THE GOLD CHRONICLES
with James Rickards and Alex Stanczyk
Forecast for June 13th, 14th FOMC Meetings
Cryptocurrencies – bubble or bull market?
Update on IMF SDR’s
Fed’s plan to normalize the balance sheet
Expecting confluence of rate hikes and tightening monetary conditions to create recession and force easing by end of 2017
Why North Korea has to be taken seriously
Forecast for war with North Korea by 2018
Trump, Russia, and media bias
Physical gold market flows Q1 2017
Dangers of the mirage of portfolio diversification and conditional correlation (Scholes)
Why todays portfolios are at risk in the same way as LTCM
Gold price behavior during liquidity crisis
Liquidity in the gold market
Alex: Hello. This is Alex Stanczyk and I have with me today Mr. Jim Rickards. Hello, Jim, and welcome.
Jim: Hi, Alex. How are you?
Alex: Excellent. Thank you.
We are recording this podcast heading into the Memorial Day weekend. For those of you not from the United States, Memorial Day is a U.S. holiday honoring those who have fallen during military service going all the way back to the American Civil War, so we want to take a moment to acknowledge soldiers who have fallen on the battlefield.
Now let’s dive right into our podcast with an area our listeners are always interested in. We have another series of FOMC meetings coming up on June 13. In the event that I don’t talk to you on a podcast before then, would you make some comments about that and what you think you see happening there in terms of rate raises, etc.?
Jim: The Federal Open Market Committee (FOMC) is the subset of the Federal Reserve Board members and Regional Reserve Bank presidents who set interest rate policy.
They always hold two-day meetings with the next one being June 13 and 14. The second day of the meeting, the 14th, is when the fireworks happen, so they’ll be in a conclave locked in the boardroom at the Fed Building on Constitution Avenue. When they come out, they’ll issue a kind of press release or statement that covers whether they raised rates or not. I’ll tell you right now that they’re going to raise rates 25 basis points, so we can already see that coming.
This is a significant meeting because it’s one where Janet Yellen has a press conference. The FOMC meets eight times a year, but only four of those have a press conference associated with it where she’ll sit sometimes for two hours and take reporters’ questions. That gives her an opportunity to expand on the statement with the new ‘transparency.’ They say we like to do communications, and obviously they overcommunicate, but be that as it may, this is her chance to signal whatever she wants about the economy and what the Fed is doing.
A lot of these questions are planted. I’m not denigrating the press; I think they do a great job, but reporters like Steve Liesman, CNBC, and others – I shouldn’t pick on Liesman – have certain questions they know the Chairman wants to hear because it gives her a platform to explain what they’re doing. This is one of those press conference meetings where they tend to do big things such as announce new policies or reaffirm existing policies.
We know they’re going to raise interest rates. I guess a different way to put the question is what would it take for them not to raise interest rates? Bear in mind it’s less than three weeks away at this point, so it’s really hard to imagine. When the May Jobs Report comes out next Friday, June 2nd, it would have to be below 75,000 or even negative or something to throw the Fed off their game. No one expects that. I don’t know what the number is going to be, but whether it’s 200,000 or 100,000 (that’s a big range and a lot of jobs), any of those numbers north of 75,000 puts the Fed on track to raise.
There’s not much inflation data coming out. Even if we saw a bad print in the inflation data, meaning it was disinflation, these inflation numbers are coming in below expectations. I do expect that and think disinflation leaning towards deflation has the upper hand now causing those numbers to get weaker, but that’s not going to be enough to throw the Fed off because they’ll use the word ‘transitory.’ Even if we get a weak number, they can say, “It’s only one month. We think it’s going up for all these other reasons like unemployment is slow, Phillips curve, etc., so we’re not going to pay much attention to it.” Even that won’t throw them off.
The only other thing in the model that would cause the Fed to ‘pause’ – that’s the operative word – on their rate-hiking path would be a severe drawdown in the stock market that looks disorderly and scary. Even if the stock market went down 5%, let’s say 1,000 Dow points or 100 S&P points, the Fed absolutely would not care. Even if it went down 10% or 15% over three or four months, the Fed wouldn’t care about that.
If it went down 7% or 8% like in three days’ trading sessions where it looks scary kind of the way it did in August 2015, that might be enough to get them to pause, but even then, I would say it would have to be a pretty rough ride. Ruling that out, I think they’ll dismiss weak inflation numbers as transitory, and job creation doesn’t have to be great, it just has to be good enough, and that’s really the important thing. They’re going to raise rates in June.
The model I just described is what I’ve been using for several years with very good results. Last December, we forecast that they would raise rates in March. By March, everybody knew they were going to raise rates in March, but if you look at the Fed Fund Futures implied expectation of a rate hike through the months of January and February up until the last couple of days of February, the considered wisdom of the market crowds, all the participants, were giving it a 28% to 30% probability. We were at 80% and 90% and indeed, they did raise it.
The model we’re using is the one I just described, which is the Fed will raise rates four times a year, 25 basis points per time from now until the middle of 2019, to get rates to about 3.25%. It will be like clockwork unless one of three things happen: a disruptive stock market, a severe disinflation that looks persistent and not transitory, or job growth well below 75,000 or even negative. If you don’t see those three things, they’re going to raise, so it’s an easy forecasting model.
Alex: The model and forecasts on what the Fed is going to be doing have been really great. We’ve had some feedback and commentary from professional money managers on that as one of the things they always like to pick up on in particular from this podcast.
Jim: One thing that’s unique about the model is that it’s completely different from what you hear from Wall Street economists, mainstream economists, commentators, bloggers, you name it. It’s a very different model. It’s not a complicated model; it’s very simple as I just described.
The reason it’s different is that people are looking at the Fed raising rates and the minutes of the May meeting released a couple of days ago making it clear that they’re going to raise rates. The market is assuming that raising rates is related to a stronger economy – they equate that to a stronger economy. It’s one of the reasons stocks are going up, because they rely on regressions and correlations. They think that in the 38 business cycles since the end of World War II, every single time the Fed raised rates was because the economy was getting stronger.
That data is true and that correlation exists, but it’s not true this time. For the first time since 1937, the Fed is raising rates into weakness, and they know it. Why are they raising rates? The answer is they must get rates to 3% or more before the next recession comes so they can cut them 3%, because that’s how much it takes to get out of a recession. If you don’t have interest rates at 3% – 3.25% before the next recession starts, you’re not getting out of the recession, because they can’t cut them enough. They would have to have to go back to QE4, and they know it.
This is all a long-winded way of saying they should have raised rates in 2010 – 2011. They didn’t because of Bernanke’s cockamamie QE experiments, which is evidence that they didn’t help at all. What it did do is prevent the Fed from normalizing interest rates. That brings us to where they’re going with this. Just because they’re raising rates, I don’t take that to mean the economy is strong. In fact, there’s a lot of evidence that the economy is weak, but they’re doing it anyway for different reasons.
Alex: Let’s move on to cryptocurrencies. This is a controversial topic in some circles right now, because some people I consider to be very smart believe that cryptocurrencies are in a huge bubble right now. What do you think about this?
Jim: They’re definitely in a bubble, there’s no doubt about that. If you do have any doubt about it, I recommend something you can do at home. Just get the latest bitcoin chart. Ethereum is another one that’s performing the same way, but bitcoin is the leader in this. The bitcoin chart is going vertical right now from $1,000 per bitcoin to $2,000 per bitcoin in about a week or less.
Now get a NASDAQ chart from 1998 – 2000 and a Nikkei 225 chart (a Japanese stock index chart) from 1988 – 1990. Take the Nikkei chart, the NASDAQ chart, and the Bitcoin chart and overlay them. It’s the same chart. They look exactly the same with one difference, which is that the other two – Nikkei and NASDAQ – both crashed and lost 80% of their value in a very short period of time, most of it in months and then all of it within a year. Bitcoin hasn’t crashed yet, but this pattern of increases and the rate of increase, the second derivative of the rate of increase skyrocketing, is completely characteristic of bubbles.
Having said that, there are two things I know about bubbles. Number one, they can go on a lot longer than you think. It’s easy to say, “It’s a bubble; it’s going to crash.” What’s not so easy is knowing when it is going to crash. I have no interest in owning them or being part of this madness, but I wouldn’t short it. I don’t know if you can short bitcoin. Maybe Goldman Sachs would write you a derivative, the new big short, but I don’t think you can short it, which is interesting.
It just occurred to me that one of the reasons it’s going up so much is because there’s no short interest. If the stock market behaved this way, there’d be somebody, Jim Chanos or Kyle Bass or somebody, who would be shorting the heck out of it. There’s no short interest in bitcoin as far as I know unless someone’s extending credit, which makes this even crazier. That’s one of the reasons it’s kind of feeding itself.
I just arrived back east this morning from San Francisco. As always in San Francisco, you end up meeting with engineers and the Silicon Valley crowd. I talked to one very seasoned guy who has a young team of engineers working for him doing some apps and things. He said, “One of my guys came in the other day and said, ‘I went out and I bought some bitcoin. I paid $1,000.’ He bought four or five, and maybe put $4,000 or $5,000 into this. ‘It’s already up to $2,000, I doubled my money.’” He couldn’t be happier although he probably never heard of bitcoin until a few weeks ago, but that’s the kind of mentality you get.
Here’s the point. You can say it’s a bubble, that’s easy, but you don’t know when it’s going to end. It can go on a lot longer than you think. The other side of that is when it cracks, it cracks hard and fast, and you’re kidding yourself if you think you can get out. If you bought it for $1,000 and sold it for $2,000, lucky you, nice job and well done. But that’s no way to invest, it’s no way to make a living.
The reason is you have to think of these things on a risk-adjusted basis. You can’t just look at returns. Let’s say you had a whole bunch of money, hired me as major money manager, and I said, “Okay, leave me to it.” I go to Las Vegas, go to the roulette table, and I put all your money on red. It comes up red, I double the money, and I come back to you and say, “I doubled your money, I’m taking my 20% management fee or performance fee, and here’s the rest.” You think I’m a genius, “Jim’s the smartest guy in the world. He’s got a 100% return, and net of fees, I got an 80% return.”
No, I’m not. I’m an idiot. The point is, I could have lost all your money. If you don’t know how I do it or if you just look at the return (in my example, I doubled your money) but you don’t know how much risk I took, you think I’m a great money manager because I doubled your money. But on a risk-adjusted basis, I’m a complete idiot because I could have lost all your money.
When you get into bitcoin, yes, it could go up. Could it go up to $4,000? Just to be clear, I’m not predicting that at all, but I’m not going to say that can’t happen. It could happen. When is it going to crack? $2,500? $3,000? $3,500? $4,000? I don’t know, but I do know it will crack. It will crack hard, and I wouldn’t want to be around when it happens.
Alex: Let’s dig into another topic area. I understand you recently had some new insights into IMF special drawing rates. Another way of saying that is SDRs. You plan to include these insights in your next book that’s upcoming. By the way, this is the first hint. I knew you were probably working on another book but recently had a first hint that this was going to be coming, so I’m looking forward to that. Without giving away the secret sauce of what this is all about, can you share anything about this?
Jim: Yes, it will be in a new book. I’m not talking much about it because the publication date right now is October 2018, so we’re more than a year away, which is good, because it’ll take me that long to write it. As you know, Alex, you don’t just write a manuscript, hand it in, they print it up, and they send it to the bookstores. With my publisher, and this is one of the things I like about them because they’re very high quality, it takes four or five months, sometimes longer, for not just proofreading and normal editing where there’s a back and forth with your editor, but also for what they call copyediting. Copyediting is the person who decides what’s capitalized and whether it’s a comma or semicolon and all that stuff. I just keep writing and hope someone else can figure it all out. Then comes legal and then binding. There’s a lot to it.
This book is going to come out in October 2018, so there’s not much to talk about right now, but I did have a one-on-one conversation at an apartment in New York with former Treasury Secretary Tim Geithner. I had some quotes from him in my second book, The Death of Money, indicating some very favorable impressions of SDRs. Geithner is one of the people who knows more about SDRs than anybody.
We went to the same graduate school, the School of Advanced International Studies in Washington (SAIS), which is intellectual boot camp for the IMF. About one-third of each class goes to work for the IMF, for the World Bank, so there’s a very close affiliation there. We received similar training although my class studied gold because I was the class of ‘74. Gold had been abandoned by the time Geithner came along, but we had the same background and training. Unless you have that specialized training, it’s hard to really get your mind around SDRs.
He said some very favorable things, and I quoted him on that. In the last crisis that started in the spring/summer of 2007, it peaked and backed off and peaked and backed off, and then finally it went completely thermonuclear on September 15, 2008, with Lehman Brothers. There was an emergency issuance of SDRs for the first time in 30 years. The last time they had issued SDRs was in the early 1980s and then none at all until August of 2009.
It went pretty much unnoticed, because you have to be a bit of a geek to see that happening. I was certainly attentive to it, but in analyzing a future financial crisis, which again, is kind of like the bitcoin bubble, you can see it coming and estimate the magnitude, but timing and specific catalysts are more difficult.
What are the central banks going to do? When we talked about the FOMC raising interest rates in June, one of the things we didn’t talk about that was in the minutes of the May meeting is normalizing the balance sheet. The Fed did not just take interest rates to zero and hold them there for seven years. They expanded their balance sheet from $800 billion to $4.5 trillion basically by printing money and buying bonds.
They still have the $4.5 trillion on their balance sheet. Not only did they not normalize interest rates, they’re about a third of the way to normalizing interest rates. Using the Taylor rule, interest rates should probably be 2.5% – 3%. They’re at approximately 1%, so they have a little way to go. At least they’ve started, but they haven’t taken any steps to normalize the balance sheet, so they’re now talking about that also.
The way they’re going to do it is not by dumping bonds. The Treasury bond market is big but it’s not that big. They’re not going to sell a single bond. What they are going to do is let them run off, let them mature. Let’s say you bought a five-year note five years ago. Sometime in the next month or so it’s going to mature. The Treasury sends you the money and, just as when the Fed buys bonds, they pay for it with money that comes from thin air. The same is true in reverse. When the Treasury sends the Fed money to pay off the bonds, the money disappears. It reduces the money supply.
The Fed is just going to sit there. This happens now anyway, these bonds mature all the time, but the Fed then takes the money and buys a new bond. They’re not expanding the money supply; they’re maintaining the money supply and buying new bonds all the time to maintain the balance sheet. What they’re going to do is stop that reinvestment. They’ll take the money, the money will disappear, they won’t buy a new bond, and little by little, the balance sheet will run off. They’re going to do this very gradually. They have all this jargon and use words like ‘background.’
They say this is going to run on background, and steady Eddie, and we’ll be transparent about what we’re doing, and no one is going to notice. It’s just going to happen, and over my estimate of seven or eight years, the balance sheet would get back down to $2 trillion. Arguably, that’s a normalized balance sheet.
Again, that assumes no recession, which is a false assumption. We are going to have a recession in the next several years, but the Fed doesn’t really deal in reality. In Fed world, there’s no recession, there are no recessions, and they’re going to run the balance sheet off over seven or eight years.
This is called QT. Everyone knows about QE, quantitative easing, and this is QT, quantitative tightening. That’s what happens when bonds mature, the money supply is reduced, you don’t buy new ones, and the balance sheet shrinks. It’s like watching paint dry or holding an ice cube in your hand and watching it melt. It happens very slowly, but it does happen.
The interesting thing about this is the whole time the Fed was doing QE to the tune of taking the balance sheet to $4.5 trillion, they told us that this was stimulative. By buying intermediate-term securities, they were keeping a lid on the middle of the yield curve, it helped mortgage rates and that helped stock prices and home prices and all that wealth effect, and they let people borrow because that’s all collateral and they’d spend more money. This was the story, but none of it was true. The wealth effect was weak or invisible or maybe even negative this time around.
They did create asset bubbles, so they were good at that, but not much good at stimulating the economy or at least returning to trend growth on a sustainable basis. That did not happen.
We were supposed to believe that it was somehow stimulative and when they do it in reverse, it’s not supposed to be contractionary. I don’t understand that at all. If you reduce the money supply, that’s a tightening of financial conditions, that’s contractionary. I’m not saying by itself it’s going to put the U.S. economy into a depression. We’ve been in a depression since 2007, so they’re kind of hitting the economy with a double whammy. They’re raising rates, which we already talked about, and I’m guessing probably before the end of the year, they haven’t said but maybe as early as September, they’re going to start reducing the balance sheet. My estimate is for every $50 billion of balance sheet reduction, that’s equivalent to one 25-basis-point rate hike. Like I say, you can’t have it both ways. You can’t say printing money is expansionary but making money disappear is not contractionary. Sure it is.
We’re going to get hit with rate hikes and tightening monetary conditions, reduction of the money supply. The economy is weak to begin with, so my estimation is that this will cause a recession later this year, probably by the summer. It will become apparent, but the Fed will be the last to know. A lot of people will see it before the Fed, but maybe by August/September when that happens, the Fed is going to have to pivot and do a 180.
I said earlier that they’re going to raise rates four times a year – March, June, September, December – like clockwork for the next three years unless something bad happens. The bad things are what I mentioned – the stock market falls out of bed, job creation dries up or you see disinflation. I think you might see all three.
We might see strong disinflation. The PCE core deflator is the Fed’s preferred inflation metric, which after about six years has finally gotten to 2%. They were hoping the whole time to get it to 2%, it finally got there, and it immediately headed south down to around 1.7%, give or take. If you see that going to 1.5%, 1.4%, 1.3%, and job creation falls below 75,000, maybe we even start to lose a few jobs or get a negative GDP print, and then the stock market wakes up and says, “Whoa, we’re way out over our skis here. We invested in this Trump trade, and we thought the Fed raising rates was a sign of a good economy. It turns out the economy stinks, we’re in recession, and Trump’s not delivering on any of his promises,” boom – there goes the stock market.
We could see all this. Everything I’m describing is based on I’ll say a conditional forecast. My expectation is that some of these conditions will fail and that by September, they’ll have to go back to easing mode. How do they do that? They’ll probably still be reducing the balance sheet, so I estimate they’ll stop raising rates in September, and they’ll use forward guidance to take a pause, so you’ll be hearing about ‘pause.’ They’ll raise in June for sure, pause in September, and then we’ll see about December and how it plays out.
This is what happens when you manipulate the economy for eight years. You can’t get out of it. You can’t un-manipulate the economy, because the economy is completely dependent on Fed policy and signaling and expectations and herd behavior and everyone following the Fed. They just can’t get out of it.
Alex: It sounds to me like 2018 and 2019 are shaping up to be pretty interesting. As you mentioned, the Fed has announced it’s not going to be reinvesting government debt. It’s basically going to let that roll off the balance sheet. From 2018 to 2019, I think that number is going to be close to $1 trillion. In addition to that, I’m going to share some information in a little bit when we start talking about the physical gold market that will dovetail into that. It’s going to create some interesting conditions for our space in particular.
Jim: I completely agree with that and am interested in hearing more on your analysis, Alex, but 2018 is when we will go to war with North Korea. That’s not on the calendar for 2017 unless Kim Jong-un is even crazier than we think. The story is well-known, so I don’t know why people are not more attentive to it. He’s out to build an intercontinental ballistic missile (ICBM) capable of reaching Seattle, Los Angeles, San Francisco, not to mention all of China, Japan, South Korea, and Taiwan. They’re not there yet, but they’ve tested more complex intermediate-range ballistic missiles that have some of the multi-stage technology and liquid fuel that you need to have in an ICBM, so they’re getting there and are making steady progress.
Sometimes these missiles go off course, they wobble or they blow up on the launch pad and people laugh them up like ah, they’re idiots, they don’t know how to launch a missile. But they don’t think of it as failure; they think of it as a learning experience. Every so-called failure is a way to learn something to make the next one better. Recently, the tests have been succeeding and have produced better results, so they’re making progress in miniaturization.
They have the fissile material, the uranium, and the plutonium. They’ve mastered the enrichment cycle but need to weaponize that, because you can’t just put a truck-sized device on a missile. You have to get it down to the size of a grapefruit or a basketball, but it looks like they’re just about there on that and a couple of other pieces of technology. All this is coming together faster than analysts estimated. The four-year estimates I was reading about six months ago have now turned into three-year and in some cases two-year estimates. That’s what he’s doing.
It is crystal clear that the United States will not let this happen. We are not going to sit here and let him perfect this technology, put a warhead on a missile, test it in some credible way, and say, “I can now nuke Los Angeles. You guys better hope you can shoot it down. I’ll send up 10 and your success rate in shooting down or intercepting ballistic missiles is probably 50% if you’re lucky (which is pretty darn good, by the way), but that means five of them go through and I just killed 10 million Americans. Don’t mess with me.” That will be his message. We’re not going to let that happen. We’re not going to put ourselves in that position. We’re not going to gamble with Los Angeles.
One or two things must happen: Either he must voluntarily give up this program or we’re going to destroy it militarily. I see no signs that he’s voluntarily giving it up, because he thinks differently about it. What he’s saying is that the guys who had nuclear programs and gave them up – Muammar Gaddafi and Saddam Hussein – are both dead. Libya and Iraq had a nuclear program. They gave them up and they both got killed. One was shot in the eye, and one was hanged. The guys who didn’t give up their program are the Iranians, and they’re still standing.
Kim Jong-un looks at this and thinks, “Well, this is simple. If you give up your program, you get killed, but if you don’t give up your program, your regime survives.” From his point of view, he’s going to keep the program. The other reason he wants to keep it is he sells the technology to Iran for gold. They’re not moving dollars through the global payment system. They’re putting physical gold on planes and shipping it either to North Korea or some of it is held in custody in Russia. The point is, he’s not giving up the program, and we’re not going to let him go too far; therefore, war is inevitable.
President Trump, Defense Department Secretary Mattis, and Secretary Tillerson are now conditioning the battle space. You don’t just go in guns blazing; you prepare. That involves diplomatic efforts and preparing the American people. When Trump basically invited the entire Senate, 100 Senators, to come over to the White House a couple of months ago, they boarded buses up on Capitol Hill and took them down to the White House. A lot of people made light of it, but that was getting buy-in from the Senate. Trump is saying, “We’re getting ready to do this when I share what we see and how we’re thinking about it,” Nikki Haley is bringing it up at the United Nations, and Trump’s talking about it with our NATO allies.
All the pieces are in place. This feels like Iraq in 2002. We invaded Iraq in March 2003, but the preparation was in place in 2002. I look for that war in 2018 after a year of warning and preparation, last clear chance, etc., so we all know what that’s going to do to the price of gold.
Alex: I thought it was interesting the comment you made about when they’re developing this weapons programs and have failures, that people tend to laugh about it and say it’s not a serious thing.
A lot of people don’t know that the same technology needed to fire an ICBM, an intercontinental ballistic missile, is essentially the same technology that’s necessary to put objects into orbit. You talked about the rate of success for shooting down things like that. They’re moving at about 6.951 miles per second. These things are really cruising along, and to figure out how to do that is no easy thing.
People forget that even in the U.S. space program, it wasn’t like success after success. There were a lot of failures on the road. I think you’re right, there’s an incredible threat that they are continuing to develop and move along.
Jim: I remember in the late 1950s and early 1960s when the U.S. was trying to catch up with the Russians. We had the Mercury Redstone program, then the Gemini program, then Apollo, and then the Space Shuttle and all that. In the early days of testing rockets for Mercury Redstone, the American rockets used to blow up on the launch pad. One didn’t work and they would try it again, but as I say, these were all learning experiences. You’re exactly right.
Not to pile on, but the Pentagon announced yesterday that they’re considering shooting down a missile with a missile as a test. What we would do is fire one of our missiles, then there’d be an antimissile battery, and their job would be to shoot that missile out of the sky as a demonstration that we can do it. The message to Kim Jong-un is: “Don’t waste your time.” Now that’s a high-stakes gamble, because what if we shoot our missile and our antimissile misses? We’re controlling the whole thing, so hopefully they rig it in our favor, but even if it hits, which hopefully it does, I think anyone who is fair-minded about it would say, “Your success rate is never going to be north of 50%.”
Alex: Continuing in this vein of geopolitics, there is a hot topic I don’t really consider a hot topic, but the media seems to be making a big deal out of it. There’s this idea that Trump improperly shared intelligence with the Russians. Is this an issue? Is it a nonissue? Is the media blowing this up or is there real substance here? What do you think?
Jim: The media is definitely blowing it up. I’ve heard people saying, “Trump leaked information to the Russians.” First of all, the President can’t leak anything. The President can reveal information or share information. He’s the Commander in Chief and can do whatever he wants with that intelligence. The President has the last word on what’s classified or declassified or shared with anybody. The President revealed information, but he didn’t leak information.
You do see the word “leak” used a lot, but that’s just incorrect and in the fake news category. Let’s come back to what he did do, which is he revealed some sensitive intelligence to the Russians that would otherwise have been classified. Good idea, bad idea – that’s debatable. A lot of people say that’s a horrible idea, he gave up sources, we can’t trust the Russians, they’ll tell the Syrians, etc.
That’s an argument I’m not dismissing, but the other side of the argument is, if we’re getting ready to confront China and getting ready for war with North Korea, we better have the Russians at our side. We better make friends with the Russians, because there are really only three countries in the world that count. I hate to break it to the Brits and Germans and a lot of others, but China, Russia, and the United States are the only three countries that really count. They’re three of the five biggest by land mass, among the five or six biggest by population (Russia is a little smaller by population), and the biggest in energy output, but most importantly, in military capability and nuclear arsenals, they’re the three superpowers in the world.
In any three-handed game, be it poker or Risk, it’s always two against one whether that’s explicit, implicit, behavioral, whatever. The oldest joke in poker is if you’re at a poker game and don’t know who the sucker is, you are the sucker. In the old board game, Risk, you’d start out with five or six players, quickly get down to three, and then two of them would one way or the other gang up on the third one, wipe them off the board, and then turn around and fight each other to see who won. That’s just how you play a three-handed game.
If we’re going to confront China, which we are, we better be friends with Russia. We don’t want to be confronting Russia and China at the same time. We don’t want to be in a war in North Korea and some kind of shooting match in the South China Sea without having a relationship with Russia, because they’ll just roll through Ukraine, parts of Central and Eastern Europe, maybe roll up the Baltic. You want to fight a war in Korea and the Baltics at the same time? The Pentagon’s worst nightmare is the two-front war. Going back to the ‘70s, we used to be able to fight what we call two-and-a-half wars. Two-and-a-half wars meant we could fight a war in the Pacific or Asia, a war in Europe, and a half a war somewhere else, maybe Africa or Cuba or someplace like that. Today, we’re lucky if we can do one-and-a-half wars, but we can’t do two wars.
This was the thinking behind Trump’s people. Jeff Sessions, Jared Kushner, Mike Flynn, all of them reaching out to the Russians during the transition and meetings with the ambassador was about getting relations with Russia back on track so we can prepare to confront China.
Where it blew up is they all lied about it. This is idiotic in my view. I don’t see why you have to lie about it. What I just described can be taken right out of Henry Kissinger’s book, New World Order. This is balance of power politics 101. If you’re going to mix it up with China, you better have Russia. So, we should have been talking to the Russians.
My view is that talking to the Russians is really smart and lying about talking to the Russians is really dumb. The reason Flynn got fired and Jared Kushner is now reportedly under FBI investigation and Jeff Sessions had to recuse himself is because they all lied and misrepresented one way or another their contacts with the Russians. That was just stupid, in my view, and I don’t know why they were hanging their heads about it. I would have been up front and say, “Hey, it’s a dangerous world. If you think Putin’s a thug, well, meet President Xi Jinping of China.”
China has more human rights abuses, they have firing squads, they have slave labor, they have child labor, they killed 25 million girls in the one-child policy. None of these people are particularly nice. If you want to pile on Putin, fine. He’s a bad actor, he’s a killer, but that’s the world we live in. All I know is if you’re going to confront China, you want to build bridges to Russia. I think that was a smart policy by Trump.
It’s blown up for two reasons. Number one, his people mishandled it by hiding in the shadows, in the bushes, and lying about it. Then, two, it fed into this separate, completely ridiculous narrative that somehow Putin won the election for Trump. Did the Russians use sources, methods, operatives, hacking, and other tools to influence public opinion in the United States maybe in a way that disfavored Hillary and favored Trump?
Of course they did, absolutely. We do that to them. You don’t think we were in Ukraine working actively to depose the pro-Russian of Ukraine? This is how the game is played.
That comes as no surprise, but beyond that, the idea that we were seeking to improve relations doesn’t strike me as odd or problematic or uncalled for, but boy, did they mishandle it. Now they can’t even be seen in public with a Russian, which is too bad.
What’s interesting is that coming up on July 7th and 8th in Hamburg, Germany, is the G20 meeting. That’ll be the first face-to-face meeting between Trump and Putin, so that’s certainly going to get a lot of attention.
Alex: Basic diplomacy is what it comes down to.
Jim: Yes, basic diplomacy. With intel sharing, again, he’s the Commander in Chief if he wants to tell the Russians something. By the way, this faux outrage is laughable. You and I have a background in intelligence. Intelligence gets shared all the time. The Jordanians pick up some pocket litter from a prisoner and give it to the Israelis, the Israelis share it with us, or we get something from the Turks and we slide it to the Israelis. Intelligence operators trade intelligence the way kids trade baseball cards. They swap it around all the time, usually for some quid pro quo, because intelligence is usually a two-way street. This idea that somehow he uniquely and clumsily revealed some hypersensitive stuff is just nonsense and a good example of media bias.
Alex: Yes, I agree. Now let’s discuss physical gold for a little bit. I’m going to give a brief snapshot on what’s going on in the physical gold markets for the year up until now. After that, we can get into some material from your last book, The Road to Ruin. I want to ask for your commentary on how that dovetails into gold.
Right now, gold flows are still going west to east. This is no news to anybody on this podcast, but it’s continuing. U.S.-based gold funds have been pretty flat as of late. In Q1, Germany and the UK actually led the investment in gold funds. We’re talking as much as six times as much capital was invested in gold through Germany and UK as was coming from the United States in Q1.
In addition to that, export data has shown us that India is basically back on top of the stack in terms of gold flow from Switzerland, so they’re taking more right now than Hong Kong and China combined. We’re talking from Switzerland, not all sources. They’ve been the top destination from January through April.
Overall though, Asia is accounting for about 74% of Switzerland’s total gold exports, which means it’s still a one-way street in terms of physical flow. If we look at China specifically, in Q1, Chinese gold imports were up something on the order of 64.5%, and their domestic production is actually dropping. The premiums so far this year have skyrocketed unlike anything in the last two to three years.
And then finally, here’s something I found to be quite interesting. Our sources are projecting that mining production is going to start dropping off after 2018. This is sort of a combined consequence of very sharp cuts in capital expenditure for new production.
Total CapEx for companies in the HUI index, for example, declined by about 65% between 2012 and 2016, and there really haven’t been any new significant discoveries. Adding that to what we were talking about a little while ago in terms of the Fed balance sheet rolling off, the deflationary effect, and the fact that it looks like mining capacity is going to start dropping off, is an interesting scenario.
Let’s talk a little bit about systemic risk. I’d like to read an excerpt from your book, The Road to Ruin. For those who don’t know, Jim was the chief counsel for Long Term Capital Management and negotiated the Long Term Capital Management bailout with Wall Street and the Federal Reserve at the time. This excerpt is about that time during the crisis period and looking at how things were constructed:
“LTCM had 106 trading strategies involving stocks, bonds, currencies, and derivatives in 20 countries around the world. From the outside, the trades seemed diversified. French equity baskets had low correlation with Japanese government bonds, Dutch mortgages had low correlation with Boeing’s takeover of Lockheed. The partners knew they could lose money on a given trade, yet the overall book was carefully constructed to add profit potential without adding correlation.”
In the next paragraph it says:
“This diversification was a mirage. It existed only in calm markets when investors had time to uncover value and cause spreads to converge. However, there was a hidden threat running through all 106 strategies that Scholes later called conditional correlation. All the trades rested on providing liquidity to a counterparty who wanted it at the time.”
Jim, what are your thoughts on what you’re seeing and how portfolios are constructed today? Do you see similar risks that apply? Maybe not necessarily the exact same vehicles but in terms of how the portfolios are constructed versus systemic risk. And what are your thoughts on gold and how it factors into this?
Jim: I absolutely do, and let me expand on that briefly. By the way, the Scholes you mentioned in that excerpt is Myron Scholes, winner of the Nobel Prize in Economics in 1997, and one of our partners at Long Term Capital Management. I worked in the same office with Myron for six years.
Yes, that conditional correlation was meaning it’s not normally there, but it’s there when you least expect it, and it’s what takes you down. I definitely see this happening again. Having lived through the Long Term Capital experience in 1998, I had a front row seat. I saw the PNLs every day, I knew all the positions, I negotiated the bailout, I talked to the banks, the Treasury, the Fed, so really, almost no one knew about it better than I did. Not because I was the head trader, the risk manager, but because I wrote all the contracts and then had to unwind them all and do the bailout.
I was a lawyer and am still a lawyer technically, but at the time I was acting in a legal capacity. That’s why I did the bailout. For years afterwards, I was very unsatisfied with my understanding of what had happened from a risk management point of view. I spent a decade studying physics, complexity theory, network theory, graph theory, applied mathematics, behavioral economics, every field I could find to help explain what happened, which I ultimately did, and then was able to move forward from there and build new models that worked much better.
Beginning in 2005, I ran around warning about the next crisis. I didn’t say, “On September 15th, 2008, Lehman Brothers is going to file for bankruptcy.” I wasn’t that granular, but I didn’t need to be. I could just look at the macro and see the size of the balance sheet, the fact that they had gotten rid of derivatives regulation so you could trade derivatives on anything, the fact that Basel II had basically gotten rid of serious capital constraints and banks could do valuate risk as their capital measure, the FCC getting rid of the 15:1 leverage ratio on certain assets, they repealed Glass–Steagall so banks could act like hedge funds.
Every single thing they did between 1999 and 2005 was the opposite of what you would have wanted to do if you wanted to make the system safer. I was lecturing at the Kellogg School at Northwestern at the time and the School of International Studies, and I did a lecture with the Applied Physics Laboratory. I have all those old lecture notes, and I said this system was going to blow up and it’s going to be worse. Sure enough, that’s what happened.
I see the same thing happening again. Now, it’s always the same and it’s always different. Let me explain what I mean by that. Every financial panic is the same. The best description I’ve ever heard of a financial panic is everyone wants their money back. People think they have money that’s not really money, so you’ll hear them say, “I’ve got money in the stock market. I’ve got money in the bond market. I’ve got money in real estate.”
No, you don’t. You have stocks, bonds and real estate. You don’t have money. If you want money, you must sell that stuff and get the money. And guess what? When you do, everyone else is going to be selling at the same time, the prices are going to be plunging, there’s going to be fear, blood in the streets, and your so-called money is going to be disappearing.
That’s what happens when people want to liquidate assets and get out. They want to do it all at once. It feeds on itself and they want their money back – real money, not dollar-denominated assets that are melting before their eyes. That’s what a financial panic is, and that’s what I mean when I say they’re all the same behaviorally.
But they’re all different, because there’s a different catalyst every time. In 2007, there were the subprime mortgages. I can’t imagine subprime mortgages being a problem now. We barely even have subprime mortgages.
There were $1 trillion of them in 2007, and then $6 trillion of derivatives on the subprime mortgages, slightly better but still pretty junky mortgage. So, it’s not a problem now. The banks are tough, the regulators are tough, the down payments and credit standards have gone up, so the next problem is not going to come from the mortgage market.
Could it come from Chinese credit? It probably won’t come from bitcoin, that’s too small and will get ugly when the time comes. It could be emerging markets, currency crisis, a Chinese credit crisis or the U.S. stock market suddenly crashing because they wake up and realize that none of what Trump said he was going to do has actually happened. Look at how the stock market went up between November 8th and March 1st: 15%. It has gone sideways since then with a couple of highs, but pretty much sideways. But 15% on those three months based on Trump’s promises of tax cuts, Obamacare repeal, the wall, infrastructure spending – not one of those things have happened and may not happen this year or even next year, because it’s an election year. Let’s see how it plays out.
I understand the difficulties, and I’m not blaming Trump. I’m just saying that the market priced a lot of good things that haven’t happened, meaning it’s very vulnerable to repricing, and that could get disorderly. So, it could come from a lot of different sources.
There’s $100 billion more leverage in the system, or more debt, I should say. There’s leverage all over the place when you count derivatives. So, the scale of the system, the concentration of assets, the use of leverage, the use of nontransparent derivatives, all of those things are worse than they were in 2008. That by itself would tell you that the next crisis will be exponentially worse and beyond the ability of the central banks to cure, because as we said earlier in the podcast, they haven’t normalized the balance sheet yet.
But there’s something worse than that. Worse than saying this is a bigger, badder replay of 2008 is the rise of robo-investing and passive investing, indexing in ETFs. I’m not talking about high frequency trading. That has its own dangers, but passive investing. Here’s why.
You have passive and active. Passive is just, “I’m going to buy the index and go take a vacation.” Whatever the index does, it does, because you can’t beat the market, you never have better information, you’re never fast enough or smart enough, so just track the market. Even if it goes down, it’ll come back and I’ll make money in the long run. This is the Warren Buffet, John Bogle, Jeremy Siegel mantra.
But there are a certain number of active investors who wake up. Whether they’re hedge fund mavens like Stan Druckenmiller, Kyle Bass or Ray Dalio who have incredible track records or even others who maybe don’t have such good track records but they’re trying, these are the people who engage in what’s called price discovery. They’re taking money, committing capital, taking a view, engaging in transactions to see where the value is by buying, selling, holding, and seeing how it works out. Maybe they have tight stops and they buy something, it blows up in their face and they get out of it, but that’s what’s called price discovery.
Think of price discovery as a healthy body. Active investing is a healthy body, and passive investing is a parasite that jumps on the back of the healthy body and sucks it dry, because that’s what passive investors do. Well, a small parasite on a large creature will carry on. The creature won’t die and the parasite will thrive. What happens when the parasite gets to be bigger than the creature? You have more and more passive investing on less and less active price discovery, active capital commitments. That is an inverted pyramid and is a highly unstable situation. That’s what’s new – the passive investing piece is now I believe larger than the active investing piece and getting larger all the time.
What that means is that when the psychology changes and people want to bid, the number of active traders out there will say, “Yes, I’ll take them, I’ll buy them,” the way the old New York Stock Exchange specialists used to do. As a specialist, your job was to buy when everyone else was selling and sell when everyone else is buying. You took the other side of the market, and that’s how markets maintained some liquidity. It wasn’t foolproof, but it worked pretty well for almost 200 years.
That’s gone. It’s long been gone in the stock market. I talked to Steve Guilfoyle, his nickname is Sarge, and he’s the Head of Floor Operations at the New York Stock Exchange. I was down on the floor of the stock exchange with Sarge when he said, “Jim, there is no liquidity down here. Don’t let anyone tell you otherwise.” I said, “I kind of thought that, but hearing it from you, I know it’s true.”
Even for the upstairs traders and the hedge funds, there are fewer and fewer of them, so things are going to go “no bid” so fast it’ll make your head spin. That’s going to make this crash worse.
Gold is where you want to be, but not 100%. The listeners know I recommend 10% of your investable assets in gold. There’ll be a flight to quality that will start out in treasuries. In the early stages of a panic, a lot of people sell gold. The reason they sell it is interesting. It’s not because they don’t want the gold, because they wish they had more. They sell it because it’s liquid.
Alex: Yes, exactly.
Jim: That’s contrary to everything I said. I said everything becomes illiquid. Gold can go up and down, but I’ve never seen it go illiquid or “no bid.” People sell gold not because they want to but because they have to.
But that passes quickly, and then it’s just, “Hey, get me some gold. Where is the gold?” Gold goes up, and Treasury bills go up. There may come a time when Treasury bills hit the wall because you’re like, “Wait a second, I’m getting out of everything else into Treasury bills, but is that a smart idea?” If the central bank is tapped out and people are losing confidence in the United States and the dollar, then maybe not. So, then the demand for gold goes up even more.
It’s obvious that’s how it plays out. A lot of people say, “Call me when that happens, Jim. Call me the week before, and I’ll sell some stocks and buy some gold.” My answer is twofold. Number one, I’m not going to know the week before. I’ll see it coming using the models I’ve developed, and I’m actually warning you about it right now on this podcast, but it’s not like I’m going to know the exact minute or the day. I won’t; I just prepare for it in advance.
What I say to those people is, “What are you waiting for? You know this is coming.” Beyond that, even if I could pinpoint it a little bit, when this hits and you go out to get your gold, you might not even get any. There might not be any available. There’ll be a price, you’ll be able to watch it on TV, but you won’t be able to get the physical gold. Again, one more reason to get it now.
Alex: Let me add a little bit to that, and then we’ll wrap this up. One thing I found interesting in what you were just saying is that the common thread there is always liquidity. I was in Minneapolis recently meeting with some money managers, and it’s interesting how often that question comes up. “How liquid is it? How liquid is gold?”
I’m saying this for the benefit of our listeners who don’t understand how deep the gold markets are. It’s basically a $7 trillion market cap. If you took all the above-ground gold in the world, it’s worth about $7 trillion. Annually, we see tremendous liquidity and depth. For example, China and India alone are consuming close to 3000 tons a year, and the amount of liquidity that’s available is pretty high.
The other thing you mentioned is that gold will initially drop down because of its liquidity properties. It’ll sell off a little bit. That’s exactly what happened in the 2008 financial crisis. It went down initially with everything else, but it ended up 6% on the year, which was the only asset in the world that did that.
Alex: That about wraps up our time. Do you have anything you want to add about that last part there?
Jim: My advice is pretty much unchanging, which is to allocate 10% of your investable assets to gold. In defining investible assets, I always say take your home equity and your business equity. If you’ve got a pizza parlor or an auto dealership or you’re a doctor, a lawyer or a dentist, whatever, you’ve got some business equity. Put that and your home equity to one side, because you don’t want to be betting with that. Whatever you have left are your investable assets. I recommend 10% of that for gold. If nothing happens to gold, you’re not going to get hurt with a 10% allocation, but if the kind of scenarios I’m describing do happen, it may be the winner that protects your losses against the entire rest of your portfolio.
Alex: Jim, I appreciate your time. This has been a great discussion as always. I look forward to doing it again next month. Enjoy your weekend, and thank you for being on the podcast.
Jim: Thanks, Alex.
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