UnderTheLens - 05-21-25 - JUNE – RATES: Risk v Inflation
SLIDE DECK
TRANSCRIPTION
SLIDE 2
Thank you for joining me. I'm Gord Long.
A REMINDER BEFORE WE BEGIN: DO NO NOT TRADE FROM ANY OF THESE SLIDES - they are COMMENTARY for educational and discussions purposes ONLY.
Always consult a professional financial advisor before making any investment decisions.
SLIDE 3 – COVER
In this video we are going to further connect the dots between yields, rates, inflation and risk. They are always changing but presently more towards risk than inflation and more towards yields than rates.
We need to understand why and what that is likely to lead to.
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As such I would like to discuss the items outlined here.
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When the Great Moderation ended with Covid-19 I began showing this schematic of where we anticipated premiums would head.
We saw higher term premiums on bonds with rising inflation and higher risk premiums in equities.
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Inflation has been the driver as the red arrow indicates and though still high by levels experienced since the 70’s, Inflation has been slowly and tentatively working its way downward.
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The shift towards stagflation with elevated inflation, but slow growth, has been having a marked impact on yields, rates and inflation.
The worry about Tariff driven inflation along with Tariff driven slowing in global trade and economic growth have both captured the focus of global markets and investors.
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What hasn’t yet received the attention it should is that yields and rates are impacted by more than Inflation expectations but also the expectations about risk!
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Credit Risk as represented by Sovereign Credit Default Swaps has been steadily rising in concert with financial uncertainties. The one year as shown here …..
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… along with higher terms such as the 5 year shown here are all headed higher.
Nominal GDP growth typically tracks 5 year UST yields which suggest rates have an upward bias based on changing risk expectations.
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Interestingly, US Sovereign Credit Default Swaps are not buying any of this Wall Street nonsense and creating a worrisome disconnect.
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When we prepared these slides we were surprised the markets were paying little attention to Moody’s downgrade last week of US credit. This doesn't normally happen in a new Bull Market but not unexpected in the early stages of a Bear Market!
Then Monday morning of this week the market moved abruptly at the open on this fact. Before quickly recovering and moving on as if was concluded to be just noise?
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Real Yields had been rising on the 10Y UST until this year, when we seem to be putting in a classic “Continuation Channel”. This suggests we are near a potential breakout higher in 10Y Yields unless Inflation Breakevens falls to offset this.
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We need to watch Inflation Swaps closely to determine if this occurs remembering the Derivatives complex is in full control of the financial markets and not the economic data or government reports from the BEA or BLS.
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The Market Technical’s from our weekly lab newsletters suggest rates will soon be taken down aggressively.
It may not be a recession but something else? In a Fourth Turning abrupt market reaction can come from any number of unintended government Policy shifts.
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We have been anticipating this since the end of the Great Moderation but timing is always a problem - though the direction and rationale has seemed clear for some time.
Longer Term we feel rates will be higher and closer to historical levels
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The history of long term yields shows that the recent era we have been in is an anomaly.
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It doesn’t mean we are going there quickly but certainly the 5-6.5% range does not seem unreasonable? For 33 years rates were in the 6% range, and for 25 years between 5.75.and 8%.
It’s about risk and the world is simply becoming a riskier place!!
Increased complexity alone makes it more risky!
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One way of thinking about this is how the financial community looks at US sovereign debt.
The reason US Government debt levels are important is because the U.S. Taxes GDP to service its debt.
A high debt-to-GDP ratio raises concerns about sustainability.
If investors doubt U.S. Treasuries' safety, they'll demand higher yields, pushing rates even higher.
This isn't just a theoretical concern…
Studies show every 1% rise in debt-to-GDP increases bond yields by 4 basis points.
So with today’s debt-to-GDP ratio level, it suggests that yields could be 400 basis points (or 4%) higher than they were back then.
If we apply that to today’s bond market, we could be looking at 10-year yields rising to 9%, without inflation even needing to move higher.
That alone could create extreme economic and market volatility.
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This is some of fundamentals that lies behind this technical chart on long duration US treasury debt.
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Another risk concern is about who owns the debt and whether they can continue to fund a growing US debt or whether they are going to need their loaned money for their own needs?
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As big as the US debt is, Global Debt has reached $324B in Q1.
To put that into perspective the Global GDP approximates $100B.
With global debt 3.2X GDP it is highly likely it is only a matter of time before we get a buyers strike.
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Though still very important, Foreign-owned US debt peaked in 2024 at just over a third as the US adopted the policy of Quantitative Easing. The steady erosion has been masked by QE driven growth in the Fed’s Balance Sheet and then the Wealth Effect offsetting slowing Credit Growth since Covid.
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Japan is by far the largest holder of US Government debt. Japan is currently facing major issues associated with their long held policies of negative rates, YCC and BOJ buying of Japanese Debt as global inflation has washed ashore.
The Japanese Carry Trade may soon demand higher UST Yields or repatriate their funds?
We are very concerned about the Japanese Bond market which may soon be the catalyst for major global movements in yields.
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Not only may foreign lending not be there for an ever growing US national debt.
But Domestic sources may not be there also.
For example, how long can US Social Security hold their $7T of US Bonds intended to fund Baby Boomer retirement payouts?
There is both a huge question of where will the funding come from to fund the US Debt but equally important - at what rate??
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Clearly there is a storm brewing on multiple fronts tied to US debt levels! One of which is the US Dollar.
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The US dollar index has witnessed its largest drop since COVID-19.
It has now completely disconnected from its underlying fundamentals. This development could have massive implications for the economy and financial markets.
Since the dawn of civilization, every currency that has come into existence has eventually died out and disappeared into irrelevance. The people holding these currencies saw their wealth completely disappear. Take the British pound, for example.
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BRITISH POUND
In the 1940s, 1 British pound could be exchanged for 5 US dollars. It was the dominant global currency at the time.
By the 1980s, the British pound was only worth 1 dollar, completely destroying the purchasing power of anybody holding pounds. This reshaped global trade, economic power and geopolitics.
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US DOLLAR
Today, it's not the pound under attack, but the US dollar – the current dominant global currency. Many are projecting a similar fate to that of the British pound, possibly catalyzed by Donald Trump's new government policies.
The US dollar index (DXY) has faced strong selling pressure since Trump's tariff policy announcement on April 2nd
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While it hasn't been an outright collapse, something concerning has happened that suggests this decline could be more dangerous than it appears:
The dollar has disconnected from US government bond yields.
US government bond yields essentially show us the return on investment you get for owning US dollars.
Throughout the last few years, these yields and dollar strength have been very interconnected, and logically so.
As the return on investment of the US dollar increases, the foreign exchange value should increase as well.
The growing gap we're seeing now tells us that the dollar has been weakening despite return on investment staying elevated. This could signal that something in the currency is breaking.
It might mean interest rates need to rise significantly more to stabilize the dollar or that without such a rise, the dollar could face a complete collapse.
SLIDE 31 - UNDERSTANDING THE CAUSES
Before making definitive conclusions, we need to understand exactly why this gap has formed:
- Tariffs Slow Economic Growth
- Foreign exchange rates are heavily influenced by local economic growth.
- If investors believe Trump's tariffs will slow growth in the US, it makes sense the dollar would weaken.
- This could be temporary though, as the US economy remains strong and leads in key future industries.
- Reduced Global Trade Volume
- Trump's tariff policies will reduce global trade volume.
- Since most global trade is conducted in US dollars, tariffs naturally reduce demand for dollars.
- If we're heading into a world of declining global trade, that could put the dollar on a sustained weakening path.
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- Deliberate Currency Weakening Policy
- Most concerning is the possibility that the current administration is deliberately seeking to weaken the dollar as part of its economic strategy.
- Trump has frequently expressed wanting a weaker dollar.
- A weak dollar makes American-produced goods more competitive, boosts exports and stimulates the manufacturing sector.
- All of these outcomes align with Trump’s "Make American Industry Great Again" objectives.
That’s exactly what happened with the British pound in the 1940s…
2 main factors drove the British pound's devaluation against the dollar.
- The British economy had a high trade deficit, meaning the UK wasn't manufacturing locally.
- Currency devaluation made British goods more competitive and stimulated the local economy.
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Additionally, the UK faced a massive debt burden after World War II. Devaluing the pound made it easier to pay back debt accumulated when the currency was stronger. The UK government essentially sacrificed the pound's status to resolve domestic issues of high government debt and trade deficits.
AMERICA'S SIMILAR POSITION
The comparison between 1940s UK and today's US is not far-fetched.
- The US has significantly increased its trade deficit over the last 30 years, with less goods being produced locally.
- The US government also has an enormous debt burden, being one of the world's most indebted countries.
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Government debt now surpasses the total size of the US economy, with severe debt accumulation following the financial crisis and pandemic.
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We are seeing global reserve growth slow. The problem is always about a rate of change and seldom about the actual level which has already been “baked” into the financials.
Without growing national bank reserve growth we don’t have growing bank reserve growth and lending.
Everything begins to get squeezed.
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In the US there has been a steady deterioration in the employee compensation share of the Gross Domestic Income.
With Inflation pressures savings rates have collapsed
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Overall US household net worth has exploded higher as the US has become a two class society – the “haves” and the “have not’s”.
The “have’s” have a home which has appreciated dramatically primarily creating this explosion in net worth growth. Meanwhile the “have not’s” have mounting debt which increasingly they can no longer maintain and is starting impact consumption.
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Net Worth as a Percentage of Disposable Personal Income is currently around 783% or 36% above average.
If it was to fall back to its long term average as it did following the Nasdaq Bubble and the Property Bubble, more than $60T in Wealth would be destroyed.
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Currently, wealth is floating on an ocean of Credit. If Credit were to contract, Wealth would crash!
Look what happened to wealth when credit took a very small dip in early 2009 (the ONLY time it has contracted since 1951). Wealth contracted sharply – until surging government debt and QE pushed it back up!
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.. and this was before the whole system became built on a mountain of derivatives which absolutely no one has full visibility to, or control over!!!
This is more than a problem – it has the makings of a potential nightmare!
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What are the conclusions?
Well the world is NOT coming to an end but some tougher times and changes are likely ahead during this era of the Fourth Turning.
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My long time source of wisdom, Former Federal Reserve Economist, Doctor Lacy Hunt describes the situation as:
“Restoring the U.S. to its historical trend rate of economic growth depends heavily on reversing the debt overhang.
The Fed has yet to cushion the economic restraint from current federal spending and adverse multipliers, the lagged effects of prior central bank actions, and the immediate demographic drag... the risk of recession is high, and the transition to meaningful recovery will be fitful, uncertain, and labored.
Such an uncertain environment of tepid or negative economic growth will be conducive to a downward trajectory of long-term Treasury rates.”
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We see in the SHORT TERM the WEALTH EFFECT is LIKELY TO BE ARTIFICIALLY MAINTAINED
In the INTERMEDIATE TERM – a TRANSITION TOWARDS BALANCED TRADE & CURRENT ACCOUNTS is likely.
QE WILL HIGHLY LIKELY TO SOON RETURN. As I said earlier:
- Bernanke: Printed $2–3 trillion in three or four years.
- Powell: $5 Trillion in 18 months.
- Expect this time to see $7 to $10 Trillion in increases in the Federal Reserves Balance Sheet in a very short period of time to keep the system from imploding.
Expect Yield Curve Control to be ADVANCED
THE DOLLAR WILL FALL WITH YIELDS. Market usually rises on a shrinking dollar value.
However, LONGER TERM – expect the US RETURNING TO A POSITION OF LEADERSHIP
- American Exceptionalism Will Return
- Dollar Will EVENTUALLY STRONGLY Strengthen
- The US and global Economy will regain strong growth … as we eventually exit the Fourth Turing!
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As a side note - EXPECT A US$ CURRENCY DEVALUATION BEFORE TRUMP’S FINAL PRESIDENTIAL TERM EXPIRES!
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As I have always reminded you in these videos, remember politicians and Central Banks will print the money to solve any and all problems, until such time as no one will take the money or it is of no value.
That day is still in the future so take advantage of the opportunities as they currently exist.
Investing is always easier when you know with relative certainty how the powers to be will react. Your chances of success go up dramatically.
The powers to be are now effectively trapped by policies of fiat currencies, unsound money, political polarization and global policy paralysis.
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I would like take a moment as a reminder
DO NO NOT TRADE FROM ANY OF THESE SLIDES - they are for educational and discussions purposes ONLY.
As negative as these comments often are, there has seldom been a better time for investing. However, it requires careful analysis and not following what have traditionally been the true and tried approaches.
Do your reading and make sure you have a knowledgeable and well informed financial advisor.
So until we talk again, may 2024 turn out to be an outstanding investment year for you and your family?
I sincerely thank you for listening!
