WBD565 Audio Transcription
Europe in Crisis with Lyn Alden
Release date: Monday 10th October
Note: the following is a transcription of my interview with Lyn Alden. I have reviewed the transcription but if you find any mistakes, please feel free to email me. You can listen to the original recording here.
Lyn Alden is a macroeconomist and investment strategist. In this interview, we discuss the recent market turmoil that followed the UK government's proposed tax cuts. Why did the market reaction nearly result in the collapse of UK pension funds? What are the underlying issues? Where are we heading?
“This period looks a lot like the 1940s, which is when you have a combination of high debt and high inflation, which is not what you had in the 70s. In the 70s they had low debt and high inflation, which means they had a lot more tools to respond to it…when you have that combination of both…that’s the closest thing that a central bank has to a checkmate scenario, where there’s only bad options.”
— Lyn Alden
Interview Transcription
Peter McCormack: Hi, Lyn, how are you?
Lyn Alden: Good, how are you?
Peter McCormack: Yeah, weird. This feels like back in COVID times when we used to get on a call once every few weeks and have a chat over Zoom, and I felt like we were never going to have to do this again. Actually, do you know what we realised today? You were the last one we also did remotely?
Lyn Alden: Really?
Peter McCormack: Yeah. Where was I? I was in Austin, Texas, yeah. But we felt like, because the UK is collapsing at the moment and some of my friends and peers at home don't know what's going on, a little bit worried, it's like, "We're going to break the rule, we're going to do a remote show with Lyn and find out what's going on". So, yeah, how are you; are you well?
Lyn Alden: I'm pretty good. I'm happy to try to be helpful too. I know it's complex times out there.
Peter McCormack: Yeah, but firstly, before we get into that, are you writing a book then?
Lyn Alden: It's a project that I want to do, yes. I've written so many articles that basically I can weave some of them together, I think, into a book, and it would help tie things together; especially because if you write a lot of really long articles, people don't necessarily go and read them in the right order or the right context, and you can link to them and you can try to get them to do that, but putting it together in a book form helps. So, I think it's time to look into doing that.
Peter McCormack: And, is it a Bitcoin book, or it is an economics book, or a mixture of the two?
Lyn Alden: So, it would be an economics book, basically a book about money in general. But any modern book on the subject has to have a Bitcoin section.
Peter McCormack: Of course, fantastic. Well, listen, I want the first copy now, I'm staking a claim to it. Let me know your price. I want the first copy that comes off the press, if I can get it. Okay, let's talk about the shitshow which is my country, the UK, and potentially a little bit of the shitshow, which is my continent, Europe. It's been a very strange few weeks, Lyn, and I do joke there; but actually, it's been quite sad and quite concerning for what a lot of people have gone through. And I know the issues we have right now are global. I can talk about the UK, but I'm aware that the other day Bangladesh announced that half the country is going to experience blackouts, I'm aware that there are issues all around the world.
But what it seems to me is that there's energy crisis, there's war, there is inflation, recessionary pressures, interest rates going up; there's lots of issues. The thing about the UK, it feels like we've got all of them at once. It feels like everything that possibly could go wrong is going wrong, and the impact has been quite severe, especially those on lower to middle incomes. So, I'm trying to understand (1) why the UK has been particularly badly hit; and (2) if anything, what people could be doing about it?
So really, just to start off, Lyn, it would be great to know, just in terms of what your observations are of the UK, why do you think the UK has been particularly badly hit right now?
Lyn Alden: Well, I think it's a cluster of things all happening at once. So, if we go back several months, I started writing about that basically, I thought we'd encounter a period where central banks would have to print into high inflation. So normally when inflation's low, central banks have more flexibility to print money; and when inflation's very high, that's when they try to pull back and tighten and try to rein that in.
But one of theses that I've had is that this period looks a lot like the 1940s, which is when you have a combination of high debt and high inflation, which is not what you had in the 1970s. In the 1970s, they had low debt and high inflation, which means they had a lot more tools to respond to it with higher rates and with tighter monetary conditions. Whereas, when you have that combination of both, it's very hard for central banks to do it. That's the closest thing that a central bank has to a checkmate scenario, where there's only bad options and they can pick between some bad options, they can delay things, but they basically run into an inability to control the system as they'd like to.
Going into this, this higher inflation, energy crisis type of period, there are some central banks where they did all the things you'd expect, like Brazil for example; they raised rates from 2% to 14% starting early in 2021. A lot of the emerging markets really have no choice, they pretty much have to front-run that, because they face more severe currency problems if they don't. Whereas, on the other side of the spectrum, some of the most indebted developed countries in the world, from the beginning of the race, they basically tripped over themselves.
So, the Bank of Japan, as all this inflation was coming in, they just said, "We're not even going to try. We're going to keep rates at zero, we're even going to do yield curve control, so even if the longer end of the bond curve tries to go up, we're going to keep printing money and buying those bonds to hold the yields down, even if inflation's above our target". So, Bank of Japan's on one side and then you have central banks, like Brazil, on the other side.
The ECB was also kind of in that Bank of Japan camp, where they had Italy with 150% debt-to-GDP, the foreign sector doesn't really want their bonds, and so the ECB is doing this scheme to sell some German bonds and buy some Italian bonds, and other countries are involved as well. So, they're kind of in a slightly more limited version of what Japan is doing. And my thesis from a few months ago is that we're going to probably see this in more central banks.
I cited that the Fed was still holding on, the Bank of England was still holding on, meaning that they were able to tighten, to some degree, but that over time they would start falling like dominoes and have to print into high inflation like Japan, and to some extent like the ECB is doing. Unfortunately, what we saw in the past couple of weeks is that the Bank of England, that domino did fall; they had to join the chorus of some of the other most indebted countries in having to do quantitative easing, despite the fact that they have official roughly 10% inflation. And we can get into some of the reasons why, but it comes down to very high debt levels, combined with that acute level of inflation, that made it so that they couldn't respond as they would have done if this was the 1970s.
Peter McCormack: What would have happened if they hadn't have responded?
Lyn Alden: So eventually, you get sovereign bond default, which is almost unthinkable in developed countries, because they have the printing press, so they almost always avoid nominal default. Essentially, if we go to the approximate issue of what happened, so the deeper issue is too much debt. Any time a country gets over 100% debt-to-GDP, it's really hard to find the balance sheet space to shove all that debt into. So, that's the deeper issue.
But the more approximate issue, the issue that's closer to the actual problem in this instance, was the pension system. So, the UK has a very large pension system, their assets are a very large share compared to GDP, so it's a very meaningful, large pool of assets and they have a lot of exposure to those government bonds. And then they also use various derivative schemes, because they have certain payouts they have to make on a very specific basis, they have to meet very specific payout schemes, and so they'll get this kind of derivative product that's offered by companies like BlackRock and others, and they have to post collateral.
So, they're essentially, in some ways leveraged, and there are experts on that specific system that can go way more into detail than I can. But the core of the problem is that as inflation was roaring and as the Bank of England was no longer buying its bonds, it actually wanted to sell bonds, it wanted to reduce its balance sheet, it wanted to try to tighten, and so the question becomes, "Who was buying the bonds?" And the yields were way below the inflation level and the Bank of England was no longer buying. So you start to get an increase in yields, and this happened across developed markets, it happened in emerging markets, everybody's yields are going up.
Then, basically the new government there announced unfunded tax cuts. They said, "Here's our fiscal budget. We're going to cut taxes and we're not going to replace that with spending cuts, it's basically going to be a bigger deficit. This is at a time when there's already deficit, there's high inflation, the central bank's not buying the bonds, and so the bond market had a freakout. They said, "Wait a second, this is going to be inflationary, the supply of these sovereign bonds is going to increase, who's going to buy them all?" And so, there started to be a rapid selling pressure on those bonds.
When you have a leveraged system like you have in the UK pension system, when the value of your collateral goes down, when yields go up, it means the bond price is going down. And if you hold all the way to maturity, it doesn't matter too much. I mean, inflation above yield still matters; but if you're posting them as collateral and you need to maintain certain ratios, if that value of the collateral goes down, you might get liquidated, you might have to sell those bonds, and basically settle that leverage.
Then the problem is, if everybody is using the same collateral and is involved in the same type of scheme, then once one party has to sell, that further worsens the price, because now you're a forced seller. That's why, for example, in the Bitcoin market, some of those price drops can be dramatic, because you get a lot of people that have to sell at the same time. And you kind of had a slightly less extreme version of the bond market, but it's more severe when it happens to the bond market, because this is supposed to be one of the safer types of investments.
So you had forced selling, which made the price worse, and therefore more funds had to do forced selling, which makes the price worse, and it creates a vicious cycle that feeds on itself, and there's no other balance sheet that's ready to jump in and absorb all of this. So, if it was left unchecked, you could have had yields just keep spiking, and then you can get outright mass liquidations and literal default.
That's where the Bank of England steps in and they literally had a speech planned the next day for how they were going to reduce their balance sheet. They had to scrap that and they had to go from plans to reduce their balance sheet to increase their balance sheet by doing QE, buying bonds. They planned on doing it for two weeks, and then they delayed their intended bond sales. They eventually want to get back to trying to sell bonds; we'll see if they ever get there. Usually, the answer with these types of things is no, usually the balance sheet keeps going up. It might pause for a period of time, it might go down briefly, but it's hard for them to ever get those down, because there's really a lack of balance sheet capacity to absorb the size of the flows.
In recent days, basically the Bank of England stepped in to solve the yield problem, so stopped that vicious cycle of force selling; we also saw that the government sort of walked back some of their fiscal plans to try and restore some degree of confidence in the market; and so, the emergency's kind of on ice for now. But you still have a situation where the Bank of England is doing QE during 10% inflation, which is kind of Banana Republic type of stuff, but that's what we get in a toxic combination of high debt and high inflation.
Peter McCormack: But how does that end then? Because, if you shouldn't be doing that, if you shouldn't be QEing during a time of high inflation, is this the early stages of Weimar; it just becomes a vicious cycle that will get even higher inflation and exactly the same will happen?
Lyn Alden: It can be Weimar-like, if you specifically have acute energy shortages. That's why the situation in Europe's so dangerous. So, hyperinflation's not been a key part of my expectation, at least in any sort of investable time horizon. So, when you look out long enough, all fiat currencies have historically failed. But in any three- to five-year time horizon, I've not had hyperinflation as any of my calls on developed market currencies.
Peter McCormack: What about instead of hyperinflation, just high inflation?
Lyn Alden: Yeah, this contributes to high inflation, because basically you have a loosening of financial conditions into inflation that's already hot. Now, the bigger factor's going to be what the budget deficit is. That's what's actually adding to money supply, along with bank lending. But if the interest rates are not suitable compared to inflation, it means the foreign sector doesn't really want to hold that currency.
Then, two, if the bank's doing QE to hold yields low, again that's contributing to the forward market not wanting to buy that currency. We saw that in Japan, for example. Now, they have a much less severe energy crisis, so they have lower inflation, but it's still above their target. And so, when the bond market can't set prices the way it thinks it should, they instead just get out of the bonds, and that hurt the currency. So, the release valve ends up being the currency, and that can happen in various degrees. Right now, both the British bonds and the currency have stabilised, to some extent, just because there's more restored confidence that this problem's contained for the moment. Be it longer term, it creates selling pressure on the currency.
When you look at something like Weimar, the reason why Weimar and hyperinflation, and why you have hyperinflation in some developing countries, is that they have liabilities that they can't print. So, in emerging markets' case, it's often they have dollar-based debts, which means that no amount of printing can just fix their liabilities; in other words, they can't dilute their liabilities with inflation, and so they actually face risk of default, which can destroy the value of the currency. Then, if you look at Weimar, they had war reparations, they owed reparations in gold, their industrial base was damaged by the war, so they had serious supply constraints.
We're seeing a mini version of that in Europe today unfortunately, where there's an acute energy shortage. It's like an emerging market that has liabilities that it can't just print. That's why we're seeing unusually high inflation in Europe, even compared to some other trouble spots like Japan or the United States, and other countries like that, because it's that specific energy shortage that is worse there for reasons we all know.
Peter McCormack: What has been the long-term impact on Japan? We've talked about it before, you've talked about stagflation, but it would be good to explain that again to people, and potentially what we're facing.
Lyn Alden: So, Japan is a weird case, because it's managed to prolong its situation more than any other country in its circumstances have done. And when people think of Japan, they often think of crazy money printing. They think the country has 250% debt-to-GDP, the Bank of Japan's balance sheet is bigger than 100% of GDP, it looks like a chart that just keeps going straight up.
But in Japan's case, they actually have very slow, broad, money supply growth. So, this is basically an example; you've had Jeff Snider on your platform, and he would quickly point out that QE is not money printing, and there are contexts where I agree and there are contexts where I don't agree. In Japan, that's a case where I generally agree, because you have tons of QE, tons of base money going up, but it's not resulting in a lot of broad money supply growth. In fact, Japan had the slowest broad money supply growth in the world over the past 10 to 20 years, and so it's no wonder that they had among the lowest inflation in the world.
The reason was, they had some money supply growth from those monetised fiscal deficits, but they generally didn't have huge deficits. And then it was also offset by the corporate deleveraging. So, when you pay back a loan, you actually destroy money. So, in Japan's case, you had maybe 5% average broad money growth from fiscal deficits, but then you had -2% money supply growth from corporate deleveraging, so it balanced out to around 3% annual growth. And so you had a pretty non-inflationary environment. Also, the past decade didn't have acute commodity shortages, and so they were able to get away with that for a very long period of time.
The problem now is that for the first time in quite a while, they're facing pretty acute inflationary problems because, just like anyone else, they need to import energy. They do export a lot, but the raw materials they often need to import, including energy, and specifically including liquified natural gas, which is now very elevated in price. And so, they're facing an issue where their inflation's above their target, their bond yields are starting to go up, but they have 250% government debt-to-GDP, so they can afford high interest rates, they can afford the interest payments, the tightening that would come with that.
So, they're doing formal yield curve control, much like the United States and some other countries did in the 1940s, where they're willing to print money and buy any bond that tries to go above 0.25% yields, which is, in my opinion, too low; they could have set that threshold a little bit higher, it would have been a little bit easier for them. But the downside is, they're doing QE into a high inflationary environment, and the bond market can't get the price it wants and so everyone says, "Well, I'm not going to own Japanese bonds", and so everybody sells the bonds they have, it takes down the currency.
Now Japan, however, does have defences. They have something like $1.2 trillion worth of treasuries, of foreign exchange reserves, and so when they're faced with a situation that they don't want to increase yields, but they also don't want super-disorderly yen devaluation, they can start selling some of their reserves and buying yen back. And for the first time since the 1990s, they did do that recently; they sold some treasuries in order to try to stabilise the fall of the yen. And they only sold a small amount. I mean, they have more than $1 trillion more where that came from, if it came down to it, which it won't. And you have similar situations in China and parts of Europe, where these big countries have a lot of treasuries.
The difference in the UK's case is they have less reserves, both at absolute level, and relative to their GDP and their money supply. And so, the UK does not have a ton of options when it comes to stabilising its currency, if they're also trying to stabilise the bond market at the same time; you kind of have to pick one or the other. And in that environment, the sovereign bond market will almost always win, because default is generally unthinkable.
Peter McCormack: You say it's unthinkable, but is it a possibility? When you look at the UK now and everything you've explained, do you think that's a possibility? And if it is, and it was to happen, how does that play out; what are the consequences of that?
Lyn Alden: So, it's always technically a possibility, but it would be a choice. So, if the liabilities are denominated in your own currency, it's always a choice not to default. The only instance I'm aware of, of a country defaulting in its own currency, was Russia in the 1990s, during the Asian Financial Crisis; they actually just nominally defaulted on some debts that were in their own currency. So, it's happened, but it's extremely rare, and it doesn't really happen in these western countries. So, I would consider it a very low probability event that they would outright default, because it would ripple through everything else.
So, banks use treasuries as the foundation of their safe collateral. So, if you defaulted on a big enough scale to banks, you would then put the entire deposit base at risk. In addition, as we saw from the pension system, they're are huge owners of the bonds. And so, if they default to some of the pensioners, now you have an insolvent pension system. And of course, for a developed market to default, you'd now be just junk status; your ability to ever get reasonable yields in the future is now highly impaired, and so you'd have just more defaults.
Normally, in this type of circumstances, a developed country that has liabilities in its own currency, 99 times out of 100 will print, rather than nominally default, because it threatens the entire foundation of the system.
Danny Knowles: Going back to the Japan thing for a second, why are they able to do so much QE; and why is their situation different and it doesn't reach the broad money supply?
Lyn Alden: So, like I said before, a lot of this was pre-COVID. So, the whole period, the whole decade of Abenomics, they called it after the former Prime Minister, was this kind of fiscal heavy printing. But they did it during a commodity bear market, so global commodity prices were going down, there were generally no tight constraints on their inputs; they were running a current account surplus until recently, meaning that there's more capital flowing into the country than out, mostly because they had a positive trade surplus; and then also, they own a lot of foreign investments. They've had decades of trade surpluses, and so they take those values and then they buy foreign assets, so they get all sorts of interest in dividends from the rest of the world. So, they generally have a pretty strong bid for their currency.
Also, there's low levels of extreme politics and polarisation, so it generally has that more safe-haven status. But like any other country during COVID, they had a bigger budget deficit than normal, and now they're facing bigger energy problems than normal. But compared to Europe and compared to the UK, they don't have the same kinds of crazy power price spikes that you're seeing over there; they're facing elevated input costs from LNG and things like that, and coal, but they don't have nearly the acute level of energy shortages, and they also have a lot of reserves.
They've been facing a weak yen, lately it's been a pretty big move, but there's nothing about their situation currently that's anywhere near as dire or uncertain as some of the things that we're seeing throughout Europe.
Peter McCormack: During the last couple of weeks, when the pension funds were at risk, the UK Government made the announcement that they were borrowing something like £60 billion, or whatever it is, to shore up the pension funds. One of the things they said is if they hadn't have spent the money, the pension funds themselves would have collapsed. Does that not mean the funds themselves are taking on too much risk, and should they not be allowed to fail?
Lyn Alden: So, yeah, that basically means they are taking on too much risk. Some pensions do that when they are -- it's like going on tilt, where you make a bad situation worse. Some of them don't have enough assets to meet their expected future liabilities, so they end up taking on more risk. So, that's one thing, and then of course that can backfire. In some cases, they could be successful, they fix their shortfall; in other cases, they mess up, and their shortfall gets wider.
In this case, a lot of it was more mechanical, because they're all holding the same type of asset, and then that asset had basically the worst year ever. So for example, looking at just the US bond markets even, it's the worst year in modern history for those bonds. So, a lot of these things are calculated assuming that, you know, you can have a pretty big fall, but they weren't really expecting the level of fall that they got, they weren't expecting this much inflation from that low of a yield level. So basically, bonds were a bubble, and then they were in, in some cases, a levered bubble.
The short answer is yes, they were taking on too much risk, but it's a very specific type of risk. It's not like they were gambling in other areas. It's basically everybody owning the same asset and then using that asset as collateral. And basically, if it was not bailed out, you would have had this cascading failure of both government bonds and pension funds, because it feeds off of itself. But on the other hand of that, the way that the whole system got so levered in the first place is because of central bank intervention. If you didn't have this kind of flexible money standard, debts would have never got this high to begin with.
So, it's like you're at the point where you need more of the poison to not die from the effects of the poison. So, it's not like a bailout's a good thing; it's like, they're putting themselves in a situation where they have few options. That's why these things, it normally ends up taking it out on the currency in the long run.
Peter McCormack: It sounds very similar to what happened with the housing crisis?
Lyn Alden: Essentially, yeah. In the United States, you had real estate went up very quickly -- well, first you had Greenspan, the former Fed Chair, cut rates all the way to 1%, and so that basically gave everyone a gigantic incentive to go out and borrow and invest in real estate. Then you had banks securitise it. So, instead of issuing a mortgage and then holding that mortgage on their balance sheet, they'd then throw it into a pool of other mortgages and sell it so it wasn't their problem. Then you had rating agencies just look at that whole bunch of things and stamp as AAA, even though there were some subprime mortgages in there.
The thesis was that real estate never goes down. Sometimes it has a flat year, maybe it goes down 1% or 2%, but it never crashes, "It's real estate, it only goes up". And of course, if you look back long enough in history, during the Great Depression, real estate went down, and this was the second time in history where US real estate went down by double-digit percentages, and that wiped out all the models and it was all highly levered, and the bank system had very little reserves relative to all their long books. And so basically, you had this cascading failure. It is in some way similar to what we just saw.
But back then, it was more of the private sector; whereas now the problem, basically the cost of bailing out the private sector back during the Global Financial Crisis, in the United States and Europe and elsewhere, was that you pushed more debt to the sovereign level. So, it's a similar type of problem, but coming from a very different spot this time.
Peter McCormack: Right, okay. Another thing I wanted to ask you about is, Liz Truss announced -- well, the Chancellor of the Exchequer announced a number of tax cuts designed to stimulate the economy, that was their thesis. The response to that was pretty negative and the pound crashed, nearly reached dollar/pound parity. The first time I went to the US, it was about 2006. I won't get the year right, but I remember it specifically, because I got more than $2 to the pound, and the pound is now quite weak. I mean, I think even at the start of the year, it was about $1.38, and I think we're about, what, $1.12, $1.08 is it now, Danny?
Surely they would have known that these kinds of announcements would have crashed the pound, so it does make me wonder, are there any benefits to lowering the pound that I would not have thought about?
Lyn Alden: Well, so one of the benefits of reducing the value of a currency is that in some cases, the export market can become more competitive. So, UK products, all else being equal, are now generally more competitive on the global market price; because essentially, UK labourers are getting paid less, because even if they're getting paid the same amount, those units are worth less. And so basically the rest of the world now, you can travel to the UK, it's cheaper; you can buy their stuff, it's a little bit cheaper; that's generally the advantage.
But no country really wants to see disorderly devaluation of their currency like they saw there. It's also, I mean Japan has specifically used currency devaluation as a tool. That's one reason why they're happy to do yield curve control is they're saying, "We're fine with a weaker currency, because we get some benefits from it", but they just don't want a disorderly fall of the yen. So, it's about the speed sometimes that matters. And of course, if you're a saver, you don't want that. Inflation is above your yields and your currency's devaluing compared to many other currencies.
Now, part of that difference is also that the dollar's been unusually strong this period, at least relative to other currencies, so generally what we're seeing is in most years, you have more volatility in emerging market currencies than developed market currencies; this year has been an exception. Some of the emerging market currencies have actually held up pretty well, because they're the ones that out of necessity have to be hawkish. So you've had, for example, the Brazilian real is flat to up versus the dollar this year, even as the dollar's crushed almost anything else. The ruble's up, but that's for pretty specific reasons; and some of the biggest losers were the euro, the yen and the pound.
Of course, I'm excluding some of the truly basket-case currencies, like the Turkish lira, the Argentine peso, I mean those are even worse, but excluding some of those edge cases, look at major emerging markets, like Brazil, China, India. They've had currency weakness in some cases, but they've not had the same severe currency weakness that we've seen in the most indebted developed markets outside of the US.
Peter McCormack: I did see one chart, Lyn, that was put out which was comparing the dollar to all other currencies, and I remember in this chart that every single currency was falling at different levels to the US dollar. I understand why, I spent a bit of time this week with Parker Lewis, and we were discussing a number of different things with relation to why this has happened, and also just trying to understand the fact that the world is short dollars. I'm going to be massively out of my depth here, but does there become a scenario where the dollar becoming so strong is actually bad for the US; and what can they do about that?
Lyn Alden: So, that's already in some ways the case, where our physical exports are in many cases less competitive, because of how we've structured the system. That's something I've covered a lot in my analysis of the petrodollar system. The other more immediate effect is, if you get a sharp rise in the dollar, you generally get forward selling of treasuries. You can think of treasuries as acorns, a squirrel will gather acorns in the summer so they can eat them in the winter. And so, when the dollar's weak and when things are going well, a lot of countries will print currency to go and buy foreign reserves; they'll buy treasuries, they'll buy other assets outside of their own currency system and store those up. Then the opposite, if you have a period where the dollar's rising very sharply, they can then sell some of those treasuries.
So often, people think intuitively, when the dollar's going up, it must mean that a lot of foreigners want to buy treasuries, US assets; but it usually means the exact opposite, which means the dollar's going up and so these countries either stop buying treasuries, or slow their purchases of treasuries, or outright sell treasuries, either to get dollars, to service dollar-denominated debts, or to defend the value of their currency.
For example, Japan sold something like $20 billion worth of reserves in order to stabilise its currency; that's a small drop in the ocean. But combined with the fact that there are very few foreign official pools of capital that are buying treasuries, it essentially means that the US system's running into a similar issue that the UK ran into, which is our bond yields are going up, the market's getting very illiquid, so wider bid-ask spreads and just thin markets where a big trader can move the market. It's supposed to be one of the most liquid deep markets in the world, but it's facing extremely bad liquidity conditions.
So you have a situation where US banks are already stuffed full of treasuries, they can't really buy more, unless regulations are changed, which has been discussed; you have the Fed letting bonds roll off of its balance sheets, so it's a net seller, just by not reinvesting those it's doing basically a mild form of QT; and then also you have the foreign sector basically on strike, either not buying or outright selling treasuries. And so, that's the constraint, that the Fed can tighten until it breaks the treasury market in a similar way that the UK market broke. And so, they're not at that point yet, but it's directionally a similar problem, where you have every type of balance sheet having to sell at the same time, and then you get disorderly, illiquid, broken sovereign bond markets.
That happened to the US Treasury market back in March 2020. So, you have kind of a similar thing playing out now, but in a less fast way. So, that was global trade ground to a halt basically overnight; they still had dollar debts they had to service; and so, you had a very rapid selling of foreign treasuries, and it basically broke the US Treasury market. The Fed had to come in and buy $1 trillion worth of treasuries in three weeks. So, that was a very rapid aversion.
What we're seeing now, it's happening quickly, but it's not happening as quickly. So, the dollar's grinding higher, foreign treasury holders are grinding sideways and down, and you have occasional bursts of sales in order to backstop currencies, and it's just not healthy for the US Treasury market.
Peter McCormack: So, what can the US do about that?
Lyn Alden: A couple of things. So, one is they can do SLR, changes to the supplementary leverage ratio, which is a wonkish way of basically allowing banks to buy more treasuries. They basically make it so the treasuries don't count when they're calculating what their capital ratios are. It essentially allows the banks to lever more, but only on treasuries, not on any sort of other assets. So, that's one thing they can do, and that has a similar effect of QE, because it basically improves liquidity conditions; but instead of the Fed buying it, it's the commercial banking system, which is actually a very similar outcome.
The other option is that the Fed can do what the UK did, which is if the treasury market breaks, they may have to come in and do surprise buying of long-duration bonds. If they want to be conservative about it, they could try to sell short-duration bonds to offset that. So they could say, "Okay, well we're still holding our balance sheet flat, but we're twisting the duration of bonds we hold". So, they have a range of options they can do, but they're kind of variations on the theme of Money Printer Go Brrr. So, when the sovereign bond market breaks, you need more currency, more reserve creation, or more leveraging to buy those bonds.
Right now, the biggest question in macro is, "How much can the Fed tighten in their quest to rein in inflation; and will something like that break and force the Fed to pause or pivot earlier than they'd like to?" So, I'm watching the treasury market pretty closely to see how close they might be getting to what we just saw happen to the UK bond market.
Danny Knowles: And, what would you actually be looking for when you do that?
Lyn Alden: So, I'd be looking at liquidity -- one is yields, so if yields keep grinding higher on the long end of the curve, that's an indicator. Number two, I'd be looking at liquidity conditions. So for example, Bloomberg has an index of government bond market liquidity. There are various ways to quantify this, and so you basically look for quantitative measures of reduction and quality in liquidity in what is supposed to be a very liquid and safe market.
We are seeing signs of that. Basically, most things are showing it's about as bad as it's gotten, except for March 2020; that was worse. It's not fully broken like it did then. March 2020 in the US looked like what just happened in the UK basically, and so we're not there yet. But it's directionally not looking healthy for the US Treasury market.
Danny Knowles: But you think it's just a matter of time before they turn the money printer back on?
Lyn Alden: A matter of time until they either turn it back on, or they do it in more clever ways, like that SLR adjustment.
Danny Knowles: If they did the SLR adjustment, does that increase risk for the commercial banks?
Lyn Alden: In some ways, yes, because it gives them more exposure to long-duration treasuries, which could potentially put them in a similar situation as UK pensions. In practice, I think that given that they'd always backstop that with some degree of yield curve control if needed, in practice I would not be worried about the solvency of the US banking system. In some ways, their position is the exact opposite of 2008 now.
In 2008, banks had very low treasuries and cash as a percentage of their assets, which meant that the vast majority of their assets consisted of loans and riskier securities. And so, that's the portion that's subject to nominal default risk; whereas the cash and supposedly the treasuries are not. Whereas now, they're very highly allocated to cash and treasuries. So, they have more of a -- basically, they would have to have worse defaults on the risky side of their book in order to have a similar event to what happened in 2008.
So overall, I'm not really worried about US banks, but basically it would stuff them with more treasuries, if they decided to do that instead of putting that on the Fed balance sheet. So, they have some options.
Danny Knowles: So, that would be what Jeff Snider talks about where he says that the banks, since 2008, have just not taken enough risk?
Lyn Alden: Yeah, that's basically -- apart from regulations. So various regulations have basically made it so that banks have to have more safe collateral. And then, above that minimum threshold, we've just not been seeing a ton of bank lending compared to prior rates. Banks generally, in the US and many other places, have been pretty conservative with exceptions, like we see in some well-known European banks.
Peter McCormack: Everything looks really ugly, everything looks really terrible right now. Everything you're explaining to me, me and Danny were talking about the other day, there's this economic tug-of-war. Like, in the UK, the government makes a decision, the Bank of England wants to respond. But every single time they pull one lever, it pushes another lever back, and we have this cascade of issues. But on the end is people unable to heat their homes, unable to feed their children sometimes, people are facing the fact that they can't pay their mortgages. There are so many things going wrong.
I struggle to see what's the way out of this. It's not just here, it's the US, it's everywhere around the world. Is there any light at the end of the tunnel; how do we actually get out of these global economic problems? Do we just actually need a reset? One of the things we were talking about is we went back to watch Ray Dalio's video. You have periods of expansion and you have periods of contraction; but if we don't allow contractions to happen, we just seem to get in these worse and worse situations, and the people who really suffer most are the poorest in society. So, how do we get out of this system; can you fix it?
Lyn Alden: So, before Europe had acute energy shortages, I was already viewing this as kind of an endgame for this long-term cycle, which is basically we've had four decades of lower and lower interest rates and higher and higher debt-to-GDP across the developed world. When you hit the zero bound, or in some cases mildly negative, you no longer have an offset. So, when debt is rising, but interest rates are falling, the debt-servicing costs are often flat, they're not going up.
But when you have a situation where interest rates are now flat or up, while debt as a percentage of GDP is also going up, that's when you have that very dangerous combination of actually higher and higher debt-servicing costs, including at the sovereign level. That's when central banks run into a Kobayashi Maru; it's an impossible scenario that there is no solution for. And so, what they're supposed to do is, if you have high inflation, you tighten; and if you have low inflation, high unemployment, you loosen. That's the model that they've been in.
What breaks that model is stagflation, when you have both weak economic situation, financial instability, basically too much debt starts blowing up and you have high inflation. So historically, in the 1940s, which is the time we have to look back to find this combination for developed markets, you had major inflation, you had major currency devaluation, you had huge spreads between inflation and yields, and you had pockets of yield curve control and financial repression, which is basically all sorts of capital controls to prevent capital from moving around freely. You basically had to trap various entities into owning these bonds, and you had central banks buying the bonds.
That's the situation I've been describing as us entering anyway for a couple of years, and we're starting to see that play out. Now, we've now added to it acute energy shortages, and really the only way out there is kind of an emergency response to get more energy supply. Basically, countries should be doing everything in their power to figure out how to get persistently more energy supply, and to incentivise companies to go out and get more energy supply; because, for some countries, it is a national security risk at this point. And as you point out, it hurts the least resourceful members in society. The ones with the least ability to pay for that are the ones that are most impacted.
The way I've been describing it is, we're going to get periods of inflation until we fix the energy system, and unfortunately that can take quite a while to happen. And so, when I rank things that would keep me up at night, in terms of markets, acute energy shortages are pretty much at the top. In developing countries, food and energy compete for that top spot. In developed countries, you don't really have to worry about food shortages, because there's more resources to fix that. Instead, it's about energy shortages, because those are complex problems that take a lot of time to fix, because grids are complex, energy sources can't be changed on a dime, infrastructure needs to be changed, new wells and new reserves have to be created to produce more of the energy that's been in short supply; and so, there's really no way out until the energy system is resolved, and that thing's going to take years.
Peter McCormack: And therefore, it's a particularly bad problem for most of Europe, because the energy sector has lacked investment, particularly in the UK; it highlights the issue that energy sovereignty is important. One of the things I've been doing, Lyn, and would love to run that by you and know what you think, but I'm now holding dollars. So, I always used to just have to manage a balance of Bitcoin and a balance of pounds, that's all I had to think about. But with such a massive drop in the value of the pound in the last year, which me and Danny are experiencing now; when we come in here and we're spending $30, $40 on a lunch, that used to be £25; it's now close to £30, £40. So, I'm starting to hold a balance of dollars, both for my business and personally. Is that a fair hedge to be doing?
Lyn Alden: So, I think currency diversification is always reasonable. The caution I would give is when we do reach a point where the Fed is unable to keep tightening; so it's really that rate of change that matters. When the Fed is tightening more aggressively than most other developed market central banks, the interest rate spread between what you get on US assets compared to foreign assets is wider. So for example, there's a lot of incentive to sell Japanese assets and buy US assets.
But when that stops increasing, and especially if the treasury market breaks, and the Fed or the banking system is forced to do some type of liquidity operation to fix that, similar to the UK, that could be a structural peak in the dollar for a period of time, relative to other currencies. So right now, we've had the perfect conditions for a dollar rally, because we are more energy sufficient; the Fed is tightening more aggressively; there are all these dollar-denominated debts throughout the world that basically represents demand for dollars; but there are major periods in history where you get a huge spike in the dollar and then you get a huge fall in the dollar.
So, with the US dollar situation, one of the biggest weaknesses that the US has had, relative to the rest of the developed world, is that we've run these bigger trade deficits, which are normally bad for a currency. And so, whenever we're more dovish compared to the rest of the world, or just as dovish, you have a tendency for the dollar to start falling. And so, if we do reach a pivot point where the Fed is unable to keep tightening, you could get a pretty notable fall in the dollar.
Now, because the United States is more energy independent, or at least less energy vulnerable than what we've seen in Europe, and to some extent Japan, that keeps our -- basically, the trade deficits of Japan and Europe got worse, whereas the US's is still bad, so that makes that comparison harder. Whereas, in pre-energy crisis markets, you would have had a trade surplus in Japan, a trade surplus in Europe, and so the Fed loosens, gets more dovish, you'd have a fall in the dollar; now it's a little bit less certain, because you have such a crisis of energy in those regions.
But I do think that at some point, the dollar could stop going up relative to some of those other currencies, because they'll reach a point where they're at max tightness. So, I'd be concerned about pivoting too hard into the dollar at what could end up being a local top. But I do think in general, currency diversification's a good thing.
Peter McCormack: Has the Fed itself essentially bought themselves a little bit of leeway then to actually print?
Lyn Alden: Well, it's funny, I mean the United Nations of all places called on the Fed and other central banks to stop tightening.
Peter McCormack: I know!
Lyn Alden: They could cite financial instability as a reason. There's things that they can do, or that the Treasury can do, in order to stop the dollar from going up. But they generally have bad optics when official CPI in the United States is 8%, and Powell's trying to do his best impersonation of Volcker, where he's trying out phrases like he's willing to sacrifice almost everything else in order to get inflation back down to the target. And I think it's either going to fail, or it's going to be short-lived, because I've described it like holding a beach ball under water.
As long as we have these energy shortages throughout the world, whenever they're not aggressively holding down demand, that inflation's ready to re-emerge. So basically, I think that this is going to be an ongoing cyclical problem until you get more of a supply response. So normally, when you have high energy prices, you get a lot of new supply coming online, but that takes time. And, because it's so volatile, markets aren't sure what energy prices are going to look like in five years, for example, so they don't want to bring on these long-duration billion-dollar projects. Then, two, we've seen basically because of the ESG environment, and because of things like windfall taxes, there's a lot of lack of clarity now about forward policy around these energy sources.
I think basically, public opinion and political opinion has to change on that in order to get past this crisis, then they can revisit whatever they want to do. But I think right now, policy's getting in the way of some of this energy supply. Also, some of it's just private pools of capital saying, "We're going to devest from fossil fuel companies, we're going to devest from this". So, fossil fuel companies, like oil companies and gas companies, they're being cash-flow positive, so they're basically being very disciplined and very careful with how they manage their capital. They're saying, "Okay, we're going to be profitable. We're not going to over-drill, we don't want to make the mistake of bringing out a lot of new supply right at the top of the market", and so they're playing it very cautiously, and that's feeding into this supply limitation.
Also, you have OPEC purposely contributing to it, so it's a toxic combo that's not going to resolve itself until more energy supply comes online and is encouraged to come online, and then is able to also get to market. So, it's not just production, it's also the infrastructure, the transportation infrastructure, LNG capacity, things like that.
Peter McCormack: Did you see that the CEO of Shell came out and recently and said that energy companies should be taxed more?
Lyn Alden: I heard something along those lines, but I haven't read into it too deeply.
Peter McCormack: Yeah, it kind of blew my mind. Okay, so last thing I just want to ask you about, Luke Gromen put out a tweet and you might have seen it. He said, "In central bank circles, it's well known that world debt markets as we know them can only be maintained with cheap and cheaper oil. Without cheap oil, the entire system fails and reverts back to pay-as-you-go economies". I didn't understand it, but I felt like it's something I should, or it would be helpful to understand, and do you agree with that?
Lyn Alden: So, I do agree with him, he's a great analyst. There's a couple of ways to describe it. One is that basically, economies flourish when energy is cheap and abundant. So, that necessary input cost becomes a much smaller percentage of our disposable income, of business expenses, of all sorts of things, and that allows other things to grow better. It also allows for less inflation, therefore lower interest rates. And when you do a calculation on, say, a stock valuation, you're generally comparing it to a long-duration bond. You're saying, "I could own a ten-year treasury. What would it take me to own this stock instead?" So, if the ten-year treasury is 1%, the hurdle for owning that equity is a lot lower, meaning that you're willing to pay a lot more than if the ten-year treasury's 4%, then you're not willing to pay as much for that equity.
So, the problem is, if you have a significant repricing in bond yields, due to energy shortages and higher energy prices and higher inflation that comes with it, basically stock valuations are going to come down, and then the problem is that because systems are so financialised, for example in the United States, our stock market got up to 200% the size of GDP; and if you graph tax receipts compared to the stock market, they're very similar charts. Tax receipts stop going up and start going down even if the US stock market rolls over. It's like the tail wagging the dog.
If you include property prices, I mean different countries have different bubbles, so sometimes it's the property market and sometimes it's their stock market, and sometimes it's a little bit of both. But generally, most developed countries, they had such low interest rates and such high valuations of many of their assets, that's really not sustainable in a world of higher energy costs.
Then you have more acute problems, like if energy gets out of hand, then you have Europe start shutting down aluminium refining and other types of energy-intensive manufacturing. And then therefore, you have just less economic activity, there's less tax revenue, you already have high deficits and high debts; so now you have more sovereign bond supply coming to market, because you're filling that deficit gap.
That's when you start to enter this out-of-control inflation scenario, where central banks have to print in order to support their sovereign bond markets, despite the fact that inflation's above their targets. And so, they encountered that in the 1940s, due to populism and due to war, and now they're encountering it due to energy crises, high debts, populism, and this time it's also because of how aged the West is. So, a lot of our entitlement systems are stressed by the fact that there's a much higher share of people that are receiving benefits relative to the size of population and compared to what it looked like 20, 30, 40, 50 years ago.
So, a lot of these things just aren't solvable in a workable time horizon. So, I think it essentially ends with Money Printer Go Brrr.
Peter McCormack: Thank you so much. You honestly have a way of explaining everything so I can understand it. It's not pretty out there and it's not enjoyable, and seeing some of the things that people are going through near where I live has me concerned. But at least you've helped me understand it a bit more and I'll share this with my friends; I hope it will help them. And I will see you very soon, because I think I'm going to see you in Los Angeles, right?
Lyn Alden: Yeah, we're going to try and make it work out there, so I'll be there and you'll be there, and we'll see if we can align.
Peter McCormack: Awesome, okay. Well listen, I'm very excited about your book, I'm looking forward to seeing you in LA and thank you for doing this.
Lyn Alden: Thanks for having me. Happy to be here.
