Lead-Lag Live

Lyn Alden on Yen Carry Trade Misestimations, US Dollar System Insights, and Global Market Dynamics

• Michael A. Gayed, CFA

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Is the widely cited $20 trillion Yen Carry trade figure really exaggerated? Join us as we uncover the truth behind this staggering number with our special guest, Lyn Alden. Bringing her engineering and finance expertise to the table, Lyn helps us dissect the intricate mechanics of market dynamics, recent market volatility, and the reverse carry trade phenomenon. We also dive deep into the unique structure of the US dollar system and its far-reaching implications for global capital flows.

We also explore the cyclical nature of US versus foreign markets, focusing on interest rates and currency valuation's impact on capital movements. Lyn provides a critical analysis of the Yen Carry trade misestimation and its potential implications, and we consider whether recent market reactions in Japan could be seen as orchestrated interventions. Additionally, we delve into the Treasury Department's strategic use of buybacks to address liquidity issues in older bonds, examining the broader implications for bond yields and market stability.

Further, we scrutinize the interplay between fiscal and monetary policies, the complex monetary strategies of Japan, and the concept of fiscal dominance. Lyn sheds light on global economic indicators and their influence on market dynamics, discussing how different central banks' policies impact financial stability. Finally, we touch on Warren Buffett's cash reserves strategy amid market uncertainty, offering a comprehensive analysis of current economic conditions and future policy decisions. Don't miss this enlightening conversation packed with financial insights and expert analysis.

The content in this program is for informational purposes only. You should not construe any information or other material as investment, financial, tax, or other advice. The views expressed by the participants are solely their own. A participant may have taken or recommended any investment position discussed, but may close such position or alter its recommendation at any time without notice. Nothing contained in this program constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instruments in any jurisdiction. Please consult your own investment or financial advisor for advice related to all investment decisions.

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Speaker 1:

My name is Michael Guyatt, publisher of the Lead Lagrime. Reporter for the Rock Fowler is Lynn Alden, who normally I'd say, lynn, you need no introduction, but there's still some people that don't know who you are, so let's just level set. Who are you? What's your background? Have you done throughout your career? What are you doing currently?

Speaker 2:

said who are you? What's your background? Have you done the right your career? What are you doing currently? Sure, so my background is engineering, and finance started in engineering. Design engineering eventually shifted more towards systems engineering, engineering management and running the finances of an engineering facility.

Speaker 2:

I've had a lifelong interest in investing and so that's been like kind of my primary side thing and I kind of found that more and more I was interested in that. I started years ago. I started just kind of my primary side thing and I kind of found that more and more I was interested in that. I started years ago. I started just kind of publishing about investing content that eventually became larger than my engineering work so I had to kind of leave and focus on it full time and I take a systems engineering view toward macro, kind of treating these big things that happen as systems, because that's what they are. They're generally human designed systems with governing logic, inputs and outputs. So that's the approach I take. So I'm active at lynnaldincom. That's where I publish a lot of research. I'm also a general partner at Ego Death Capital, which is a venture firm. All right.

Speaker 1:

since you mentioned systems governing logic, it sounds to me like you're obviously very focused in on mechanical aspects of the way markets work, and we've had a bit of a mechanical accident, at least the last three trading days, through what now everyone is calling the reverse carry trade. I know a guy who also said that way, before most people did. I want to just get your take on the mechanical aspect of what's happened to markets, because it's not really based on fundamentals yeah, that's a good point.

Speaker 2:

A lot of this is mechanics. Now there's obviously social elements involved as well, so you can't have a strictly deterministic view. But a lot of what happens in finance is mechanical. There's multiple things happening at once. For example, michael Green talks a lot about that passive mechanical action that's happening. Green talks a lot about that passive mechanical action that's happening and you've been emphasizing for a while this carry trade that was presenting risk to the market.

Speaker 2:

And one of the things I focus on is kind of the structure of the dollar system, which is to say that most currencies they trade in terms of relative interest rate differentials and they trade in terms of current account balances. So if a country's weak in one of those areas or both, it'll generally the currency will weaken until an equilibrium is found. The United States is different because, as the global reserve currency, it's the largest, most liquid currency, deepest capital markets, and so our currency has this extra monetary premium on top of it because there's so many entities around the world wanting to have dollar-divided assets, and so that makes our currency kind of like stronger than it would be based on those normal metrics. So we have stronger import power, weaker export competitiveness. So we've run these structural trade deficits and put lots of dollars out into the world and all these countries a lot of them become creditor nations. They take their dollars and then they reinvest them into US capital markets. So they own more of our debt, they own more of our stocks, they own more of our private businesses and our real estate and over the past several decades everyone's kind of on one side of the boat.

Speaker 2:

There's so much global capital stuffed into US markets and then a component of that, like a subcomponent of that much larger thing, is the yen carry trade, which is basically, if you can borrow currency at near zero interest rates and you can invest it in currency or bonds or equities of a higher yielding currency, especially when those higher rates also help strengthen that currency relative to the zero yielding one, people will do it.

Speaker 2:

So people borrowed a lot of yen and then they use it to buy interest-bearing dollar type assets and equities and all that. And now we're seeing somewhat of a reversal, which is to say that, as Japan takes fairly minimal actions to defend its currency from disorderly devaluation, there's a sharp move in the other direction, and so that caught a lot of those investors off sides, because it's a fairly leveraged trade. It's kind of perceived as being risk-free because the yen only goes down. But when there's a combination of sharp interventions, like the Bank of Japan and Japan's government getting involved to defend the currency with basically asset sales or in terms of a little bit harder industry policy compared to what they've been doing before, it can sharply unwind those things. So a lot of what happens in global markets is a result of these kind of structural, mechanical issues, many of which has built up over a long period of time.

Speaker 1:

I want to expand on this point about everybody's on the same side of the boat. I mean, I've used that line before. Everyone's on the same side of the boat holding an anvil is the analogy I've given. How much of that in the last I don't know 12 years is because of economic strength versus sector allocation. I say that because one of the main reasons the US equity markets have performed so much better than international is because of our tech sector. Tech is nowhere near as pervasive when it comes to Europe and at least the Asian averages. How much of it is that the real driver as far as the divergences of performance.

Speaker 2:

So it's part of it. Generally speaking, us tech stocks trade at higher valuations than foreign tech stocks as well. So some of it is sector component and some of it is even sector by sector were more expensive. In addition, it feeds off itself. So, for example, by attracting so much capital to US equity markets, it makes the equities more valuable and then they can issue a lot of shares and pay their employees and it doesn't really devalue the shares because it's such a strong bid. So they actually get a competitive advantage because so much capital wants to flow into them. So then you can go back and say, well, how much of the success was because of their internal fundamentals. A lot of it was versus. They had this extra component of automatic buying that they gave them. Even further entrenchedrenched advantage is basically lower cost of capital than any other company in the world, those kind of like mag seven type stocks, um, and thus this a lot of the tech in this era.

Speaker 2:

This that that purity mentioned was social media and so english being kind of like the, you know, the broadest spoken language, not, you know, not actually the uh, the top by number, uh, in terms of the world, but the most spread out language spoken is English. It's basically the global language of business and kind of international communications. So the United States had a pretty strong advantage in the social media space, in addition to our focus on venture as a kind of like entrepreneurship in general. So a lot of it is that, in addition, these loops tend to feed on themselves. So, for example, the world has something like $13 trillion in dollar-dominated debt. Ironically, most of it's not owed to the US. Most of it's owed to other countries, like China will lend dollars to country XYZ, for example, to country XYZ, for example. Or France will lend dollars to country XYZ. And so when the dollar strengthens and capital's flowing into the US, it squeezes all those countries that have dollar-dominated debt in a similar way that yen carrier traders just got squeezed by the yen strengthening a little bit. But imagine this more pervasively Companies and governments around the world, mostly in developing countries, holding dollar-diamond debt and so they do poorly in that stronger dollar environment. So capital wants to leave them and it wants to go into the US, which even further exacerbates that. It even strengthens the dollar further and further suppresses them, and that feeds on itself for a very long time.

Speaker 2:

When you look back in cycles of US versus foreign markets generally.

Speaker 2:

That kind of engine can go on for 10, 15 years and then it kind of rolls back in the other direction where, for example, after the dot-com bust, the US cut interest rates and the dollar weakened and capital started to leave the overvalued United States market started to go to all these beaten down emerging markets that got wrecked by the Asian financial crisis and just kind of broadly had an issue from strong dollar and it starts flowing into there, flowing out of the dollar, and then that whole engine goes in reverse, because now the dollar is weakening, those countries that owe dollars are getting a reprieve on their liabilities, so they're getting like a liquidity benefit. They're, you know, their, their cash flows relative to their liabilities are improving, and then more capital sees that it says, well, I want to, I want to invest there, it's cheap, it's beaten down, it's it's coming out stronger and you get that flywheel in the other direction. Uh, and so that that's some of the mechanical aspects that can happen here over fairly long time frames.

Speaker 1:

I want to show a meme slash post that you put out, juxtaposed against a DM that you sent me talking about Japan. I give you credit for the meme here I keep seeing people saying that the Yen Carry trade is $20 trillion. I have been one of those, by the way, because I just saw it from other sources. That number doesn't make sense. It's big but it's not nearly at that range. And then you sent me a DM actually trying to prod me on that point. Carry trade is big but the commonly cited $20 trillion figure doesn't make sense to me. Nobody can really tell what the number actually is. There's a lot of things that are obfuscated in general, but I guess question number one would be does that number ultimately matter, however big it is? And two, even if it did matter, what could you do with that?

Speaker 2:

information to begin with. Well, the number matters because it gives you a relative scale of what we're talking about. If something's $500 billion versus $30 trillion, you know that's a meaningful thing in terms of existential kind of impacts on markets. You know how big are we talking here compared to global fund flows. That's a number I've seen post multiple times, like you know. I DM because you mentioned it and this meme. I was actually watching a podcast and one of my friends mentioned 20 trillion on the podcast. I'm like, where are people getting this number? It's like I always it's always the same number. So I posted the meme. I'm not calling anyone out with it. It's come up a number of times.

Speaker 2:

I dug into it. Below that meme, for example, I linked to the Wall Street Journal that shows data from the Bank for International Settlements and other sources that they estimated somewhere around 250 trillion yen in cross-border lending, which is something like 1.7 trillion at current exchange rates, which is about an order of magnitude smaller, but that's still massive, right? So it doesn't mean that the carrier trade is not an issue. It doesn't mean it's not. It's obviously been an issue in recent days. It just kind of helps put scale on what we're talking about here. And then it's like well, if people are measuring it differently, I want to know how they're measuring it.

Speaker 2:

The first way I realized that the 20 trillion can't be literally accurate is because when you lend, like when a bank lends currency, it creates more of that currency in the broad sense Lending creates deposits. And that 20 trillion figure is bigger than all of Japan's broad money supply and, of course, only a part of the money supply is used for things like this. Most of it's actually just like cash balances of corporations, households, things like that. So my initial assumption was it was probably around 2 trillion, and that's when I found the Wall Street Journal piece. I actually looked at some of the numbers and they're saying, you know, 1.7. And even then, like, not all of those foreign, like cross-border yen loans are for carry trades per se. Sometimes they do a little bit of actual business funding with yen. But yeah, if we assume most of it is carry trade, that gives us like a roughly idea of how big it is, which is quite large. Anything measured in the trillions can obviously impact global markets.

Speaker 1:

So there's an interesting question here, a little bit maybe on the conspiratorial side. From YouTube I'm going to show up here, which is from Boffin Do you think this was an intervention? This was orchestrated to offload older bonds to the retail investors to save the Japanese banks from failure. Now the reason I want to show this is I myself admittedly I was early slash wrong in making that argument. I've made the case that dramatically multiple times last year to save treasuries you got to crash stocks. Right, because it's not my opinion. Historically, when you look at the top 1% biggest declines for the S&P 500, yields drop in those extreme declines. That is the flight to safety. That also coincides with credit spread widening and I'm sure that's not just a dynamic for the US. So a little bit of conspiratorial type of mindset. But let's talk about that because I think the reaction on the Japan bond market side and the interaction against the carnage on the Japan banks I think is worth addressing.

Speaker 2:

Right. So I mean one fact is that the Treasury Department has initiated treasury buybacks to try to address the liquidity problems in older bonds. So they basically will use proceeds from newer bonds on the run securities to buy off the run securities from the market. So basically, if you have a fresh 10-year treasury, that's a super liquid asset. But if you held it for six months and now it's a treasury that matures in nine and a half years, that's kind of an awkward asset compared to this brand fresh new 10-year treasury and so that nine and a half year one is now considered off the run. It's less liquid and so the treasury will buy those back. They're actually trying to improve liquidity in what is supposed to be one of the deepest, most liquid markets in the world, which, ironically, is quantifiably less so than it used to be. If you look at, for example, trading volume relative to market size, it's been on a steady downtrend. So I don't think that they're taking actions to make things more illiquid or problematic. In addition, even though during asset price crises it is true that bond yields normally go down, but it doesn't necessarily mean that a lot of money structurally flows into bonds. That price is set around the margins, so a fairly small percentage of capital can move into a fairly large market and affect the price pretty significantly on that particular day or week.

Speaker 2:

The COVID crash of 2020 was interesting because while the crash was happening, bond yields were going down, as one would expect, but then at the very bottom of it it got so illiquid and we go back to those dollar-dominated debts that I mentioned before. There are all these entities around the world that had to service their debts. They needed dollars, so some of them just outright had to force sell treasuries to get dollars, and so you actually had the treasury market go illiquid. Yields started to spike from that low level and that's when the Fed had to come in and buy like a trillion dollars worth of treasuries with new base dollars in a week and then keep buying for a while. So, in addition, if they want to save the treasury market, the size of the deficit matters and if asset prices go down broadly.

Speaker 2:

In the United States in particular, our tax receipts are very correlated to asset prices, and that's in large part because we've structured our tax differently. So, starting in the 90s, there were all these bills basically saying that certain types of stock-based compensation are given better tax treatment than like cash-based compensation. We also just have more wealth concentration in general. So asset owners, as asset prices go down, they have less capital against taxes, they spend less. Their executives are getting less compensation and so our tax receipts are very heavily correlated with that. So if we hurt the stock market, ironically that widens our deficit, which means more bonds coming to market, even if we could also have incrementally more demand for those bonds as a safe haven asset. But it's basically a very complicated relationship. So that's why I wouldn't purposefully take that conspiratorial view, even though there are. I think there are conspiracies I agree with, but I think this one is probably just too many investors on one side of the trade and Japan trying around the margins to protect its currency.

Speaker 1:

I recall when I read the Age of Turbulence by Greenspan that he had brought up that point from 2000, 2002, as they were trying to model out the impact of rates by Greenspan, that he had brought up that point from 2000, 2002, as they were trying to model out the impact of rates on the economy, that they did not factor in properly exactly how much the markets decline would impact tax receipts. So I think that point is incredibly important. Let's continue with the conspiratorial talk for a second because there's interesting questions on YouTube. This is from Heisenberg. Raoul Paul said this was orchestrated by the US Treasury, aka Yellen. For good reason, she visited China twice this year and also Japan, Thoughts, I guess. Maybe maybe less conspiratorial. How much, how much power does Yellen, does the Treasury secretary in general have when it comes to affecting demand for?

Speaker 2:

treasuries. I mean significantly. I mean the recent paper on activist treasury issuance basically says that the Yellen and the treasury are purposely issuing more short duration bonds than they would normally be doing this environment to deal with. Basically it's better liquidity. They kind of reduce industry risk on the market. So that's like one lever they can pull. Buybacks are another lever they can pull. But there's also deals.

Speaker 2:

I mean, for example, the Plaza Accord in the 1980s was a massive pivot for currency differentials and that was basically like US government working with other governments and kind of making deals or kind of certain threats and things like that basically force negotiations to change their currency. So we can't really know exactly what was said between Yellen and Chinese officials, but certainly Yellen, like the Treasury officials, in combination with other government officials, do have quite a lot of power to change things. In addition to that, I mean they, the treasury, doesn't even use their nuclear option, which is basically they can. They can increase their reserves, you know, or decrease their reserves. They can, um, they can do all sorts of actions to influence the currency uh, which the United States is like.

Speaker 2:

Countries did all the time States, countries do it all the time the United States has not been. We have actually among the lowest reserves as a percentage of our GDP or as a percentage of our broad money supply than almost any other country, and that's because we're the axiom of the system. So we are the reserve basically, at least the past several decades. But that's an option that's pretty much fully within treasury authority, so they actually do have a lot of power. The question is, how much have they used here?

Speaker 1:

Treasuries have got power on treasuries, but maybe not so much on corporate credit. So I want to show another good comment, because this is actually part of my overarching thesis. Everyone has been which I'm humbled by congratulating the reverse carry trade kind of seemingly playing out. We'll see. But I always argue myself that that was the spark to credit spreads widening. That that's the main event. I'm now calling that the main event. That that was the spark to credit spreads widening. That's the main event. I'm now calling that the main event. Spreads finally widening, pricing into full risk after this duration crisis finally metastasizing into that.

Speaker 1:

So from Pickquidity Capital, we're all waiting for credit spreads to blow out. Next, making the liquidity crisis visible I think it's actually an interesting word to use visible Best way to play for retail. So not investment advice, but I do want to get your thoughts on the ability of policymakers to, in quotes, control credit spreads, because it very much correlates to the VIX. And if that does blow out, as I myself expect, that's the credit event that I've been rolling in early on but still is out there, I believe what can the policymakers ultimately do?

Speaker 2:

Yeah, it's a good question. We already have seen a spike in credit spreads, not a big one, but an increase from a low base, obviously very sharp, based on what happened. I think the sustainability of that spike will in large part depend on what happens. If we're talking about US credit, I think it'll largely depend on what happens with US economic performance. Us credit I think it'll largely depend on what happens with US economic performance. Basically, if these businesses continue to hold up well, fundamentally I think that basically that spike can be contained.

Speaker 2:

There's a weird. So over the past couple of years the United States has been running really loose fiscal policy basically massive deficits but very tight monetary policy basically positive real rates, balance sheet reduction and so there's a bigger than normal divergence between fiscal and monetary and some sectors are more impacted by fiscal and others are more impacted by monetary. So, for example, if you're in the travel business and a lot of fairly wealthy people are doing great on the right side of all the fiscal deficits and they're traveling, your business is doing pretty good and you really care that much about interest rates. On the other hand, if you're in the commercial real estate business, you're not really on the receiving side of much of the deficits. But you are on the worst side of all those kind of high rates and problems there, in addition to work from home and kind of structural trends around demand, and so that's been a particularly challenged space.

Speaker 2:

And, ironically, the longer that some of the stronger parts of the economy stay strong, the more the Fed can stay tight, which keeps hurting those weaker areas, and so, ironically, anything that kind of starts weakening those stronger areas which we, you know, like recent data points, came in pretty weak Even before this.

Speaker 2:

This yen carry trade blow up the market started to rapidly price in more Fed cuts in the months ahead because of some of these weak data points in the US economy and while in the near term that's bad for like assets across the board, but actually some of those more cyclical things, or some of those more those things that have been troubled by five plus percent interest rates, let alone whatever interest rates they're issuing their liabilities at, they actually get a little bit of a reprieve if we start to get some cuts and those stronger areas of the economy weaken.

Speaker 2:

So I think I tend to think of this in terms of rotations, about what's doing good, what's doing bad, and I think we're going to continue to see somewhat uncommon movements compared to normal business cycles because we continue to have this wider than normal divergence between fiscal and monetary. So I don't think it's the same as everything kind of going up or down together, but it's like things rotating about what's doing good, what's doing bad, and then if the big things do bad, that's when you get something like a recession, basically that the quorum becomes weak.

Speaker 1:

You've done a lot of work on this. I like focusing on divergences, so fiscal, monetary, but what about just divergences in terms of country monetary policy? Because it seems to me that that's what's at the core of the whole carry trade.

Speaker 2:

and now, possible reversal of it, which is, every other central bank would manage raising rates except one. Yeah, Well, this ties into the idea of fiscal dominance, which is, if you have. So industry policy really comes down to two things when they try to impact inflation. One is making their currency more or less attractive to the foreign market, to basically stabilize exchange rates, and the second is to encourage or discourage bank lending, so basically encourage or discourage money supply growth in your country. Those are kind of the two main areas where interest rates impact inflation, money supply, that kind of thing.

Speaker 2:

And if we go back to, say, Paul Volcker's era, when he raised rates to try to combat inflation, in his era most of the money creation was coming from bank lending. So baby boomers had entered their home buying years, so kind of peak credit formation from a large generation, in addition to going off the gold standard and having oil shortages and stuff like that. So you had both bigger than normal money supply growth and supply constraints. And so what he's trying to do by raising rates is, one, strengthen the dollar and two so it helps put energy prices down, but then two, slow down that rate of lending and money supply growth. But the problem is that when you fast forward. So back then there was, you know, in the U S you had 30% debt the GDP. Now you have 130%. The problem is, if you raise rates when you have a much higher public sector debt, um, then you actually increase your interest expense from the government at a by a bigger number than you slow down bank lending by raising rates and the people on the receiving side of those interests. That's actually stimulating them. For example, if I have a fixed mortgage and I have a money market account, every time the Fed hikes rates I get a raise. I can spend more. Now, right, and there's a lot of especially upper middle class baby boomers kind of in that bucket, and so the policy starts to get a little weaker.

Speaker 2:

Now Japan is further in fiscal dominance than any other country, with over 200% that the GDP and very little bank lending on a net basis, and so their interest rate tool is mainly meant for exchange rates, got that first lever.

Speaker 2:

It doesn't really affect bank lending or money supply growth, other than, ironically, if they raise rates it potentially increases money supply growth because now you've got even bigger deficits If they try to raise rates to like 3% or 5% or they have 200, some percent debt to GDP, you can imagine how large those deficits would be. And so that kind of speaks to the problem that countries kind of get in like a checkmate scenario when they have very, very high public debt, where there's really not a lot of good answers, and that's why they've had abnormal policy, mainly because they have abnormally high public debt. And they're the ones that are like firmly in fiscal dominance, where some of the other countries, like the United States, are kind of flirting with fiscal dominance. We kind of go in or out of it for periods of time, whereas Japan is like deep, deep into fiscal dominance.

Speaker 1:

Yeah, I thought the narrative was Japan wants inflation, so they want the yen to keep on weakening. Apparently, that's not exactly as simple as you'd think.

Speaker 2:

Yeah, when the yen was kind of on its constant weakening trajectory, I kept reminding people of a couple of things. One, they got a huge amount of foreign exchange reserves they're nowhere near out of ammo and two, domestic inflation still wasn't particularly high. They have high levels of social harmony. They always have the option to subsidize energy or whatever, and so basically I was like the fact that they're letting the currency weaken this much is because they're allowing it, not because they're. It's not like an emerging market with a balance of of trade problem and there's like nothing they can do.

Speaker 2:

Japan had plenty of ammo, uh, and they would deploy it sparingly, uh, when it started to get disorderly. Basically, if, if people got too comfortable with the yen weakening and started to lever that up, uh, that can accelerate it. So they would kind of go in and like break some of those um, like leverage positions and eventually they did enough times that it clearly had more of an impact. Sorry, this time. And they still have ammo, right. So I mean, you know I'm not exactly super bullish on the yen, but the yen in some cases can kind of be where they want it to be, depending on how much they want to spend to put it there, and they still have plenty of spending power.

Speaker 1:

I did make this point that if the reverse carry trade gets more violent, it seems like a catch-22, right? Because if the response is the Fed lowers rates to that, then the interest rate differential between Japan and the US obviously narrows, which oddly might make it worse for the reverse carry trade as the yen keeps on rallying. So let's go through sort of some scenario analysis. What happens if the yen were to push further here? Do you expect more volatility? What happens if the yen resumes its decline? Then we just go back to the old playbook of large cap tech. What are sort of the different ways?

Speaker 2:

this can play out. So I think it depends on the speed. I think there's reasonable logic that, for example, the Fed cuts rates, it could exacerbate the trade. We have to keep in mind there's already cuts priced in right, so that's already kind of accounted for. They'd have to kind of cut rates more than expected to really impact that. And two, there's already been now a lot of deleveraging because of this, and so if the Fed were to start a process of gradually cutting rates after kind of sharp deleveraging events have happened, that's a different outcome than a big move all at once, right, so I'm less in the camp that rate cuts would exacerbate the problem, assuming that they're kind of done at a pace that doesn't shock the market.

Speaker 2:

In addition, those cutting rates would potentially help emerging markets, which could do very well, and so some of that yen carry trade can just get redirected elsewhere. They can reduce their US assets, if there's less of a differential, and they can put them into, say, brazilian assets or whatever the case may be. They have a number of other markets that are at least around the margins Some of that carry trade can go into in addition to just being outright deleveraged, like they can just shrink the carry trade because it makes less sense now. But they also have other markets they can put it into. So my base case expectation is, uh, you know, a little bit softer economic performance in the us, uh rate cuts, uh periods of turbulence, um, but then probably some rotations from some of these countries that are dollar indebted but otherwise doing pretty well, and I think they're going to be more of a sponge for global capital, potentially including some of that Japanese capital or Japanese funded capital.

Speaker 1:

It's a comment from S Bain about fiscal dominance, saying it's also known as socialization of the free market economy. Is that a fair characterization of fiscal dominance, saying it's also known as socialization of the free market economy? Is that a fair characterization of fiscal dominance?

Speaker 2:

Kind of. I mean, because the way out of fiscal dominance is basically not paying bondholders back their purchasing power. Now that can take a couple of different forms. In an emerging market there's often a default you were owed a certain amount amount and you get less of it because you just can't pay it back. Like a junk bond. If a country controls its own currency, usually you get every currency unit owed to you, but they buy fewer goods and services than they did when you lent money in the first place. You would have been better off owning gold or almost anything else than owning that bond. And so fiscal dominance is basically. You know, we kind of push things. You know we kind of deleverage the private sector, push that leverage onto the public sector, which gets the idea of socialization, and then you kind of just burn that value away by having cash and bonds that don't keep up with most other things, that are scarce.

Speaker 1:

Another comment from Boffin. I think all governments want inflation to wipe off their debts, choose the easy way of indirect taxes. This, I think, relates to just sort of a broader question of where real rates are headed Again. You've probably said this far more than I think relates to just sort of a broader question of where real rates are headed Again. You've probably studied this far more than I have, but it seems to me that we have in general a history of negative real rates and that governments tend to prefer it, obviously during wartime. But where are we in terms of the actual real rate against inflation currently? And is there an argument being made that bonds will rally, treasuries will rally, just because they got to get that rate to be higher than, or rather lower than, inflation?

Speaker 2:

So in this period of time, right now, real rates are positive, whether you measure it by CPI or whether you measure it by money supply growth, because I like to look at it more than just money. Supply growth, I mean more than just CPI. I like to see basically the question is how fast are you being diluted? Supply growth I mean more than just CPI. I like to see basically the question is how fast are you being diluted? And so, based on how much public debt there is relative to GDP, positive real rates for a long period of time, I would argue, are unsustainable, therefore unlikely, and so I would expect some degree of financial repression, which is basically holding rates below the inflation rate. There's more or less skillful ways to do it. I mean, if they hold rates low but they let the long end kind of float around, then the banks get that interest rate differential. But in addition, if you look at New York Fed projections, they expect to, by the end of 2025, probably go back to buying treasuries but continuing to sell off their mortgage-backed securities for years ahead. That's the New York Fed projections, based on their annual report, because their goal is to maintain bank reserves that are roughly in line with nominal GDP, so basically a static percentage of GDP. So it'd be balance sheet increases, not for stimulative purposes but, in their words, basically to maintain adequate bank reserves and things like that.

Speaker 2:

So you have a gradually increasing monetary base due to a gradually increasing Federal Reserve balance sheet. But the composition of that can rotate toward treasuries, which is kind of the market where there's too much supply of. I mean, if you look at the Congressional Budget Office, they expect something like $20 trillion of net treasury issuance over the next 10 years. So they usually understate it because they usually assume no recessions in moderate interest rates. So basically I think they're going to be helping that market.

Speaker 2:

But then we could just get kind of persistently wider spreads on private sector like interest rates compared to the federal interest rates. Like if the Fed's always selling mortgage-backed securities but buying treasuries, you probably expect that delta to be wider than it has been, which means you can still put downward pressure on private sector lending due to having fairly high rates, or at least substantive real rates, while treasuries themselves are kind of at or below the CPI or much below money supply growth. So I think that's probably how we're going to see it. Is that pretty low cost of financing for treasuries in general, but still somewhat restrictive funding for private sector.

Speaker 1:

There's a lot of noise in this industry, as you know, and there's a post I want to share, which you commented on, as it relates to Warren Buffett. This is making the rounds on X, this point about the cash pile on the Berkshire end of things, and that this is, in your words, a serious jump, and that this is a signal. Now, of course, when you're dealing with numbers that large, you better be way ahead of a cycle change, because it takes a lot of time to build up that cash. What do you attribute this to? I mean, buffett made a lot of headlines for investing in Japan, I think at the start of the year. Right Now, it seems like there's a big defensive posture going on uh.

Speaker 2:

Well, so to provide some context, every quarter it comes out with, like you know, berkshire's cash level, and every single time you see headlines of, oh, buffett's got record cash. Um, but as you can see in that chart there it's usually a gradual increase. I mean, the whole money supply is growing. They're a profitable business. Uh, as a massive insurance company, they need tons of liquidity, right. So they're always growing their cash hoard, in nominal terms or usually, but as a percentage of their assets or as a percentage of their market cap or however you want to measure it. It's usually fairly static. So usually those quarterly updates are noise, even though people love the headline of Berkshire's got record cash, you know, because it's kind of a doomy headline, whereas I point out that this time there actually was some signal to it that it actually was a bigger than normal rate of selling equities and a bigger than normal rate of cash accumulation. That doesn't mean that maybe Buffett's wrong, right, it doesn't mean that, you know. It just means that this was more active decision-making than just all the numbers are going up. He trimmed his Apple position by a lot. He trimmed his Apple position by a lot. He trimmed his Bank of America position by a lot. I haven't checked if he trimmed his Japanese ones.

Speaker 2:

He, actually he did that Japanese trade initially back in early 2020 or 2021. He borrowed yen and bought the Japanese trading houses and they outperformed not only the S and P 500, but also the Japanese market. Uh, and I know that cause I, I was in some of those trades as well Um, I did it without leverage. Uh, he, he did the. He'd actually did the carry trade. Uh, buffett, um and uh, you know, but they always do it moderately. So Berkshire has not caught out on the on the yen carry. Yen carry trade. Um, they might choose to eventually decrease it, but I mean, they basically borrowed it near zero and they bought profitable, inexpensive companies with hard assets that are generating free cash flow and paying dividends. So, and uh, unlike his, there's no currency differential. He basically just borrowed japanese yen to buy japanese companies. So he basically did the really smart version of the trade.

Speaker 2:

Um, so I don't think that his deleveraging is tied to them getting caught out in any sense. I just think, basically, they they've got absolutely massive apple position. It's huge, it's been a massive winner for them. They probably want to diversify. Uh, he might not be super confident about apple's, a three trillion dollar company, um, with really slow top line growth now, um, and pretty high valuations for a company that's not really growing at a very past like fast. Basically it's a value stock price is a growth stock, um. So I'm not surprised that he wants to get out of that position or, like you know, kind of normalize that position.

Speaker 2:

Um, bank of america is interesting because he, you know, a while ago decreased a lot of his bank exposure and he's historically liked financials. It's kind of one of his bread and butter areas, along with consumer staples and stuff. But he kept the Bank of America position, whereas now he's actually trimming that one. So I would take it as a sign of bearishness on Buffett's part. Maybe he's worried a recession's coming. Maybe he just wants extra optionality due to potential signs of turbulence or capital rotations, like we talked about before. So I don't want to read too much into it other than to say that there was signal in his rapid increase in cash.

Speaker 1:

What else do you think is signal? I am and a lot of this just comes from a backtesting perspective for me. I am skeptical of most things as having signal. I think a lot of people reference things, but until you actually backtest and see if there's actually merit to it, um, you're not going to be as skeptical. But what else do you tend to look for as signs of a cycle shift? That's maybe new.

Speaker 2:

I mean I look at a number of economic indicators. I look at PMIs, I look at the recent jobs numbers across a number of different metrics. I look at global liquidity, so basically dollar denominated global money supply or even just the dollar index itself. These are things that have a fairly large impact on fundamentals, on basically how countries operate, how companies operate. I look at SLU's reports, basically senior loan officer surveys, to see if, to what I said, banks are tightening or loosening their credit standards.

Speaker 2:

I look at market internals. You know, kind of like when you have like cyclicals doing bad and defenses doing good or vice versa. Those are the types of things I generally look at in terms of these things. And then rotations, like these really big rotations. I do look at things like industry differentials. I do look at things like industry differentials. If we do get Fed cuts, as we're expecting, it'd be the first Fed cut, since the last time they started a cutting cycle was mid-2019. So it's basically over five years later. So it's been quite a while since we would have these kind of market conditions since we would have these kind of market conditions.

Speaker 1:

So when I named this interview, it was along the lines of the yen is the quintessential example of broken money, which of course relates to your book, which is called Broken Money. I've got the post here from your website at lynnaltoncom. By the way, for those that don't know it, lynn's got some great research. I myself have read some of her work. I encourage each of you to go take a look at her website and sign up. But I know you've got all kinds of accolades for Broken Money, but did you I have yet to read it myself, in fairness but did you touch on fiat in different countries, or is it primarily focused on on us? I know there's a lot of history there, but I'm curious if you touched on japan at all uh, so I did.

Speaker 2:

I did take a global view with it. The book actually starts out, uh, by mentioning, um, people robbing banks in lebanon to get their own money back, which is a phenomenon that happened some years ago. Uh, people would literally go in with a gun or a fake gun and just say I want to rob the bank, but only for my deposits. Like, my deposits are frozen, I want them back. Uh, so it's like a more, it's like a more ethical wave of bank robberies. If there is such a thing, an ethical robber.

Speaker 2:

That's yes, exactly so. Um, it's just kind of a stark example, and one of them was like uh, she was like a interior decorator robbing a bank, right, it's just like that. That's, that's how they find themselves because of broken money. Um, and there are, there are literally dozens of countries that have hyperinflated in our lifetimes. Um, so while I do I do mention japan in the book, I focus a lot on the longer tail of other currencies. There's like 160 currencies in the world. Most of them have virtually no saleability outside of their own country, basically no acceptability. They inflate at fairly high rates, pretty persistently, and then a handful of times they break.

Speaker 2:

I mean, whenever people think of hyperinflation, they usually think of either 1920s Weimar Republic or they think of Zimbabwe, but it's not always that far back or that extreme. I mean Brazil, hyperinflated, as like the fifth most populous country in our lifetimes. That's in living memory and not like a small edge case, like living Brazil. And so it kind of catalogs why, as a species, we've gotten so much better at so many other things. We have way more energy per capita than we had decades ago. We have way more technology than we had decades ago, more information, more connectivity but our money still like.

Speaker 2:

It's terrible, especially if you're outside of the dollar or Europe, or even Japan, I mean if you, you know Japan's right now. I mean inside the country. It's not like they're having a crisis, they're going to work just like we are, whereas in Egypt, for example, when I launched that book, I actually published it while I was in Egypt. I wrote it most in the US, but I published it when I was in Egypt. They had over 30% official inflation when I published it and they've had double digit average inflation going back to the 60s, even though they were actually one of the ones that didn't hyperinflate. They just had persistently high inflation. So I catalog basically all the problems that money has had over the past several decades and some of the causes that went into it and what some of the solutions could be.

Speaker 1:

I know you like to, I think, take on more of a longer termterm view from an investing perspective. But if things get to be or look like they're going to be more challenging, more volatile, if we're in an entry recession which is unlike the prior recessions, which are short and kind of more event-based, do you do any shifts to your own personal portfolio or do you just stick to things long-term?

Speaker 2:

So I do fairly minor shifts, which is to say that I do take a long-term view, like five plus years, but I do like moderate that with, say, an 18-month outlook, right. So do I expect everything to get worse or better over, say, an 18-month period? For risk management purposes, like, do I want a little bit overweight defensive assets or a little bit overweight aggressive assets in the context of a portfolio with low turnover and low changes in general? In addition, you know when I like my current portfolio kind of framework, like structural is a three-pillar portfolio. So one pillar is good equities, another pillar is cash equivalents, which includes cash or fairly short duration treasuries up to medium duration tips. And then the third pillar is energy producers, commodity producers, card monies, basically that kind of real asset bucket that does pretty well if you get inflation or stagflation or just kind of major currency debasement, and so those three pillars can get you through most circumstances, like if you have a disinflationary recession, that's where the cash equivalence positions are going to do pretty well. And if you have stagflation, you're probably going to like the fact that you have energy producers and gold and Bitcoin and that kind of stuff and if you're in a period of kind of Goldilocks pretty low inflation growth. That's where the equities come into play.

Speaker 2:

I have somewhat of a defensive view, but in the context of fiscal dominance, which is to say that when a developed country runs into fiscal dominance and has a recession, that recession can have certain emerging market-like characteristics not to the same extreme, but if you look at emerging markets and how they do in their local currency during recessions, it's usually not that bad. Sometimes things even go up because the currency itself is not doing great. Now it'd be less extreme than that, generally speaking, in developed countries, but I do think we're probably going to continue to run hot in the nominal sense, even as some of our real numbers could be problems, and so I treat it a little bit differently than, say, the 2008 recession or the 2020 recession. I'm kind of treating it more like the dot-com recession or like the 1970s, like the 1940s, those types of environments which are a little bit different.

Speaker 1:

Everybody, please make sure you follow Lynn Alden on X. Check out Broken Money. Go to lynnalaldencom. Show a lot of support, lynn. You've got all kinds of people putting comments saying you're the GOAT, which I didn't actually know what that word GOAT meant until like two years ago, what it was an acronym for. It's like it's a kind of insult. Everybody, please make sure you follow Lynn. And, of course, because I'm fasting now, I'm thinking about eating. Now I'm thinking about eating, so goats is now in my mind. Appreciate those that watch the live stream. I have this as an edited podcast under lead lag live and hopefully I'll see you all in the next, next interview. Thank you and appreciate it. Thank you, cheers everybody. Thank you.

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Michael A. Gayed, CFA

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