What Is Happening In TradFi…
And What Are They Potentially Missing
Introduction
In the wee hours of the morning on Friday, September 23rd, 2022, markets saw yields on the US 10 Year Bond (ticker US10Y) spike up over 3.751% (highs not seen since 2010) shocking the market into fears of breaching 4% and the potential for a run in yields as economic and geopolitical uncertainty continues to gain momentum. Yields would slowly grind throughout the weekend and at approximately 21:00 Chicago time on Tuesday, September 27th that feared 4% mark on the US10Y was crossed. What followed approximately 8 hours later, around 05:00 on Wednesday the 28th was a precipitous cascade in yields falling from 4.011% to 3.698% by 14:00 that day.
Now, that may not seem like much cause for concern to those unfamiliar with these financial instruments but it is important to understand that when the US bond market is estimated to be ~$46trillion deep, (spread across all of the various forms that “bonds” can take) as reported by SIFMA, and take into consideration the Law of Large Numbers; to move a market that is as deep as the US10Y that rapidly, requires quite a lot of financial ‘force’ — for lack of a better term.
It’s also important to note here for readers that yields climbing on the US10Y denotes exiting of positions; selling of 10Y bonds, while yields falling signals purchasing of 10Y bonds. This is where it is also important to have another discussion, because at this point I can hear the gears turning; “but if yields falling represents buying, that’s good!” Sure, it could be determined as a good thing, normally. However, what is happening now is not organic market activity; i.e. yields falling currently is not a representation of market participants purchasing US10Y’s because they believe it to be a good investment or in order to hedge positions; they are buying because circumstance is forcing them to buy. This is a strategy that has come to be known as yield curve control.
“Under yield curve control (YCC), the Fed would target some longer-term rate and pledge to buy enough long-term bonds to keep the rate from rising above its target. This would be one way for the Fed to stimulate the economy if bringing short-term rates to zero isn’t enough.” — Sage Belz and David Wessel, Brookings
This is effectively market manipulation; preventing markets from selling-off as they would organically. The justification for this is that bonds selling-off tends to impact entities like larger corporations, insurance funds, pensions, hedge funds, etc. as treasury securities are used in diversification strategies for wealth preservation (which I briefly describe here). And, following the market manipulations of the GFC by propping-up markets with bailouts, the current state of financial markets is of significant fragility. The wider financial market (encompassing equities, bonds, real estate, etc.) can no longer weather a sell-off in any of these silo’s as all are so tightly intertwined with the others; a cascading sell-off would likely follow, otherwise known as “contagion.”
The Brief
Host: Demetri Kofinas
Speakers: Evan Lorenz, Jim Bianco, Michael Green, Michael Howell, Michael Kao
What follows is a brief recount (with elaboration & input from myself throughout) of a Twitter Spaces discussion led by Demetri Kofinas, host of the “Hidden Forces Podcast,” which has been one of my favorite sources of information and elaboration on geopolitical machinations of late. This article is meant solely for education and entertainment, none of what is stated here should be taken as financial advice or recommendation.
What we have been seeing over recent months is central banks across the world are being forced into resorting to YCC in an attempt to defend their own fiat currencies from obliteration by the US Dollar ($USD) as a dynamic of the Federal Reserve Bank of the United States of America’s aggressive raising of interest rates.
An additional problem to the US’s raising of interest rates is that as the Federal Reserve (“the Fed”) hikes interest rates, that also causes the interest rates that we owe on our own debt to rise; increasing the interest bill that we owe to ourselves as well as those who own our debt. Resulting in a “doom loop” of requiring further debt sales to pay down interest bills as a function of raising the cost of said interest bills. And this is why YCC get implemented, as an attempt to place a ceiling on yields while raising the cost of debt for everyone else. All of the currencies shown in the above image have now effectively implemented YCC for these reasons.
Meanwhile this is all occurring, the Fed is also attempting to implement Quantitative Tightening (QT) by letting Mortgage Backed Securities (MBS) reach maturity and effectively get cleared off their balance sheets — whether QT is “ackchually” happening is up for debate. What really matters however is that this all leads to the $USD producing a financial & economic power-vacuum, resulting in the world-over losing purchasing power in their native currencies to that of the $USD. Now, this is important to understand because each country having their own currency provides the potential for maintaining a virtual check on $USD hegemony. This is because if a foreign power is capable of providing significant value to the global market (like providing oil/gas/coal for example), their currency can gain power against the $USD and allow them to not be completely beholden to US policy & decisions. By obliterating foreign fiat currencies, the US gains significant power in steering global trade and decision making, by essentially crippling the trade capabilities of foreign bodies; allied or not.
This relationship of vacuuming purchasing power into the $USD is also resulting in a global shortage of $USD; this is what many of you have likely heard at least once now as “tightening of liquidity.” Providing another point of fragility within economic conditions, on top of the fragility discussed in the introduction. Increasing the likelihood of “something breaking.”
The Bank of England
This brings us to events around the United Kingdom (UK) and the Bank of England (BoE). What transpired across the Atlantic was effectively something breaking. According to the speakers (because I have zero experience in these matters) the UK pension industry employs what Howell referred to as “duration overlays” which can reportedly involve leverage of up to 20x.
Meaning that volatility is a dangerous game for such a strategy. Volatility like the bond markets have been experiencing this year, and particularly these past recent months. When volatility strikes, and markets go against the trades involved in these types of hedging strategies, when margin is involved, then calls will go out to those whose trades are losing money to put down cash or collateral in order to meet margin requirements if the trade is still desired to be held; otherwise known as margin calls. When margin calls go out, and if collateral or cash is not posted, then we get what is known as a forced liquidation; where the trade has gone so far against the holder of the position that the exchange/brokerage forces an exit of the position in order to protect the exchange (and the position holder) from going into a negative account balance — which can have the potential of going very, very deeply negative.
Which readers may remember a story like this from the Gamestop-Robinhood event during 2020 where a user committed suicide over such a dynamic playing out.
What is rumored to have occurred is that a private entity was involved in one (or more) of these strategies, the market went against them placing them in a losing position, and margin calls were very likely to be sent out. With the potential of resulting in a dangerous cascade of liquidations, the BoE decided to step in Wednesday and deploy YCC in order to avoid said liquidation cascade.
To further elaborate on the depth of this issue, we look to strategies deployed in the US with pension management. Within the US we have situations where pensions are [criminally] underfunded (which I briefly mentioned here). In order to remedy the delta, pensions are either required to put up cash or collateral to cover the difference, or deploy leverage overlay strategies in order to meet the returns as promised to pension constituents. Seeing how just holding cash on a corporate balance sheet is not a popular strategy (due to inflation resulting in consistent loss of purchasing power) many prefer to deploy the leverage overlay strategy; requiring allocating capital to margin trading on financial assets in the aim of producing returns to cover the delta provided by the underfunded position of the pension. Meaning that the pensions are being forced by circumstance to venture further and further out onto the risk curve in order to meet their obligations.
As Jim Bianco accurately described; the move by the BoE was not a solution to the problem. This was a band-aid, a temporary alleviation strategy. The risk to financial markets is still the threat of a stronger dollar on the back of increasing interest rates coming from the Fed.
Howell brought up an interesting point of discussion around governments, and by extension central banks, typically do not predict (and prepare) for recessions they normally react to recessions. Giving credit to Bianco’s consideration that there is potential for the BoE having acted too early in this environment.
One very big dynamic, as positioned by Kao, is that while so many countries are resorting to intervention across the globe everybody seems to be expecting this to apply pressure on the Fed providing that fabled pivot, there’s the likelihood that this environment actually incentivizes individualist strategies for participants to act in their own interests. Alluding to; the Fed throwing the rest of the world’s purchasing power under the bus in order to preserve $USD hegemony.
Oil
Going further, Kao also brought up his position that price inflation in oil is a major elephant in the room; price per barrel has been falling as expectations for demand continue to slide along with continual sales of the US’s Strategic Petroleum Reserve. Washing markets with oil; when supply outpaces demand (or in this case the forecast of demand) then basic economics dictate that prices will diminish. It is important to understand here that when the price of a barrel of oil falls, incentives to produce more diminish, leading to slow downs in investment in oil production infrastructure. And what Kao goes on to suggest is that if the Fed were to pivot, this would result in demand returning to markets, and the inevitability for oil to resume its ascent in price will place us right back to where this problem began.
I agree with Kao’s positions here.
Kao continued to elaborate on how these interventions by central banks are ultimately futile because as the Fed continues to hike interest rates, foreign central banks simply only succeed in burning through reserves while also debasing their local currencies. Kao also briefly touched on a concern with significant levels of corporate debt around the world.
China
Evan Lorenz chimed in with the addition that the US & Denmark are really the only jurisdictions that have access to 30 Year Fixed Rate Mortgages, with the rest of the world tending to employ floating rate mortgages or instruments that institute fixed rates for a brief period, later resetting to a market rate. Lorenz went on “…with rising rates we’re actually going to be crimping spending a lot around the world.” Lorenz followed-up to state that, “The housing market is also a big problem in China right now… but that’s kind of the tip of the iceberg for the problems…” Evan went on referring to a report from Anne Stevenson-Yang of J Capital where she details that the 65 largest real estate developers in China owe ~6.3 trillion in Chinese Yuan ($CNY) in debt (~$885.5 billion). However it gets worse when looking at the local governments; they owe 34.8 trillion $CNY (~$4.779 trillion) with a hard right-hook coming, amounting to an additional 40+ trillion $CNY (~$5.622 trillion) in debt wrapped up in “local financing vehicles.” This is supposedly leading to local governments getting squeezed by China’s collapse in their RE markets, while seeing reductions in production rates thanks to Xi’s “Zero Covid” policy. Ultimately suggesting that the Chinese have abandoned trying to support the $CNY against $USD, contributing to the power vacuum in $USD.
Bank Reserves
Contributing to this very complex relationship, Lorenz re-entered the conversation by bringing up the issue of bank reserves. Following the events of the 2008 Global Financial Crisis US banks have been required to maintain higher reserves in the aim of protecting bank solvency, but also preventing those funds from being circulated within the real economy, including investments. One argument could be made that this could be helping to keep inflation muted. According to Bianco, bank deposits have seen reallocations to money market funds to capture a yield with the Reverse Repurchase Agreement (RRP) facility that is 0.55% higher than the yield on Treasury Bills. This ultimately results in a drain on bank reserves, and suggested to Lorenz that a furthering of the dollar liquidity crisis is likely.
Meaning that the $USD continues to suck up purchasing power — remember that shortages in supply result in increases in price.
Conclusion
All of this basically adds up to the $USD gaining rapid and potent strength against nearly all other national currencies (except the Russian Ruble), and resulting in complete destruction of foreign markets. While also disincentivizing investment in nearly any other financial vehicle or asset.
*** This is where the strictly informative portion stops, readers that are not interested in hearing my input should stop here.***
Now For What I Did Not Hear
I very much suspect that I am wrong here, and that I am misremembering (or misinterpreting) what I have witnessed over the past 2 years.
I was personally surprised to hear zero discussion around the game theory that has been occurring between the Fed and the European Central Bank (ECB), in league with the World Economic Forum (WEF), around language during interviews attempting to suggest that the Fed needs to print more money in order to support the economies of the world. By support meaning maintaining the balance of power between the opposing fiat currencies by printing $USD in order to offset the other currencies being debased. Now, we know what has played out since, but the game theory still remains; the ECB’s decisions have resulted in significant weakening of the European Union, leading to the weakness in the Euro, as well as weakening relations between the European nations. The ECB and WEF have signaled aggressive support and desire for developments of Central Bank Digital Currencies (CBDCs) as well as for more authoritarian policy measures of control for their constituents (vaccine passports and attempts at seizing lands held by their farmers, for starters). Over these past 2 years Jerome Powell of the Federal Reserve had been providing aggressive resistance to the US’s development of a CBDC, while the White House and Janet Yellen have ramped up pressures on the Fed to work on producing one. With Powell’s aversion to development of a CBDC seeming to wane in recent months against pressures from the Biden Administration (I’m including Janet Yellen in this as she has been a clear extension of the White House).
It makes sense to me that the Fed would be hesitant to develop a CBDC, aside from being hesitant to employ any technology that is not understood. Reasoning being that the US’s major commercial banks share in ownership of the Federal Reserve Bank; a CBDC would completely destroy the function that commercial banks serve in providing a buffer between fiscal & monetary policy and economic activity of average citizens and businesses. Which is precisely why, in my humble opinion, Janet Yellen wants production of a CBDC; in order to gain control over economic activity from top to bottom, as well as gain the ability to violate every citizens’ rights to privacy from the prying eyes of the government. Obviously government entities can acquire this information today anyway, however the bureaucracy we have currently can still serve as points of friction to acquiring said information, providing a veil of protection for the American Citizen (although a potentially weak veil).
What this ultimately amounts to is; (1) a furthering of the Currency War that has been ensuing since the start of the pandemic, largely going underappreciated as the world has been distracted with the hot war occurring within Ukraine, and (2) an attempt at further destruction of individual rights and freedoms both within, and outside, the United States. China is the furthest along in the world with regards to development of a sovereign power’s CBDC, and their implementation is much easier for them; they’ve had their Social Credit Score system active for multiple years now. Making integration of such an authoritarian wet dream much easier, as the invasion of privacy and manipulation of the populace via the SCS is providing a foot-in-the-door.
The reason I’m surprised I did not hear this make it into discussion is that this adds a very, very important dynamic to the game theory of the decision making behind the Fed and Jerome Powell. If Jerome Powell understands the importance of maintaining the separation of Central & Commercial Banks (which I believe he does), and if understands the importance of maintaining $USD hegemony with regards to the US’s power over foreign influence (which I believe he does), and he understands the desires for bad actors to have such perverse control over a population’s choices and economic activity via a CBDC (which I believe he might), he would therefore understand how important it is for the Fed to not only resist the implementation of a CBDC but he would also understand that in order to protect Freedom (both domestically and abroad), that this ideology of proliferation of Freedom would require both an aversion to CBDC implementation and a subsequent destruction of competition against the $USD.
It’s also important to understand that the US is not necessarily concerned with the $USD gaining too much power because we largely import the majority of our goods — we export $USD. In my opinion, what follows is that the US utilizes the crescendo of this power vacuum in an attempt to gobble-up and consolidate the globe’s resources and build-out the necessary infrastructure to expand our capabilities. Returning the US to a producer of high quality goods.
This Is Where I May Lose You
This therefore opens up a real opportunity for the USA to further its power…with the official adoption of bitcoin. Very few discuss this, and even fewer may recall, but the FDIC went around probing for information and comment in its exploration of how banks could hold “crypto” assets on their balance sheets. When these entities say “crypto,” they more often than not mean bitcoin — the problem is that the general populace’s ignorances to bitcoin’s operations cause them to see bitcoin as “risky” when aligning with the asset, as far as PR is concerned. What’s even more interesting is that we have not heard a peep out of them since… leading me to believe that my thesis may be more likely to be correct than not.
If my reading of Powell’s situation were correct, and this all were to play out, the USA would be placed in a very powerful position. The US is also incentivized to follow this strategy as our gold reserves have been dramatically depleted since WW2, with China and Russia both holding massive coffers of the precious metal (and Russia obviously flexing significant power with its control over the Asian-European hydrocarbon industry). Not to mention, there’s the fact that bitcoin is still very early in its adoption with regards to utilization across the globe and institutional interest only just beginning.
If the US wants to avoid going down in history books as just another Roman Empire, it would behoove them to take these things very, very seriously.
But… and this is the most important to consider, is that I assure you that I have likely misread the environment
Sources:
Bonds
https://www.thebalancemoney.com/10-year-treasury-note-3305795
https://en.wikipedia.org/wiki/Bond_market#cite_note-1
https://www.zerohedge.com/markets/how-much-liquidity-us-treasury-market
https://www.brookings.edu/blog/up-front/2020/06/05/what-is-yield-curve-control/
Duration Overlays
Pension Funding Image
https://taxfoundation.org/state-public-pension-plan-funding-coronavirus/
