December 6, 2017; The Case Of The Inexplicably Missing Defaults

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

“You have a majority of investors today who are signing up for bonds as if there is no risk, signing up for stocks as if it is a one-way bet, signing up for bitcoin as if 20% volatility is no big deal because you know you know you are going to have 40% upside tomorrow. Maybe – but maybe not. So my advice – step aside, hedge your bets. That’s it.”

– David McAlvany

Kevin: David, again, you’re remote. But this time we can say that the conferences – the ones we did this summer and the ones we did late this fall, are now over. Now, you’re still not back in the office. I was joking with you a little while ago. I said, “Maybe what we need to do is come up with a coffee table book that shows where you do the show from different venues. You have done them in Switzerland, you have done them in airport bathrooms. You’re in a laundry room right now because they’re doing construction next door there in Florida.

David: Yes, Kevin, 15 minutes ago I was in the surf, got about three-quarters of a mile swim in. We’re in the Florida panhandle, if anyone knows were Destin is, and I’m meeting with some family for a day or two just to brainstorm a variety of things. So yes, I got a good swim in just before the Commentary, and now I’m in a laundry room because it is the only quiet spot next to construction adjacent. So if you do hear any jackhammers in the background, that is what it is, but I’ve turned the laundry, the washer and dryer, completely off.

Kevin: Dave, I remember interviewing your dad earlier this year while he was in the Philippines there at the orphanage. There was this guy who was mowing the lawn right outside the open window. You know your dad. He gets so focused, he didn’t even know it was happening, but about every three minutes I would hear this loud roar go by him (laughs). It made for a good recording. It just proved to me that Don is focused on the things that are important. You, being in a laundry room, are focused, as well.

While you were swimming, I hate to say this, Dave, but here we go again – 1.5 billion dollars’ worth of gold futures – naked futures – were dumped on the market to push gold below the 200-day moving average. This is amazing. We’ve talked over the last couple of weeks how three weeks ago it was four billion dollars’ worth of gold dumped instantly to knock the market down, and then it rose again, and then two billion dollars’ worth of gold, and then it rose again – 1.5 billion this week dumped on the marked instantly to try to push it down. I think, instead of focusing on gold going down with these futures manipulations, we probably ought to look at who the heck is buying the physical gold every time it drops.

David: You’re right, Kevin. I think one of the things it reminds me of – you and I have had a conversation about an old book called, “Magic and showmanship, and it talks about the art of redirection, and so much of what we see today in the markets is just that – the art of redirection. There are so many things that are happening in the sovereign bond market that are of substance that what happens in the gold market, certainly there is this design and desire on the part of the powers that be to say, “Look, not only is it good, but it is getting better. We’re moving toward our perfect economic and financial utopia. All you have to do is trust us and everything will be just fine.”

A part of that is hammering the gold price periodically. We saw Paul Volcker – not speculation on our part – from his memoirs he said his one mistake in the 1970s was not destroying the price of gold as an indicator of concern in the marketplace. And that’s really what it is. It is a barometer of things that aren’t quite right. The fact that there is massive physical demand all throughout Asia, and that keeps on buoying the price, you are running into this conflict between the paper world which gets sold off periodically, short-term manipulation, today’s case in point, and the longer-term trend where real supply and demand are in play, and demand in Asia is taking the available supply simply off the market.

Kevin: Yes, China has actually been buying all the gold that is mined in the world, and they’re not selling any of theirs. They are the number one miner, as you know, in the world. They don’t sell any of their gold, they keep it and then they still turn around and buy just about as much off the market.

I’m going to ask you a question, Dave. It’s about time for us to have a guest – the stock market, of course, is hitting all-time highs, we have bitcoin hitting all-time highs and wiggling around. We have this mania that seems to be going on in the markets. One of my favorite authors, as far as the charts that he produces and the evidence that he shows of historic highs always turning into a consequence later, is a guy named Alan Newman. I wonder if we ought to have Alan Newman on the show maybe in the next week or so to bring to light just where we are in historic terms with these markets.

David: I think the importance there is that in the last four years we have had a number of guys who have been writers and commentators in the marketplace pass away. Alan Abelson was a regular guest on our Commentary, Sy Harding, Joe Granville, Richard Russell, Marty Zweig. You have a number of people who spent 40-50 years in the markets commenting and bringing insight. And what you have with Newman is the same. He has been writing 53 years as an editor of Crosscurrents. And to get some perspective on where we are, and where we are going, I think we do a reasonable job on the Commentary, but frankly, to bring in someone who is seasoned by an additional 25-30 years of market experience, I think it is very important to have some winsome thoughts from someone who has been there and done that.

Kevin: So I would recommend for the listeners who can tune in next week, definitely listen to the Alan Newman comments. Now, it’s sort of sad, Dave, thinking about some of the great minds that we have had on this show since we have been doing this for a decade now, have passed away. Sometimes the greatest lessons come from the oldest people. I hate to say this. In fact, it reminds me of a John Maynard Keynes’ quote. He said, “In the long run, we’re all dead.” That’s a truth, and what we are running on right now is all borrowed money.

I’m not fan, and I know you are not a huge fan of John Maynard Keynes’ solutions, but he had some pretty witty ways of saying things. And there is a quote that he came out with that talks about foreign loans because we have been just living on borrowed money. He said, “Foreign loans enable a country to live beyond its resources for a considerable time at the risk of ultimate default.” Dave, we have been living on foreign loans, we have been living on loans to ourselves. The only thing we are really missing is the defaults. Like the lady said in the Wendy’s commercial, “Where’s the beef?” Where are the defaults? We don’t have them anymore.

David: Carmen Reinhart has written another great paper on sovereign defaults. The title is Capital Flow Cycles: A Long Global View. I found it intriguing that her cohort of academic contributors – her husband, Vincent Reinhart, and Christoph Trebesch (I can’t help think of Alex Trebek every time I see his name) – they are all curious as to the unexpected outcomes here in the post 2011 to present period. Looking at emerging market debt crises going back to the first big one in 1827, they look at the pattern of credit booms and busts where there is a meaningful number of defaults that typically follow in the bust period. They point to this 1999 to 2011 boom in the emerging markets and in the commodity sectors, and they say, “This is kind of the odd man out.” There should be at least 15-20 significant sovereign defaults following the run-up in commodity prices and the increase in hot money flows into the emerging markets, actually, following that timeframe, so it’s from 2011 to the present.

Kevin: So that is a natural consequence of these credit booms and busts, that there is a certain amount of defaults that you would just expect to occur.

David: Yet they are not there. Or should we say that differently? They are not there yet. Word placement is amazing, isn’t it? Was it the extraordinary central bank intervention which prevented these 15-20 cases of sovereign default from ever happening? Or, as the paper asks, has it merely postponed it for the duration of those policies, which remain in place? Personally, for me, coming from a Minskyan or Austrian perspective, the current stability is very suspicious.

Kevin: As you remember, Dave, last September, 2016, there was a very illuminating interview that you did with Carmen Reinhart, the co-author of this paper. What made that interview illuminating was that one of the ways they have been able to avoid default on these debts is by trying to close up the system. She says ultimately we will have to create a captive audience to keep things held together. She co-authored a book back in 2009 with Ken Rogoff, who is a very strong proponent of getting rid of cash in the system. And now, she has co-authored this paper with her husband and Trebesh saying, “Where are the defaults? And will they ever come?”

David: The conversation between the co-authors is a fascinating one because in these cycles of default, Reinhart and that crew point to the inflationary disruptions that usually follow on the heels of sovereign defaults. We pointed this out a couple of years ago, Kevin – I think it was Lex Rieffel , if my memory serves me correctly – that there is a much higher correlation in the 20th century between credit problems and currency crises that follow than in the 19th century. It used to be that when you had credit problems, it impacted banks and the financial sector players, primarily, so that a credit crisis and a banking crisis were linked.

But something changed, because in the 20th century, with the popularization of fiat currency, you could almost say the democratization of credit, what we have also come up with is the democratization of crisis. Now, every man, woman and child gets to stand between the credit and banking sector dominos as they fall. And they get to see and enjoy the consequences of default as they get played out in a devalued currency.

So, what under the gold standard was fairly limited in terms of the impact on individual lives because it was cordoned off within the banking sector, now you see some follow-through between the credit market problems, and ultimately, currency crisis. So again, whether it is Reinhart and this paper or Rieffel from years ago looking at sovereign defaults and restructuring of loans, it is just interesting that we are not seeing the defaults.

Kevin: Didn’t we see this from 2008 on? It was the bankers that largely gained the reward of the credit boom that came up to the credit bust, yet the consequences are being spread to the innocent, those who didn’t have any of the gain from the risk that was being taken that they are paying for at this point. It is almost like, consolidate the gains to the few and spread the risk to the innocent and the many. That is amazing. It’s criminal.

David: Privatized gains, socialized pain. The paper explores the capital flow bonanza, as they put it, between 1999 and 2011, and the big question is: Why is this period different than other historical antecedents? So again, massive capital flows 1999 to 2011. And if you are looking back in time, there have been 14 major booms just like this period. Eleven of those were followed by a rash of sovereign defaults. Six of the default periods were on a massive global scale. And four of those six included a double bust of both capital and commodity markets. So very common in nearly all the cases was a surge in capital flows, and then the economic crisis that came afterward, as the dust began to settle you had inflation and currency problems as a result, as well. So, where are the defaults?

Kevin: It takes me back to September of 2011. Gold was peaking at $1900 an ounce and it looked like it was going to go higher because the crisis was actually playing itself out still from 2008. And then Mario Draghi, the head of the European Central Bank, said, “We’re going to do whatever it takes.” Those words – who would have thought – here we are at the end of 2017 and those words are continuing to play out as we speak. Of course, gold peaked out in 2011, it came down and it really didn’t bottom out until December of 2015. It has been rising since then, but we still see this “do whatever it takes” out of all the central banking community. It doesn’t seem to have an end.

David: Draghi’s comments came in June and July. Then you have the subsequent European Central Bank, Bank of Japan and Fed balance sheet commitments where they bought tons and tons of assets and just absorbed them onto their balance sheet. So maybe that is sufficient to eliminate defaults from the cycle, but the reality is, it was normal in the 2012 to 2015 period to expect a number of sovereign defaults because that is what happens in history. That is what happens as a consequence of these massive capital flows. But it didn’t happen, and so figuring out why is very important.

This is significant because the findings of the study return us to some very basic concerns that we had in 2011, and have reconfirmed them as valid. You have credit boom, both prior to 2008 and 2009, and the subsequent credit expansions in its wake, where the central banks have increased their balance sheets, cumulatively, ten trillion dollars between the major world central banks. And everything we know from history and the way that market dynamics have worked in the past, is that that should, with very high probabilities, lead to a series of sovereign defaults, with economic ramifications, as well as the normal pattern of currency devaluation commonly associated with a sovereign crisis. So here I am, blue in the face from holding my breath from then to now.

Kevin: There is always a consequence. One of the things in human life that can get us into trouble over and over and over, and hopefully we start learning our lessons as we get older, but when you are young you do an awful lot of things thinking, “Well, I can get away with it. There is really probably not going to be a consequence.” As you get older you start to realize there are always consequences. So we look at this and say, “Where are the defaults?” Well, there will be a price to be paid. Now, maybe default looks a little bit different, but Dave, are we seeing any consequences currently?

David: I listen to one of the Dallas Fed folks, Kaplan, who said this last week, “We have now gone 12 months without a 3% correction in the U.S. stock market. This is extraordinarily unusual,” he says. I think, whether we are talking about defaults or the current behavior in the stock market, those words – extraordinarily unusual – suggest that either something has radically shifted and we are dealing with a brand new set of variables, or we are just playing with time. Again, I’m searching for an explanation. Perhaps it is that the central banks did enough. Perhaps it is.

This is one of the unique aspects of that boom period. You go back to the boom period and you had a massive increase in commodity prices. Again, you go back to 1999 to 2011 – in real commodity price terms, non-oil, you had increases, in percentage terms, which were unbelievable. They increased, in percentage terms, more than they did back in the 1938 to 1951 period, which had been the highest price increase in this century. And it even exceeded, if you go back a long time, the commodity price bonanza of the late 1790s – 1792 to 1801.

So we ask this question – is it possible that sovereign defaults were averted due to the massive increase in reserves that countries were building from the export of those commodities? Normally, the commodity boom/bust cycle is an overlay for the credit boom and bust cycle. So there is a possible explanation here. Maybe they just reaped the reward of a huge commodity price increase, and therefore had enough reserves, had enough cushion, to avoid a significant drawdown. That is a possible explanation.

I looked through the paper carefully, and in one of the tables on page 21, titled “Capital Flow Surges, Declines, and Sudden Stops,” you can see that as a percentage of GDP, the change between 1999 and 2011, a 12-year period, nearly matched the period from 1918 to 1929, both in duration and in terms of percentage change. Again, we’re talking about a credit boom – 18.4% growth in the earlier period, 18.3% growth in this most recent period. The 2011 to 2016 period, getting us to the current day, almost, we have seen a decline in capital flows by 23.7% as a percent of GDP, which is nearly twice the average, still not as great as what happened during the great depression, 1929 to 1933. So again, we have had a massive increase in capital flows and credit, and then a massive decrease, 23.5% as a percentage of GDP, and yet, sovereign defaults are virtually non-existent. 15-20 would be normal. That would be the norm.

Kevin: That is incredible because what you were talking about, anytime you have a massive boom – 1918 to 1929 – of course, we all know what happened in 1929. We went into a long depression, the longest that we had in the century. And then, that’s the bust, you have defaults during that time. Then from 1999 to 2011, of course, that was another boom period, and then we had our bust. But we really haven’t had the bust.

We have talked about this before. There is a name for this, Dave, when the central banks come in and create an environment where there are no defaults, where they hide that there is actually a consequence to actions. That is called moral hazard, because you don’t just stop there. You’re not just papering over mistakes or sins of the past. You are creating sins for the future.

David: Back to that critical issue. You have central bank intervention that can prevent defaults. Is it only for the intervening period where central bank activism remains in place? And to get to the chase, does normalization of interest rates – because that is what we are talking about right now, we’re talking about central banks normalizing rates, and if we see normalization of interest rates and reconstruction of central bank balance sheets, because that is what everyone in the central bank community is talking about doing now and in 2018, going back to the pre-crisis formats for both of those.

Does that trigger a return to the normal pressures that debtors feel under the strain of high debt levels, and less than adequate, even potentially declining revenues? This is the key. We have, in essence, covered over a problem, and if you take away the props, what happens? I think Reinhart is asking a serious question. I’ll put it in the most approachable language I can. Do the wheels come off in the sovereign bond market, as they typically do, when central banks step back from their current commitments?

The obvious ramifications are directly into the countries affected by default. You have a variety of emerging market players which would be impacted. But also, you have the investors who need to be aware of their exposure to those emerging markets, as well. And then a third category is that you have implications into the global economy. An emerging market crisis based on defaults is not limited to the emerging markets. We have a very interconnected global economy. We all would surely feel the pain of the linkages and the pressures that creates.

Kevin: Don’t you think that is maybe why, in reality, they can’t normalize rates? I think of the song – I’m wondering if it’s too late, we’re too far into this. Like Richard Duncan talks about, “Hey, don’t stop now.” I hate to sing to you, Dave, but “It’s too late to turn back now. I believe, I believe, I believe in the central banks.”

David: (laughs)

Kevin: I’m wondering if that’s the song at this point. It’s just too late to turn back at this point. What is the consequence, worldwide, not just in the United States? You’re talking about the emerging markets now.

David: Basically, what we have had happen is, investors have said, “I can’t find a good value here in the United States. Things are getting pricy in U.S. stock market. Maybe I will go and look in the emerging markets.” So investors may be tempted to look on a comparative basis at the emerging markets as a better value than the developed world markets today, certainly the U.S. And if you’re looking at valuation metrics alone, you are correct. The emerging markets are selling at prices which are considerably below the U.S. markets.

But is cheaper cheap enough? Or can it get even cheaper still? I think the answer to that is always, it can always get cheaper. The issue in play is really whether or not the emerging markets can escape entirely from what Reinhart describes as that capital inflow default cycle, or whether that pain at the economic periphery in these emerging markets is actually closer than we think today, with very significant implications for the economic core, as well.

Kevin: Well, Dave, if we’re going to give praise to the central banks and say, “Good. Lowering interest rates really did work. Printing money, quantitative easing, really worked,” isn’t it a contradiction to say that when we reverse those things they won’t have any other consequence to the other direction? In a way, you are nullifying the causal effect of what the central banks are claiming success at. If they can turn around and say, “No, if we raise rates, and we stop quantitative easing, it will really not do anything to the system.”

David: There is no doubt that what we experienced, 2008 and 2009, was the equivalent of medical triage, with the banking sector and the financial markets hemorrhaging, and tourniquets necessary, cauterizing of wounds necessary, extreme interventionist measures necessary. And the big question is, has the patient fully recovered? Is the patient capable of getting up on his or her own and moving on?

I am fascinated by this. On the one hand we have what Reinhart talks about, the capital flow boom and bust. How she describes it is, you have had declines in interest rates at the center, which act as a push factor to capital inflows, and rate hikes often contribute to an abrupt reversal. That is her conclusion. So yes, she agrees with you, when you start to hike rates and normalize, you lower rates to accommodate, and that is your version, or one of the many versions of market triage. But then yes, you put rate higher and that can contribute to an abrupt reversal, which may be, in fact, a sufficient trigger for those 15-20 missing defaults.

So that’s one thing, we may just, in the process of normalizing, get our 15-20 sovereign defaults, and that could be a 2018-2019 event unfolding as we “normalize.” On the other hand, think about this a little differently, instead of just going back to normal, because these guys believe their own B.S. at this point. “Everything is healthy. Everything is fine. We’re going ahead because we know the patient is just fine.” But what if, on the other hand, we had a single-party actor lash out and change the rules of market engagement, triggering a panic?

Kevin: Dave, you know what that reminds me of? It always cracks me up, when I have to get a map or a globe out to figure out somebody who actually triggered a worldwide crisis. Maybe some people know where Malaysia is, but not everybody. You go back to the Asian crisis and I remember I had to go get a globe when the Asian crisis occurred because – Malaysia? Really? They triggered billions and billions of dollars’ worth of loss? Where’s Malaysia?

David: This was back in September of 1998 and you had Mahathir Mohamad – he is now the former prime minister of Malaysia. He was a single-party actor in the Asian crisis who did this. Now, fast forward. Turkey may be just the actor today. You have capital controls – they have huge consequences. That is what we saw happen in 1998, declaring capital controls September 1, 1998, and literally, all hell broke loose and the Asian contagion was off and running, certainly exaggerated by that. One of those implications of capital controls is that it causes a broad rethink on capital accessibility.

So when controls are raised in one geography, whether it is Malaysia or Turkey, it has a sobering effect amongst investors all over the globe who might have forgotten that getting their money back from a certain region of the world is not always guaranteed. So when you have capital controls put in place, there are those directly impacted, and then there are the investors indirectly impacted with allocations in every other fund imaginable who ask, “If it could happen to them, could it happen to me?”

Kevin: Dave, there is nothing more frustrating than going to an institution like a bank, or in this case a country, and saying, “I’d like my money back, please,” and they way, “Well, no, you can’t have it.” What an incredibly helpless feeling if you have ever been told you can’t have your money. What it does is create panic, and that panic is what becomes contagious. That’s what a bank run is.

David: I think what is easy to forget, when we see prices and technology and complexity all playing in together, really, the markets are one thing. The markets are psychology, and psychology, in the market, is contagious. That can be positive momentum or negative momentum, but this is why and how momentum becomes so powerful, both on the upside swing, and on the downside, as prices decline. You can go from normal times to abnormal in a matter of seconds.

Those bank run dynamics of the 1930s – probably the best paper I ever read on that was a classic 1983 paper titled, “Bank Runs, Deposit Insurance, and Liquidity.” It was co-authored by two people – Diamond and Dybvig. What they consider at the bank level is just as true in terms of international capital flows and those run dynamics. When a bank says you can’t have your money, when any institution says you can’t have your money, what they call suspending convertibility where you temporarily are not able to access your assets, is comparable to a country implementing capital controls. What you end up having is individual investors, or actors, if you will, rationally determining that the game has changed.

And you know what they try to do? They try to change their allocations. They try to grab as much of their money as they can. It’s like a bank robbery. And en masse, it looks like an irrational panic, when at an individual level, it is just another way of saying, “If I don’t get my money now, I might not get it at all.” We’re getting awfully close to that dynamic in Turkey.

Kevin: Dave, we were talking the other night about the movie, Dr. Strangelove. Of course, Dr. Strangelove is a comedy parody of the mindset of the two rational actors in nuclear war. It was made in the early 1960s. We have talked about mutually assured destruction actually being a form of game theory. As long as you have two rational actors you can say, “This is a gentleman’s agreement between the two of us. I’ve got a lot of nuclear weapons, you have a lot of nuclear weapons. As long as neither one of us uses them, we’re all going to live in peace.”

In a strange way, we have created a form of mutually assured destruction with this debt system. Everyone has gone into huge debt, but really, the agreement between rational actors, as long as we have rational actors, is, “As long as you don’t call in your debts, I won’t call in mine.” The reason mutually assured destruction doesn’t work anymore is because you have North Korea with nukes, you have Iran, possibly, with nukes. That whole rational actor agreement thing with nukes doesn’t work anymore. I’m wondering if Erdogan will be the guy who is no longer the rational actor, no longer the gentleman’s agreement guy that actually pulls the plug?

David: To be generous on this, maybe he is entirely rational and he is just working with bad economic assumptions, in which case he comes to what appears to be irrational conclusions when, in fact, they are to him and to his counselors, entirely rational. They are just working with bad assumptions. He sees the increases in interest rates which are now above 12% as objectionable. And he is close to reacting in ways that you typically see authoritarians act. You have rates in that country which are rising, you have the lira, their currency which is falling, and he is on the verge of lashing out. Our friend, Russel Napier, points out that that is the perfect environment for capital controls, and Erdogan is the man for the job.

Kevin: So what are the consequences of that?

David: It may be the trigger which recalibrates investor thinking on emerging markets. Again, why is that important? Because here we are wondering where the defaults went, and the defaults may be waiting in the wings, and it may be because we normalize and come back to balance sheet normalcy in the developed world, or it may be that from the emerging markets we have something that represents a singular trigger and initiates the missing default cycle.

It comes down to this. Will we see a string of sovereign defaults due to the central bank gravity-fighting, all the measures that we have seen post 2008 and 2009, and the blanket promise that Draghi gave us in June of 2011? Will we see that shelved, and will gravity now begin to have its impact on the market? Or will we see a string of sovereign defaults due to a recalibration of investor thinking akin to a run on the bank, as you have new data, something like capital controls. That’s a new information feed which introduces a new perspective on risk in the current environment. Or maybe there are just no sovereign defaults at all. We’ll have to see.

Kevin: That’s what we were talking about. Is it too late to turn back, and will central banks do anything they possibly can? But this whole central bank cartel still seems to be somewhat of a Western world phenomenon. We now have China in the mix and we know that they are doing things that are looking more independent every day. How about China trade relations and some of these things? Again, mutually assured destruction only works when you have a couple of players all in agreement. When they start coming out of agreement, whether it is an Erdogan, or whether it is just natural forces that come from China emerging as a new world economic superpower. That could also trigger it, couldn’t it?

David: Yes, because we are really talking about a terms of trade crisis. And so, when you look at the trade relations that China has with so many of the emerging market commodity producers, it is difficult to imagine that tightening credit, whether it is in Asia – let’s say China is able to wrap its arms around the wealth management products and start to get control of the shadow banking system. Whether it is tightening of credit in Asia, China specifically, or in America, or Europe. The question is, doesn’t that lift the carpet a bit and show you what was swept under it four or five years ago? Do we know the trigger? No, we do not know the trigger. But can we see issues which serve as a backdrop for financial market instability? Absolutely.

Kevin: Dave, wasn’t it William McChesney Martin, the head of the Federal Reserve back in the 1950s, who said, “You can put the punchbowl out, but you want to remove the punchbowl before the party really gets started?” Something like that. The central banks right now – let’s just use the Federal Reserve as our central theme here as I ask this question – the Federal Reserve has got to be watching what is going on on Wall Street right now, and almost the euphoria that is being played out. Most of it is corporate share buy-backs, but what it is really doing is pushing the market into new territory, higher highs – we have higher margin debt than we have ever had. At some point, they are going to have to start considering removing the punchbowl.

David: Right, so that the recently retired head of the Bank of International Settlements in Basel, Switzerland, said something to the effect of, “You should not under-estimate the danger of being too slow in normalizing rates and normalizing central bank balance sheets.” I don’t disagree with that, Kevin. I don’t disagree with that. But in our opinion, there is a real conundrum here, because the need to normalize is already past due. Yet, the financial system frailties may, in fact, be revealed by that very thing.

Normalization – again, going back to the patient analogy, having assumed the patient no longer needed life support, wouldn’t it be tragic to discover the acute underlying needs only after you have taken the respirators off and the IVs are disconnected and then pulled away. This takes us back to Reinhart’s suggestion, “Have we only delayed the default cycle?”

Kevin: Not only delayed it, Dave, but when you delay something like this, you only make it bigger. So if the default comes, this will probably be much larger than what it ever would have been had it played out naturally.

David: Here is one other thing that makes it interesting, Kevin. You say bigger. The big shift, the past debt crises that we saw were tied to bank lending. This may be a subtle difference to those of you who are not financial market practitioners, but past debt crises were tied to bank lending, and you had panic dynamics which exacerbated an exit from the asset classes. That was a particular geographic region and it led to a unique currency chaos dynamic.

The transformation in recent years has been borrowers tapping the bond market rather than traditional bank lending, which has provided for, not only exceptionally affordable loans and generous terms, but it has also created a world in which people feel as if they have lots of liquidity with those assets. Here are some things to look for. It is not clear what happens when a mass of investors want out of the bond market. Liquidity is assumed, but it is not guaranteed.

Kevin: If they are treating bonds like banks, they are assuming there is an FDIC standing behind them that will always provide liquidity. But the bond market doesn’t have an FDIC, do they?

David: It’s not just an FDIC or an implicit guarantee, it’s that there is really not as much of a two-way market – I don’t want to say there is not much of a two-way market. There is a two-way market in the bond world, obviously. But there is no – just like in the past couple of months we have talked about a gutting of the incentives for Wall Street market-makers to inventory shares of companies, and we really don’t know what liquidity dynamics are in the next downturn with all the ETFs that have traded, and the popularization of ETFs, and the elimination of market makers.

The same thing has happened to the bond market, where there are not as many people who are willing to step up and buy the asset class. There has been an expansion of debt, not just in banks, but specifically in the bond market, and there is implied liquidity in the bond market. I’ll say it again – liquidity is assumed, but it is not guaranteed. I think the next emerging market debacle may, in fact, test the idea of bonds being a liquid asset class.

And then we come full circle. We have central banks trying to extricate themselves and normalize, but a non-virtuous cycle of illiquidity in the bond market, as it is revealed it may require a buyer of last resort, arguing for another round of central bank balance sheet expansion. So what takes the Fed’s balance sheet from four, almost five trillion, to ten trillion? Maybe it is a reduction by 500 billion on its way to ten trillion, as that creates problems in the bond market, which they, then, have to step in and fix.

Kevin: Something you have talked about many times, Dave, and this is so important to keep in mind – when risk is not accurately priced, when you have a buyer of last resort always coming in and infusing that IV, as you talked about being on life support – life support has a consequence also to the market. If the central banks are the buyer of last resort of all the debt, it re-prices the risk, the interest rate that is being paid. In a way, we are seeing very, very high-risk investments, things that are probably going to default, priced as if they have no risk whatsoever.

David: Yes, so what do you get in a price anymore? When I see Turkish bonds yielding 12%, that should tell you that there is greater risk there. And yet, you look at a 12% rate of return there, factor out local inflation in the lira and compare that to the U.S. dollar, and local inflation in dollar terms. And this is somewhat ironic. The investor in U.S. ten-year treasuries is compensated, in real terms, almost identically with the investor in Turkish bonds. Again, take out the inflation penalty, and your Turkish and U.S. bond investors are getting in the neighborhood of 30 basis points apiece. What’s the difference? The whole world has been homogenized. And whether you think the prices are relevant or not, the whole world is being homogenized. That was the point with the conversation with Carmen Reinhart 6-12 months ago, and I would say that in both cases, the Turkish and U.S. investor, these are investors that are not adequately compensated for the risks that they are taking, whether it is inflation risks – I think we have a high likelihood of inflation rate surprise in the United States. They already have inflation in Turkey. So in real terms, they are on a par with each other. It is an interesting deal. Are they being adequately compensated for the risks that they are taking? I just feel like that is an easy no.

Kevin: In a way, we feel used and abused because we see not only buyers of last resort, the central banks, printing money, coming in and just, like you said, socializing all the prices. The risk has been completely masked by the amount of interest that it is paying. And sometimes it is easy to just get angry with the manipulations and this control force that is in the world. But actually, we can only control ourselves. We can only control what we do.

Dave, so that we don’t leave the podcast feeling helpless and hopeless, what are things that the individual can do right now so that they are not participating in something that maybe they clearly see and don’t want to participate in?

David: If you wanted to sum it up in simple terms, my advice is step aside and hedge your bets. You have Saunders, who is one of the key players at Charles Schwab. She says, “I think it is finally starting to suck people in emotionally.” She is talking about the stock market. And actually, it is hard to judge why, now, all of a sudden, but maybe it is because of how persistent the move has been with so little volatility on the upside, and on the downside, this year has been different. This kind of year pulls people in.

And that just says to me, hedge your bets, step aside. When everyone and their brother is being sucked into the market, everyone and their brother is ignoring risk in the bond market, and in the stock market. This is one of those clear signs – just count the burgeoning mass of people and what they are doing, and try to take the other side of the trade. Try to move the other direction. Try to think a little bit differently, because when everyone is moving one direction – this goes back to something my dad said in our last presentation to clients – “The majority is always wrong.”

And you have a majority of investors today who are signing up for bonds as if there is no risk, signing up for stocks as if it is a one-way bet, signing up for bitcoin as if 20% volatility is no big deal because you know you’re going to have 40% upside tomorrow. Maybe. But maybe not. Maybe not. So my advice – step aside, hedge your bets. That’s it.