Erik: Many investors claim to have been around way back in the day when Alan Greenspan was Fed Chairman. Today’s guest, Dr. Lacy Hunt, defended his PhD thesis 50 years ago in 1968, back when William McChesney Martin headed the Federal Reserve. He served as HSBC’s chief economist and has held many other very senior roles in the industry.
Today he is with Hoisington Investment Management and he has been spectacularly consistent and spectacularly right about Treasuries for many years.
With so many other experts in the field declaring that the bond bull market is over, and that a new secular bear market in bonds in on the table, Dr. Hunt, we wanted to get you back for your view. Do you agree with the people who are saying, okay, that’s it, it’s over? And, if not, what is the bullish argument for the bond market?
Lacy: I do not agree, and I have to admit it’s a lonely position. My view is that we are going to see lower long-term Treasury bond yields in the years ahead. I think the best and most complete and consistent theory of interest rates was provided to us by the late Nobel laureate, Milton Friedman. And the main conclusion of Friedman’s theory is that monetary decelerations such as we’re having today ultimately lead to lower interest rates and not higher interest rates.
What Friedman had in mind is that, when the Fed engages in a tightening of monetary policy – what he called a liquidity effect – this tends to raise the short-term rates, but it begins to restrict the flow of money and credit. If this liquidity effect is repeated several times, it will eventually produce a countervailing income effect in which the rate of increase in interest will be slowed as the economy begins to moderate its rate of expansion.
And if the monetary deceleration extends for a protracted period of time, ultimately the inflation rate will fall. Hence Friedman’s conclusion: Monetary decelerations ultimately lead to lower interest rates, not to higher interest rates.
Erik: Joining me now is JDI Research founder, Juliette Declercq. Juliette prepared a fantastic chart book that you’re not going to want to miss. So I strongly encourage you to download it now, as we’ll be referring to it throughout the interview.
Registered users will find the download link in your Research Roundup email. If you’re not yet registered, just go to macrovoices.com and look for the red button labeled Looking for the Downloads above Juliette’s picture.
Juliette, thanks so much for coming back and joining us again on MacroVoices.
Juliette: Well, Erik and Patrick, thank you very much for having me on such a high-caliber podcast. Now, Erik, I know that all you want to know is where the dollar is going. And I’m afraid 2017 was rather straightforward and 2019 may be straightforward as well, but 2018 is a transition year and a time to be more tactical.
I’ve not found the magic recipe yet this year. So this interview will focus on my thought process for you to extrapolate your own tactical game plan.
I have put together a chart pack of exclusive macro pictures. Some from my CIO-tailored reports and some created just for you guys. Please make sure you download it, because I will refer to it through the whole interview. And, also, you know that my motto at JDI is “better a good chart than a 10-page waffle.”
Erik: Joining me next on the program is Gavekal partner and founder Charles Gave. Charles, thanks so much for joining us on the program. You penned an article recently – so many people look at the yield curve as a sign of oncoming recessions. But most people only bother to look at the yield curve on government debt, on Treasury debt.
You’ve recently observed that the corporate yield curve is sending a very different message than the government yield curve.
Please elaborate. Tell us what that was about. And give us a sense of what that signals in terms of your expectations for market conditions as a result of what you’re seeing.
Charles: Okay, let’s start with something that probably all your listeners agree. And it’s a very simple one. It’s that the government is not responsible for the growth in the economy. I think most people would agree with that.
So if your government is not responsible for the growth in the economy then why is the yield curve, which is basically the cost of money from the government which is subtracted from the cost of long-term money for the government. And there is no reason why it should work, because the government can always borrow on top of that, as there is no variable that the government cannot go.
So the answer is the - we have done a lot of work on a Swedish economist called Knut Wicksell.
Wicksell lived at the end of the 19th century, beginning of the 20th. He had a massive influence on the Austrians and on Fisher and so on in the US.
And he/we had a brilliant idea. He said the economic cycle is created by the presence in the economy of two interest rates. And, let’s put it simply – the rate at which you can borrow and the rate at which you can invest. Wicksell said, in order not to have too big an economic cycle, financial cycle, the two should be meet each other most of the time.
Because if the cost of capital is way above the retail invested capital, then it pays to repay the debt. And we move into what specialists call a debt deflation. Which means that’s what you had in the 30’s, that’s what Japan had for a decade. And it doesn’t work.
On the other hand, if the rates are too low, then it pays to buy against the assets by borrowing money. You borrow at 2 to buy an asset yielding 4. The price of these assets eventually goes up. But nobody is investing new assets because it entails a risk.
And what it leads to at the end is that the rich get richer, the debt gets bigger, the price of assets goes higher. And what happens is the poor are getting poorer since nobody is investing into capital spending. So productivity goes down, and the poor guys, the only way for them to have the highest standard of living is capital spending for them to have a higher productivity.
So Wicksell was saying something quite brilliant. He says, look, trying to create growth by maintaining interest rates too low always ends badly. You never know when.
It always ends badly because it leads to accumulation of debt, inflated asset prices. And eventually the cost of money starts going up because everybody has been borrowing. So return on invested capital starts going down.
And we always end in a period where the cost of money moves above the cost of capital and you have a debt deflation. So he says, Wicksell, be careful guys, don’t manipulate short-term rates lower because it always ends badly.
Keynes used a lot of Wicksell’s work too. And it’s almost a perfect condemnation of Keynes’ theories.
So that’s the first idea.
And what I’m trying to say is that – the classical yield curve works in the US for a very simple reason. It’s because short rates on governments are proxy for the cost of capital. Long rates are a proxy for the long-term return on invested capital.
And so if the curve inverts, it means that the cost of capital is above the return on capital and then all hell breaks loose. It cannot – it leads to recession. But all I’m saying is it’s a better idea to do it with the cost of capital for the private sector and the retail non-invested capital for the private sector also, rather than do it with the government sector.
That’s all I’m trying to say.
Erik: Joining me next on the program is macroeconomic strategist Russell Napier, also author of Anatomy of the Bear, one of the most respected books on bear markets and bear market bottoms.
Russell, thanks so much for joining us on the program. You recently penned an excellent article emphasizing the case for deflation rather than inflation in the United States, based on central bank policy.
One of the things you emphasized in that article, back at the time it was written everybody and his brother were saying the US dollar is about to crash. You said no, the opposite, the US dollar is bottoming and about to strengthen. And a lot of people thought you were crazy.
Needless to say, the tape action has proven you right, at least so far. We’re seeing very strong positive action in the US dollar.
So please give our listeners a quick overview of your argument favoring deflation, and why you have such a bullish view on the US dollar at this particular juncture in time.
Russell: Sure, happy to do so. And I would just – there’s many issues I could raise for the US dollar, but let me just pick on two: The level of real rates of interest in the United States of America and the growing prospects of a credit event or a default outside the United States of America.
Both of these, I think, are ingredients for a strong dollar and also ingredients for lower global inflation. And it may be globally feeding back into the United States of America.
The interest rates – I know most people, or just about everybody, believes that US rates are rising to reflect more inflation. And, of course, that could be correct.
I would point out something that’s happened with that US Treasury market that hasn’t happened in my entire investment career, which is now 30 years old, and that is that, as we speak today, central bankers are net sellers of Treasuries.
We know what the Federal Reserve plans to sell this calendar year, $228 billion. We know what the rise in global foreign reserves is, and about 64% of that will flow into the United States’ assets. Slightly less of that will flow into Treasuries.
$228 billion, at the current rate at which foreign reserves are accumulating, we are not going to see foreign central bankers offsetting the sales from the Fed. So that’s a net sell. We don’t know what that net sale will be, but it’s a net sale from central bankers at a time when the Congressional Budget Office forecasts a roughly $1 trillion fiscal deficit.
This is the first time in my investment career that savers will have to fund the whole lot. And it’s perfectly normal that real rates of interest have to go higher to attract those savings.
$1 trillion is still a large amount of money. It can come from anywhere in the world. It can come from outside the United States. It can come from inside the United States. But it’s a liquidation of other assets or a rise in the savings rate, which is necessary to fund this. Either of these things is positive for the dollar.
What we can’t know for sure is how much of the capital to fund the US Treasury will actually come from offshore. But history suggests that huge amounts of money can be attracted into the US dollar at reasonable rates of interest.
I think we’ll come on to discuss whether this is a reasonable rate of interest or not, but the fact that the dollar started to rise in the last few weeks is perhaps confirming that foreigners believe that this is an attractive rate of interest. And it is, obviously, relative to what is available in the so-called risk-free assets that are government bonds – compared to Japan, compared to Northern Europe.
Therefore, that is attracting capital. And that will continue for quite some time. It will clearly have to bring up, to some extent, European yields with it. It can’t bring up Japanese yields. So I think it will continue for some time.
And that’s the first thing that underpins the United States dollar.
Very briefly, because I suspect we’ll come back to it, are these credit events that are recognized in various places in the world. Remember, the United States dollar is heavily borrowed across the planet. And it is also heavily borrowed by people who don’t actually generate US dollar revenue.
The rise in the dollar, the rise in interest rates, the rise in the spread of cost of borrowing dollars in Europe is causing some distress.
My particular bugbear in this is Turkey, where I think the whole country has basically been getting to the edge of defaulting on its debts. It’s a $432 billion credit risk, Turkey, on the global financial system. I think it’s important.
And history shows one thing and one thing clearly. If you get into a situation of a credit event, particularly as it pertains to people who borrow dollars and don’t actually have them or generate them, then you get a strong dollar. We get an unwinding of that situation. And I think if we were very unlucky, it could spread beyond Turkey into other emerging markets.
So that would be the two building blocks for saying why the dollar is probably going up and not down.
Marin, I was thinking about you quite a bit recently as I’ve been watching the news flow with this escalating tension between Donald Trump and Vladimir Putin. And I couldn’t help but think to myself, Donald Trump clearly has not read your book Colder Wars, because if he did he would understand the degree to which American is dependent on Russia and trade with Russia.
But, for our listeners who may have missed your first interview on MacroVoices, please explain what I’m talking about. What could go wrong, for US energy policy particularly, if there was a complete breakdown of trade between the US and Russia?
Marin: Unfortunately for the Americans, a lot can go wrong. Let’s go back 30 years as the collapse of the Soviet Union – the infrastructure was in place with the Russians where they could downblend their nuclear warheads into cheap nuclear fuel.
The Americans took advantage of that, and now one in every ten homes in America is powered from a Russian-sourced enriched fuel. That’s on top of one in every five homes in America is powered by nuclear energy.
Setting that framework, when you understand that Americans consume a little over 50 to 55 million pounds of uranium a year for their nuclear reactors, and this past year (in 2017) produced just under 3 million pounds, they import over 95% of what they consume.
So it’s by far the biggest energy source that they’re importing. And, more importantly, Russia is in a situation where exactly 45% of the world’s enrichment capacity is owned and operated by Russians.
All of the enrichment facilities in America are actually not operating today. And these are radioactive facilities. So it’s not like you can just show up, turn on the switch, open the doors, and get going again. These are radioactive. There’s a lot of items that you have to do.
When you look at the timeframe – if Russia does play hardball with Trump – right now the nuclear reactors in America have just under 12 months of stockpiles that they can consume of enriched material.
Now, Urenco, which is a very complicated European-structured ownership, they could make up some of that. And a lot of people in the investment community go, well Canada and Australia can just make up the difference. Well, actually they can’t. The Canadians have a long offtake agreement with India. And the Australians have signed major long off-term agreements with the Chinese.
So what will eventually happen is there will have to be a major increase in the spot price for the American facilities to be able to come on because these are not owned by the government. They are owned by private enterprise, and they’ve lost money and they’ve shut down.
So, will anything change overnight? No. Because these nuclear reactors – it’s not like coal or natural gas where they need daily feed. These are set up. The rods are there. But these nuclear reactors – if you think that the price of uranium is about $20 a pound, and if it went to $40 – let’s just say 100% increase – it would not change the spot price of the electricity generated by more than 5%.
So, for a nuclear utility, they don’t really care too much if the spot price is $20 or $25 or $40. But they care about a secure long-term stable supply. So this is the first time ever in the nuclear sector that the government of America has found itself in a serious predicament.