first is by straight borrowing in dollars. So if you’re a foreign…if anybody borrows dollars, but in particular, if you’re foreign and borrow dollars, for whatever reason, you know, there was one raised US rates were at zero, It was cheap to borrow dollars, that is great, but you need to pay back dollars, and then if your currency falls against the dollar, as has generally happened since 2011, or 2014, the real value of the currency adjusted value of your debt obligations has risen, relative to your currency. And so there’s this, that translational impact, but also just the need to have dollars to pay that back. You’ve borrowed a bunch of dollars, now you got to go earn them to pay that back. You’re short the dollars. The other and arguably bigger dynamic is something Jeff Snyder talks a lot about and the euro dollar market, where are you are, you know, again, you’re creating dollar loans with no base money to pay it back. It’s sort of selling, you know, of the bigger version of sort of the same problem, which is basically, you know, offshore dollar deposits, offshore dollar loans, and you need dollars to pay them back. But the only people that can create dollar base money is the Fed. And so, that is ultimately, the dollar shortage. And it leads to one or two conclusions, either the Fed creates all the dollars needed, or the global economy implodes. And that’s sort of what you know, Jeff talks about a lot. And that’s what we’ve seen, you know, the stagnation that we’ve been battling for a number of years. That’s ultimately it.

Stig Brodersen  30:59

What you described there at the end, the Fed is implicitly forced to print more. Now, when you have that dynamic at play, and you consider all the other central banks that are in a similar situation, many would argue that you would need to work back to sound money. And when I say sound money, it’s money that’s not prone to a sudden appreciation or depreciation in purchasing power over the long run. So for instance, it could be something like Bretton Woods in 1944 that was built around money being packed to gold. Now, the game theory around that, by game theory, I mean, that for you as a central banker, you don’t just need to think about what you’re doing, you also need to understand what other central bankers, depending on what you’re doing. Is the game theory in place to revert or perhaps never revert to something like sound money?

Luke Gromen  31:50

Great question. You know I–when you talk about game theory, I think there’s a–been a couple things going on. I think, what this system is ultimately resulted in is, is basically if you think about many people have criticized the onshore-offshore China currency relationship and how much leverage the Chinese banking system has, rightfully so. It’s extraordinarily leveraged. That said, virtually nobody ever criticizes the leverage of the euro dollar system, which is orders of magnitude larger than any in China could ever hope for in their best day. And it’s infinitely levered because there’s no base money reserves backing. Basically, onshore dollar, offshore dollar system, and the offshore dollar system is infinitely levered. So with that in mind, when you talk about game theory, it appears by all indications of their actions. The Chinese figured this out a number of years ago, and said, “Well, this is great. The dollar’s massively overvalued because basically this euro dollar system helps support the value of the dollar after we went off the gold standard, right? That’s part of what support dollar hegemony, so the Chinese said, “Okay, great. You want to have dollar hegemony. You’ve got this offshore euro dollar system that’s infinitely levered. And either the world is going to collapse if you don’t print all the dollars, or you’re going to print just an enormous number of dollars, basically, to cover that euro dollar system.

Either way, we’re going to borrow as many dollars as we can. And we’re going to go buy ports in Greece, and gold mines, and you, you know, oil fields and copper mines. And basically, you know, we’re going to buy up the the rare earth supply around the world. And you know what, we’re also going to finance One Belt One Road. And a lot of people say, well, China’s not trying to dedollarize; they’re financing One Belt One Road in dollars, so of course they are. They’re borrowing in dollars in the euro dollar market low. They’re adding a spread, and then they’re lending it in dollars to these One Belt One Road countries. As long as they don’t default, making a positive dollar spread, which makes it harder for them to run out of dollars. And in meantime, they’re great–gaining political favor with these countries. They’re–it’s actually probably a wildly positive IRR project, when you bring electricity to a village for the first time. The IRRs have to be off the charts. And if they default, you end up with a *port. You end up with–like an oil field or something, which is what China wants to do anyway; which is what they need anyway. So the game theory to me, I think China sort of caught on pretty quickly.

I think Russia figured it out shortly thereafter. We’ve seen them dumping treasuries and buying gold in their FX reserves. And, and, you know, gold isn’t priced with the right digit in front of it, relative to this theory, and, and, you know, this is another market where, you know, the same way the euro dollar market sort of supported dollar hegemony. The LBMA, levered as much as it’s levered, has helped support dollar hegemony as well. And so, Russia and other central banks have been saying, “Well, the price of gold is 1200. Okay, great! Give us some more,” because they know the price isn’t in 1200. They don’t know what the price will eventually be. It’s not 1200. And furthermore, on the game theory, I thought there was something really interesting, you know, Zero Hedge highlighted it, but it was a Dutch national bank piece, where they noted in a presentation that, you know, if the system collapses, gold will be used to reset the system. And so to me, I thought that was an enormous clue that, yeah, the European banking systems got real issues. But at the end of the day, those are the Fed’s issues like they wanted–the US wanted the euro dollar system and the dollar to be the reserve currency.

I guess in theory, if the European banking system tipped over, it’d be good for the dollar for like 48 hours, but you know, that’s immediately going to infect the global bank. There’s only one banking system globally. It’s a dollar-based system. And so, the European banking systems’ problems are really the Fed’s problems, so it all keeps coming back to this gun to the head of the Fed–you’re going to print the money; you’re not going to print the money. And I think when we talk about the dollar, you know, it ties back to your earlier question, which is, I don’t think people realize yet that the Fed’s going to have to bail out the euro dollar system. They don’t believe it. Nobody believes it, but that implies needing to take the Fed’s balance sheet to at least 10 trillion. And you know, people hear this, and they’ll go, “Hahahaha!” But that’s where this movie has to go. Either that or you basically, you know, have some sort of currency deal or Bretton Woods system, where they come out and say, “Look, you know, we’re going to, you know, the IMF had a proposal in 2011, when they said let’s price oil, and gold, and SDRs,” and that’s certainly something or something like that that you could do where you move to a neutral settlement asset where you say, “Okay, all trade deficits, and energy, and you know, all, all current account deficits need to be settled in SDRs, and the IMF values gold at 5000 SDR.”

So now you can either buy gold at 5000 SDR, or your currency has to fall, and it would, it would reorder things very quickly. You basically back to a balance of payments type system, and you can sort of rank countries from the current account surplus to the current count deficits, but just in the SDR basket, right? You know, the euro, the yuan, the yen would all rise, and the, the, the pound would fall, and the dollar would fall sharply in that, you know, if, if we were rank them on a balance of payments basis strictly. So I’m not hearing anything that, you know, you, you’re anywhere near a Bretton Woods type scenario. I’m optimistic, maybe in–Mnuchin said, “There are currency components to the, the phase one deals that are similar to what was in USMCA.” We’ll see. But in the meantime, global central banks, you know, they’re buying the most gold since Nixon was in office and have been since 2010. And that suggests to me, and when it, when it started off, it was just “rogue nations. “And now, it’s basically everybody except for the Americans, and the Canadians, and, and the British.

Preston Pysh  37:25

Okay, so this question comes from somebody on Twitter as well. His name is Will Ray. He said Luke has been quoted saying, “That most investors aren’t going far enough in their estimates of what the Fed will do to keep the stock market afloat in a crisis.” He said, “While this is good for gold, why isn’t it bullish for treasuries? What mechanics cause yields to rise?”

Luke Gromen  37:47

When you have the US government as indebted as they are, they cannot afford to pay positive real rates. Once you debt the GDP is, you know, over 100%, and when your obligations are 500-1,000% GDP, they have to pay negative real rates over time. And that’s good for stocks and it’s bad for bonds, broadly speaking. That’s not to say in any given year. Obviously, last year, you get a monster year at the long end of the curve. And, you know, that certainly can happen in any given year, but that is to me, you know, because the stock market, they have created an economy where we offshore manufacturing, and you know, high end, you know, we increased financialization, and then there were tax law changes that incented corporate America to, you know, take more compensation in equity, rather than in cash. And the net of it was we now have the US government.

One of the ways we looked at it is net capital gains, plus taxable IRA distributions are around 200% of the annual growth; year over year growth; and personal consumption expenditures, which is about two thirds of GDP. And so, whether you look at it that way, and that’s not to say people are selling stocks and buying, you know, boats, and cars, and healthcare servers, but just simply that mathematically, PCE or consumer spending can’t grow if stocks aren’t rising. Whether you look at it that way; whether you look at the tax receipt impact, either both directly from, you know, net capital gains, or taxable IRA, or executive comp and options is, is taxable as ordinary income. So it’s tougher to strip out that the bottom line is it’s, it’s difficult for tax receipts to rise, and it’s difficult for consumption to rise in the United States if stocks aren’t rising. And so, they’ve never explicitly said it like I just said it, but they’ve said enough about markets, etc., where you can infer that they understand this relationship, at least on some basic level. And I just think that they may not like that reality, but that is the reality that they’re operating in, and I think they understand it, and as such are, you know, I’m not saying the stocks can never go down. I just think that you, from this point, you get down 10%, you’re going to see them get really aggressive. You get down 15%, the extraordinarily aggressive.

Stig Brodersen  39:49

You mentioned a really big number there, $10 trillion on the government balance sheet. Do you see that come through monetary policy or through intensive fiscal spending?

Luke Gromen  39:59

You know, it could, it could be both. You know, it’s interesting, when, when we say a fiscal event, we wrote a report, gosh, probably two and a half years ago, about six months after Trump got elected. And at that time, if you remember middle of 17, it was, hey, they’re gonna, they’re gonna run the, you know, it was really the Volcker playbook or the Druckenmiller playbook, right? We’re gonna, we’re gonna raise rates and have a tight monetary policy. And we’re gonna stimulate and really loose fiscal policy and the dollar is going to rise. And so, you need to own the dollar. You need to own and rates are going up. And, and something we wrote at the time is, is it continues to be under appreciated that the United States already has a $100 trillion fiscal stimulus. It’s already approved and ready to go. Maybe it’s 200 trillion, but it was approved by Franklin Delano Roosevelt in 1938. You know, social security. It was approved by Lyndon Baines Johnson in 1968, Medicare; Medicaid. It was approved by President George W. Bush in 2004 with Medicare Part D and the Gulf, you know, the wars we’ve had the last 20 years. We sort of have had, but in particular, the, the entitlement, you know, we have a $100-200 trillion in fiscal stimulus, largely unreserved that we’re going to have to effectively monetize. I, I think we could definitely see the fiscal side.

There was a great white paper by *BlackRock Investment Institute in August of last year that when I read it caused my jaw to drop, and then, you know, these days it takes a bit to make my jaw drop anymore, but it was written by Stan Fischer for vice chair of the Fed, and Jean Beaubien for Bank of Canada governor, and then Philipp Hildebrand, former head of the Swiss National Bank, and it just laid out in the next downturn, we’re going to need to do fiscal spending married with monetary policy, and we will pin yields to make sure that yields don’t back up and offset the benefit from the fiscal spending. And you know, here by region are the legal implement, you know, legal hurdles we would have to clear to operate in Japan, and in the US, and in Europe, and in Asia. And so is this 20-page document basically saying from three former senior central bank governors saying, here’s our version of MMT. And here’s what we’re going to do, and get ready for it. So that to me, I think is sort of fait accompli at this point. I think they’re, you know, looking for political cover. And I think a lot of people thought we needed a recession, a full on recession to do that. And I think bed sort of whatever it takes moment came in September, when repo rates spiked. I think that they sort of had to address that on the fly, and, and go from there.

Preston Pysh  42:32

So let me play back what I think I heard. I want to get your opinion on this. So if we go the fiscal route, it’s going to cause consumer price inflation, which is going to be bad for the bond market, and it’s going to be bad for the repayment of all this debt that the US is issuing, right? Because we can’t have interest rates go up. If what I just said is true, that means that we’re going to get creative with monetary policy for the insertion of this $10 trillion that we’re talking about. So now, if we’re using monetary policy in a creative way in order to do the insertion, and we’ve already both kind of agreed monetary policy is causing asset inflation, not necessarily the “inflation” that our textbooks all say there is. That means that you kind of suspect that we’re in for even a further melt up in the stock market. Is that how you see it?

Luke Gromen  43:29

The short answer is yes. I wouldn’t be surprised if we had a modest pullback here or some sort of little sort of normal; what we used to call a normal healthy correction, right? You know, five, five, or 8% something like that, which, which you’d probably feeling death because it’s been nothing but up on absolutely no volatility for, you know, whatever, the last four or five months, but the US now has the exact 180 degree opposite problem that Volcker had, right? So Volcker was trying to defend the dollar and basically was raising rates, and so the more rates, you know, rose more inflation picked up that actually helped him. And so, it was sort of self regulating, ultimately, and accomplished what he needed to accomplish. And now, the dollar is too strong, but the Fed and central banks broadly, they’re going to have a sort of nonregulating, self-regulating system here, where they’re going to have to, you know, implement some combination of monetary and fiscal policy, and then the bond market is going to try to stop them, and they’re going to have to implement more monetary policy to stop the bond market and the bond market may, you know, then you know, switch from just government bonds, then maybe you see spreads rise in mortgages.

Well, that’s gonna be a problem, so then they’re gonna have to contain the mortgages, well then the corporate market spreads may rise, so then they’re going to contain the corporate market. So it’s, you know, the path matters. But to me, what happened in September, the path got much shorter than anybody thought, and you know, once repo goes to ten, you know, I keep saying, “Hey, great! If the Fed falls behind, you should start to see repo rates start to rise. But listen, if the Fed wants to step aside, let them step aside. Let repo go to ten, and let’s see how that plays out within a month or two, treasury will be, you know, trying to issue treasury paper at 10%. They can’t afford that. Corporate debt issuance will grind to a halt because nobody can afford to roll over corporate debt at 10%. Corporate profits will tank, when you look at the leverage in the corporate market; stock market will fall by half. That’s probably conservative. I’m very overweight gold, you know, when you get into these situations, ultimately, the way these cycles end is the price of everything falls against gold.

Stig Brodersen  45:28

So if you relate this to the stock market, basically what you’re saying is that you can see a small sell off, but both the government and the Fed won’t allow that to be too much of a sell off?

Luke Gromen  45:40

The short answer is yeah. I, I think you can absolutely see, you know, especially with some of the geopolitical tensions, could you see a five or eight, you know, maybe 10% sell off? Sure. When you look at the levels of debt globally; when you look at the importance of stocks to consumption, to tax receipts, given the fiscal situation is precarious as it already is. They just simply aren’t going to be able to stand aside, and let it, let it go down, you know, more than 10%, they are going to have to do whatever it takes, as you near that threshold, or maybe less, which is, which is incredible.

Preston Pysh  46:14

Are we talking about hyperinflation here?

Luke Gromen  46:15

Hyperinflation is a very, you know, there’s a paper I need to read. It’s a very, it’s a politically touchy subject. It is–there’s a number of criteria that have to happen. I have to read the paid IMF paper, someone put it in front of me, but apparently the US is basically checking, you know, the majority of the boxes typically that you need. That said, we’re the global reserve currency. I’ve been saying, I think you’ll see Argentina with US characteristics in the US, which is, you know, I think you’ll see higher consumer inflation, but I think, you know, we will, CPI will remain firmly pinned below 3% or 3.5%. Because of how its defined and they will change that definition as much as they have to, you know? I may be eating Skittles one at a time, but there will be no inflation, you know, you know? The bag will come with one Skittle, but there will be 3 1/2% CPI inflation. You know, to answer your question, I, I think it’ll be an Argentina with US characteristics, right? We have this central bank. We have this reserve currency, and they have an ability to sort of manage perspectives on inflation, pin curves, and so where I think it’s going to show up is I think it’s going to show up in asset markets.

I think that’s really where, there’s really nowhere else you can go to hide from. I think it’ll show up in gold as well, obviously, but certainly first, I think you’ll see it in asset markets. I think we’ll continue to see that. Global central banks are buying gold. They’re not buying treasuries. I mean, that’s another wildly under appreciating. You know, I first started pointing that out two, three years ago, people looked at me like I was nuts. And now, it’s interesting people, you know, hey, oh yeah, central banks are buying 20% of the world’s gold supply every year. And what’s interesting is kind of everyone’s gone, “Uh!” And if, you know, if you went and asked, you know, a room of a hundred financial professionals, “Raise your hand if you’ve ever held a one ounce gold coin in your hand?” Maybe five would raise their hand, maybe. And then, you know, you say, “Okay, tell me how I could buy a physical gold coin,” and maybe two would know where to go and how to buy a physical gold coin. It’s just, it’s so…you know? I, I can’t remember who said it, if it was Warren Buffett or somebody else–do you want to buy what’s hard to buy?

Preston Pysh  48:18

So anyone listening to this, Luke Gromen, he runs the macro economic research firm, the Forest for The Trees. I want to say something, Luke. So I bought your book, Mr. X Interviews. And the reason I bought your book is because every time I talk to you, I just walk away from the conversation saying, “I just wish I could tap into his brain to fully extract everything he knows.” Truly, like that’s how I look at you.

Preston Pysh  48:44

It’s like I know there’s things that you understand that I just don’t have access to, or I just haven’t had that exposure, or that vantage point. I just wish I could extract all of it. And so, I went and I bought your book, The Mr. X interviews, and, man! It was, I felt like I was able to get a glimpse of behind the curtain of what goes on in Luke Gromen’s brain, when it comes to understanding finance and economics. So I can’t tell the audience enough how awesome your book is. And you know what’s great about it is the way that he wrote it, it’s just really easy to kind of follow along and really kind of understand what it is; the way that the questions are asked. Because it’s a conversation in the book between two people. And it’s just such a fascinating book, and I can’t promote it enough. And so, we’ll have a link in our show notes for your book. And we’ll also have the link in the show notes for your firm there, and thank you so much for always making time to come on the, on the show. I really enjoyed these conversations.

Luke Gromen  48:44

Thank you.

Luke Gromen  49:40

Thanks again for having me on! Always great to come on.

Preston Pysh  49:43

All right, so at this point in the show, we’re going to go ahead and play a question from the audience. And this question comes from Lee.

Lee  49:49

Preston and Stig, thank you for your show. I followed you for over two years now, and with no financial schooling, I feel like your shows have been invaluable. I have a multipart question for you. In sticking with the theme of excessive debt and fundamentals that don’t seem to add up, I find myself looking for a safe place to keep my money. But with the recent repo market blow up, it seems like it could be a precursor of worse things to come. Since money market funds seem to be the automatic sweep accounts when selling positions, is that truly a safe place going forward? How does the repo market affect money market funds? And if that’s a safe default place for cash accounts, what happens during another repo blow up or Fed default? Could money be withdrawn or even reinvested into equity markets? Or is there a safer place to be invested? Thank you for your help.

Preston Pysh  50:39

So Lee, this is such a very difficult question to answer, and to be quite honest with you, I don’t even know if I have the right answer for you. All the things that Luke and I were talking about during this past episode, really kind of just shows you how complex, how difficult this is to understand, and how many government decisions can take place that could drastically change the direction that things are going because whether people like to hear this or not, the, the markets are very manipulated right now. And what I mean by that is with the repo, and with the QE, and the insertions. I mean, we, this, this market’s been running for, call it 11 years at this point, bull market, and they’re aggressively doing repo insertions, and it looks like there’s going to be QE on the horizon.

There’s definitely not going to be any more tightening, so that doesn’t make any sense. And you have to ask yourself, “Well, how long is that going to persist?” My concern and what I think might be a trigger point for where you’d see the stock market or the equity change, just like Luke and I had discussed, if the insertion point for that liquidity changes from the top of the pyramid, which is what QE and this repo insertions are doing, and it starts to become an insertion of liquidity to the bottom, which would be your universal basic income, where if you’re a citizen and you paid your taxes, all the sudden you’re going to get $5,000 back this, this year straight into your account. That type of action, which is pretty much the same thing as QE only you’re not doing it through the bond market, you’re now doing it straight through the citizens. I personally think that that’s going to cause traditional textbook inflation. And if that’s true, then I think that you’re going to see everything, securities wise, get repriced and not in a favorable way. Because when you look at how securities are priced, whether it’s bonds or stocks, they’re completely dependent on the inflation rate because your interest rates are a premium above that expected inflation rate.

So if the expectation of that is gonna go up, which very few pretty much nobody thinks that inflation is going to go up at this point. If you start inserting the, the liquidity at the bottom, that’s when I think that whole dynamic starts to change. This is so hard to understand, you know, when we go out to the Berkshire Hathaway shareholders meeting, and you listen to Warren and Charlie talk about it. You know, Charlie Munger always makes the comment, “If you find somebody who says that they understand what’s going on, you’d, you–that probably the person you want to listen to the least.” But those are some of the dynamics that I’m thinking about. So now we’re where this really gets interesting is when you talk about how do I go about it in a conservative way? How do I protect my cash? Do I put it in a money market account? All these things, right?

Well, like Luke and I were discussing during this, this show, what I think you’re starting to find is that, that inherently, the problem is with the currency. You got fiat currency all over the world. There isn’t a country out there that has a peg currency. In fact, there’s no incentive for a country to have a peg currency at this point. So as long as there’s a race to devalue the currency, and that’s really the kind of the fundamental problem. That’s where you have to ask yourself, “Well, how much longer can this go on, and with the, with these bond markets starting to go into the negative yield?” The, the real issue is people are going to equities–stocks, specifically because they’re acting as a form of pegged currency is, is what I’m calling it these days. And so, do I keep my money in this fiat cash in this bank account that’s devaluing relative to something that has a scarce or somewhat scarce pegged attribute like a stock? I don’t know.

That’s, that’s the really, really tricky question. And it’s all dependent on and my humble very, very humble opinion, I think it’s, it’s highly dependent on where that liquidity of this additional fiat currency is being added. And as long as it keeps being added to the top, you’re going to see things continue to get bid on the security side, whether that’s stocks or bonds, and therefore that’s probably the place that you want to be. Who knows if we’re going to see that tide change? If I was going to argue with myself, what I would tell you is, there’s reports that you’re starting to see inflation in labor rates throughout the country. They’re some of these quarterly reports are coming in. And there’s, there’s talk that you’re starting to see inflation in wages. So whether that’s all even though the insertion points at the top, does that mean that some of the inflation starts to creep in, and you don’t even need UBI to get that? I don’t know. So those are some of the thoughts as they’re just kind of spewing out of my head, and some things to think about. I don’t think that I helped you manage your risk any better.

I think what I’m trying to say is, as I completely agree with Luke Gromen, and his opinion on this might have even more to go, simply because currency is in such a bad position at this point; fiat currency is in such a bad position at this point that I think investors are finding stocks and bonds here in the US that still have a positive nominal rate; they are, they’re not in the, in the green in a real terms, but I think they still see those as being more desirable than cash, so some things to think about. I hope that it helps you think through the risks on all the different angles. But I don’t know that I have a good answer for you. This is a very tricky time. And it’s something that is going to require people to be very aware of, of what’s going on in order to come out on top. So I, I wish you the best, and thank you so much for, for listening to the show. It’s really fun to answer your question. So Lee, for asking such a great question, we’re going to give you free access to our Intrinsic Value Course. For anyone wanting to check out the course, go to tipintrinsicvalue.com. That’s tipintrinsicvalue.com. The course also comes with access to our TIP Finance Tool, which helps you find and filter undervalued stock picks. If anyone else wants to get a question played on the show, go to asktheinvestors.com, and you can record your question there. If it gets played on the show, you get a bunch of free and valuable stuff.

Stig Brodersen  57:22

For you guys out there, that was all that Preston and I had for this week’s episode of The Investor’s Podcast. We see each other again next week.

Outro 57:30

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