We Live in Funny Times

“We are living in funny times. Some care, others don’t. We don’t”.

— Anonymous bartender (his response to my question about Covid restrictions)

April 10th, Plovdiv, Bulgaria.

“We are living in funny times” hits the issue on the head. It is getting more and more rare, to encounter people who mind their own business and “don’t care” how others go about their own lives. Everything has become a public spectacle.

Here is someone who does care:Chelsea Clinton @ChelseaClintonAnti-vaxx grift going strong – why is Substack facilitating science denialists’ ability to profit from destructive lies (and comfortable profiting themselves)? “Anti-vaxxers making ‘at least $2.5m’ a year from publishing on Substack” via ⁦@guardian⁩ Anti-vaxxers making ‘at least $2.5m’ a year from publishing on SubstackCenter for Countering Digital Hate research calculates that anti-vaccine figures could be making $12.5m from the online platformtheguardian.comJanuary 27th 2022396 Retweets1,232 Likes

Substack is one of the platforms which remains open for critical thought. It allows people to speak out freely, without worrying about being deplatformed at any moment, when they express an opinion that is not conform with the current public narrative. That is also the reason why I chose the platform for publishing this newsletter.

Chelsea Clinton is one of those elitist “world improvers”, who claim to be forward thinking. Born into a family right in the center of the deep state, well educated and with connections to get everything handed on a silver platter.

I am singling out Chelsea Clinton here, but there is a whole group of such people. People who love power over others and who live in their own government bubble world, totally detached from the common people on the ground — who they enjoy bossing around.

It is the same class of people who once a year meet in Davos, to discuss about the future of the economy, or take their private jets to Glasgow and decide what everyone else beside them should do, to stop the climate change.

These “world improvers” presume to know better than others what is (supposedly) good for them.

Asking my Bulgarian friend, why she thinks that life here in Bulgaria feels so comparatively relaxed and normal, her eyes light up and she explains: “Bulgarians are quite stubborn. We don’t like to be told what to do.”

I can much better connect to that attitude.

But Chelsea belongs to a totally different species. She cannot accept it, when other people think differently. She does not want to engage in open discussion. Instead, she wants to cut them off. de-platform them. Silence them.

Meanwhile, the situation in Ukraine is actually not so funny…

The war keeps going on… Putin keeps killing people… and Zelenskyy — while wearing his trademark military T-shirt keeps sending out video messages to encourage the West to send more military aid… to kill even more people…

…and the West also seems not interested to stop the war, or all the nonsensical sanctions… instead they want to add and increase their own military spending… most likely to also kill more people in the future… why else would you need more military spending!?

…the NATO is already in the progress of stationing more troops in the bordering countries.

The NATO is a funny institution by itself: It was formed after World War ll, to have a military alliance against the Soviet Union. When the Soviet Union was dissolved in 1991, the whole purpose of the NATO was basically gone.

But — as with all government institutions — they never go away. Instead, they tend to remain and grow. Too many well-payed bureaucrats, politicians and interest groups had become part of it. And therefore the NATO continued, the funding increased, new members were added and it extended its reach.

In short, the NATO would be best described as a self-licking ice cream cone.

Moreover, if you are a military alliance, that consumes a lot of money, you need to have a justification for it. And if you don’t have any enemy, you need to create one.

Looking at the NATO activity over the last three decades, that is probably the best way to describe it. Keeping hostile rhetoric against Russia… expanding eastwards by adding former Soviet Union members one by one… keep placing missile systems in reach of Russian territory… even meddling in Ukrainian elections… while at the same time TOTALLY ignoring Russia’s openly stated security concerns…

Well, Putin is probably a psychopath… and if you poke him too much, you gonna get what you are asking for at some point. A real enemy.

The way and speed, in which the narrative changed about the Ukraine is also quite amusing. Usually, in the western media, it tended to be portrayed as a poor country, with lots of crime, political instability, many human rights issues and lots of corruption. Far away from fulfilling any EU membership requirements.

Now, it suddenly has become a heroic country, fighting for freedom and democracy.

The Ukraine ranked 130th in the most recent Herritage Foundation’s freedom index. It was categorized as “Mostly Unfree”, even placed a few spots behind Russia (ranked 113th) and with a severe lack of government integrity:

The judiciary’s susceptibility to political pressure, corruption, and bribery weakens public confidence. Government integrity remains severely compromised.

Of course, it should be added to the EU and NATO as soon as possible.

Unfortunately, there are thousands of real people dying, millions of people suffering and billions of people around the world are going to feel all sorts of negative consequences from this stupid political chess game.

The silver lining of the conflict is only that Covid seems to have suddenly lost all its public interest.

Maybe we could at least give Putin the Noble Prize for Medicine!

After desperately fighting against Covid for more than 2 years, Putin seems to have defeated it single-handedly.

After ranting over the funny (and sad) world of Covid and geopolitics, lets turn to the world of finance (which is probably even more funny).

In this month’s newsletter I will cover the following topics:

• Part l: Market Analysis
  • Key Indicator Rundown
  • Macro Implications of the Russian Invasion
    • International Trade
    • The Pendulum is Swinging Back
    • Imminent Supply Chain Issues
    • Globalization is Good and Free Trade is Important
  • The Fed – Between a Rock and a Hard Place
  • The US Dollar Indicator
• Part ll: Yield Curve Invasion
  • What is a Yield Curve?
  • What is an Inverted Yield Curve?
  • Historic Importance
  • Yield Curve Control
  • How to Evaluate the Current Inversion?

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Market Analysis

Rundown

March has been another month marked by high volatility and surging commodity prices. Main concerns are the ongoing war in Ukraine, as well as surging inflation across the globe.

• The highly anticipated first rate hike since more than 3 years has finally occurred: On March 16th, the FOMC decided to kick off the tightening cycle by raising the rate 25 basis points. The new target rate is therefore 0.25% – 0.50%. The cited reasons for the hike were:
  • elevated inflation
  • strong job gains
  • falling unemployment
  It is expected that there are going to be 5-7 more hikes in 2022, which would bring the rate up to about 2% at the end of the year. This sent the yields up sharply throughout the whole bond market while the bond holders saw their prices plummet. The 10-Year Treasury Yield went as high as 2.5%, a level which it last saw in May 2019. It closed the month at 2.32%.
  Moreover, the bonds with a shorter maturity period witnessed way higher rate spikes, leading to several yield curve invasions along the maturity spectrum. This further increased worries about a potential recession on the horizon.
  (We will take a closer look at the meaning of a yield curve invasion in part ll of the newsletter).
• While the funds rate was hiked, the CPI number increased even more and therefore the gap between them keeps widening. The U.S. CPI came out at a staggering 7.9%. Biden and some analysts quickly blamed the increase on Russia’s invasion, but the vast majority of the data points were obtained prior to the invasion, hence, the huge commodity spikes that were observed since then are not even priced in yet. This means that it can be expected that we are going to see even higher inflation rates in the upcoming months.
  The Eurozone CPI had an even higher increase with the latest published rate of 7.5% . Since the publication came out late in the month (March 22nd), it already shows the impacts of the war in Ukraine: We can see that energy has been the main driver of the inflation rate:Bar Graph Source: ec.europa.eu/eurostatFurthermore, there is a wide spread between different countries, which can be mainly explained by how dependent they are on Russian energy supplies.For instance France (5.1%), which can rely to a greater extent on its nuclear energy production is far less affected than countries like Lithuania, Estonia, Latvia, Slovakia, Bulgaria and the Netherlands (15.6%, 14.8%, 11.2%, 9.5%, 10%, 11.9% respectively). These countries import a far greater amount of their energy from Russia and are therefore far more affected by the current conflict.
• Oil prices are up about 6% in February alone and a staggering 70% over the year.
• The price increase in natural gas is even more substantial with a monthly increase of 28% and a yearly increase of 124%. While it is possible to shift oil suppliers, it is far more difficult to change sources for natural gas. Oil can be globally transported on tankers while gas is mostly transported to Europe through pipelines. In order to ship gas from other sources, it first needs to be cooled down into liquefied natural gas (LNG). This process is complicated, more expensive and requires an infrastructure which first needs to be set up, requiring time and capital expenditures. Currently, a bit more than 50% of the natural gas is supplied via pipelines with a distinct geographical destination, which is the reason why the gas prices have way higher variations across different geographical areas than oil has.
• Most stock markets around the world have been rebounded a bit after a rough start in the year. The S&P 500 gained 4.58% and the MSCI ACWI was up 1.94%. After new Covid breakouts in China and the government’s response to close down Shenzhen, Shanghai and some other major cities, to maintain its “zero-Covid” policy, the leading stock index in Shanghai (SSE), as well as the Hang Seng (HSI) in Hong Kong plummeted and also pulled down the Taiwanese stock market (TAIEX). They all recovered a bit since the initial downswing, but still ended up closing out March with a decline. This lockdown is population-wise the largest so far in China and since several economically important cities are affected, it remains to be seen what ramifications it might have for the already strained global supply chains over the coming months.Chart Source: Jonas Oppermann via tradingview.com
• Due to rising stock markets, the CARPE ratio and Buffet Indicator also increased slightly, indicating a generally still overheated stock market.
• The volatility index (VIX) reached a high of 37 in early March, but has declined since then to a level in the low 20s. It seems that markets have absorbed the majority of the turbulence caused by Russia’s invasion and priced them into its future stock expectations.
• Despite all the talks and concerns about rising inflation, the validity of the USD as the world’s reserve currency and its future prospects, the dollar index keeps its upward trend at 98.31. It appears that the fear of holding other currencies is even higher. Especially interesting is that the Japanese Yen, which is usually viewed as the ultimate “currency save haven” in the investment landscape, has significantly lost value against the dollar throughout the recent turmoil:Chart Source: tradingview.comWe will take a closer look at the US Dollar as a key indicator below.
• As the freezing of Russian reserves has ignited the conversation about potential future implications, concerning countries possibilities to secure their reserves from confiscation, gold has seen a spike, crossing the $2000 mark and coming close to its 2021 all-time high. However, somewhat surprisingly it has been losing its traction and it is currently trading in the $1900 – $1950 area, closing the month at $1942.
• Bitcoin has also gotten a lot of press due to the sanctions and some comments from high-ranking Russian officials, that cryptocurrency could be among the options to facilitate international payments. So far it has been a clear winner of the war ramifications, up more than 25% since the invasion. It closed at $45,539, up 5.43% for the month.Some other noticeable news from the crypto-hemisphere:
  • The 19,000,000th Bitcoin has been mined. The total amount of bitcoin that is ever going to be mined is 21 million. This means, there are now less than 10% of the total supply outstanding, which yet have to be mined in the future (until roughly 2140).
    Chart Source: glassnode
  • Withstanding the fact that the price is still more than 33% below its ATH and the difficulties that miners in Russia and Ukraine are currently facing, another new record in the hash-rate was reached. While it becomes more and more obvious, how fractured and insecure our current financial systems are, the Bitcoin networks is more secure than ever before and gets more robust with every blog added — on average every 10 minutes.
  • The largest DeFi Hack occurred on march 23rd. Roughly $625 (in the form of 173,600 ether and 25.5 million USDC) were stolen from the Ronin Network, an Ethereum side-chain. The hackers managed to get access to enough private keys to withdraw from the multisig contracts and it was only discovered 6 days later, when users were unable to withdraw their ether. It highlights the fragility that still underlies such smart contract solutions due to their complexity and strengthens the argument for the use of second layer solutions, based on a resilient blockchain with a narrow use case, like Bitcoin.
  • The Bitcoin Conference in Miami kicks off this month and it is going to be the largest Bitcoin conference so far. There are numerous prominent personalities lined up as speakers and some have made claims of announcing some groundbreaking news. This conference has become famous for breaking some crucial news over the years. In last year’s conference for instance, president Bukele announced that El Salvador would make Bitcoin legal tender. Thus, we can anticipate some interesting revelations.
  • Another groundbreaking announcement has come from the Luna Foundation Guard (LFG). The foundation is implementing the algorithmic stablecoin TerraUSD (known as UST), which currently sits at more than $15 billion in market cap. Terra is described as “a public blockchain protocol deploying a suite of algorithmic decentralized stablecoins which underpin a thriving ecosystem that brings DeFi to the masses”. There are now a whole bunch of stablecoins out there. The ones which currently have the widest range of use are regulated stablecoins, who are pegged to the dollar and mostly also backed by the dollar and/or commodities, such as Tether, USDC, and BinanceUSD. The problem with these stablecoins is, that the underlying assets are held by banks and therefore bear the risk of potentially being confiscated. Terra is currently the 4th largest stablecoin and its founder Do Kwon has announced the plan to back it in the future by a basket of other crypto-assets, primarily bitcoin. Consequently, over the last days the Luna foundation has started buying huge amounts of bitcoin on a daily basis, already holding more than $1.5 billion worth of bitcoin. The transparency in the Bitcoin blockchain allows for tracking and monitoring the amount of bitcoin which is purchased by the foundation:Chart Source: bitinfocharts.com
  • Except for Microstrategy and Tesla, LFG has already acquired a higher bitcoin stack than any other publicly-listed company. Further, according to Do Kwon, Bitcoin is the “most pristine” collateral asset and with the declared goal of keeping acquiring another $1.5 billion with current reserves, this would amount to a total of about $3 billion in total (at the current BTC price). Additionally, it is planned to obtain another $7 billion in bitcoin through users wanting to get access to UST. This would promise the possibility of a stablecoin that is truly decentralized. While offering the benefit of low volatility and commercial usability, just as any other USD stablecoin, it would not rely on the granted permission by central authorities. In other words, this might be an enormous step in the direction of a more free financial system. The world is taking step after step, to slowly but surely realize the value that bitcoin offers. It is the most pristine monetary asset the world has ever seen.

Macro Implications of the Russian Invasion

“From now and so on Lithuania won’t be consuming a cubic cm of toxic Russian gas”

— Ingrida Šimonyte (Prime Minister of Lithuania)

And:

“If we can do it, the rest of Europe can do it too”

— Gitanas Nauseda (President of Lithuania)

Given these statements, it comes as no surprise that Lithuania is the European country that currently experiences the highest rate of inflation. It is also the same country that recently stressed its trading relationship with China by setting up a Taiwanese embassy under the name “Taiwan Representative Office” (bearing the name “Taiwan”, instead of “Chinese Taipei”), and the same president that later officially regretted this move, since the economic retaliations have real-life consequences for Lithuanian people and companies.

Unfortunately, private Lithuanian people don’t have a say in stupid political delusions — but they do have to pay the price for it: As of March 2022, a staggering 15.6% inflation.

International Trade

This case is just a snapshot out of a broader and more fundamental global macroeconomic development that seems to be gaining steam.

The chart shows the amount of GDP attributed to international trade. Current developments and narratives around the world seem to indicate that we might have peaked back in 2000 and are now headed towards a global environment that is more focused on nationalism, security and self-reliance, instead of openness, free trade and globalization.

When I started to learn and study about economics, I developed a huge interest in international trade. I found it fascinating, how people across the globe can — mostly unknowingly — be connected together through the production of goods and services that each of us desires, in the most efficient way. The result of this, so termed globalization, is to raise the standard of living across the whole world.

Especially after the fall of the Soviet Union and the opening up of China, the whole world has experienced 2 decades of unprecedented globalization (as can be clearly seen from the steep increase of the red line in the above chart). Within a rather short time, a massive amount of previously untapped labor, started to participate in the global market, leading to a vastly interconnected global market.

This enormous burst in global trade, efficiency and cooperation, was mainly manifested in:

• Offshoring: Taking advantage of comparative advantage by shifting production facilities to places that are cheaper and provide better suited environments.
• Outsourcing: Allowing companies to implement a more distributed and cooperative production process and thereby increasing the production quality, while also lowering costs.
• The “Just-in-time” manufacturing concept, developed in Japan, was increasingly implemented across the world, allowing processes to become more efficient.
• In general, the lowering of trade barriers allowed for a more advanced division of labor, which in turn, led to the build-up of sophisticated supply chains, that are capable of achieving crucial qualitative progresses and technological advancements.
• All of the above points enhanced the standard of living enormously. Hence, there was also a striking decline of extreme poverty — especially in those countries that opened up to take part in international trade.
  Chart Source: ourworldindata.org(Note: For instance most African countries still implement comparatively high barriers of trade and have not yet largely implemented policies promoting free trade. Hence, they have not been able to reap the same benefits as large parts of Asia did).
• Moreover, one tremendously important side-effect of globalization — often not sufficiently emphasized — is peace. Countries tend to be far less likely to engage in war with trading partners. Thus, it is no accident that we have witnessed a relatively peaceful area over the past decades.

After the 2008 financial crises, this trend has started to stagnate and various opinions against globalization have become louder over the last decade.

Critics of globalization mainly condemn the fact that there are also victims of this process and that globalization might also include the exploitation of people.
I personally believe that most critics, due to a lack of economic comprehension, don’t really grasp the full scope of what’s happening — and more importantly, what the “anti-globalization” consequences would pertain — but nonetheless, the critics of globalization have been on the rise.

Another ‘negative’ aspect of globalization, that actually does have real credibility, is how dependent we have become on a flawlessly working global supply chain. I put ‘negative’ in apostrophes, because it is not necessarily a serious problem: In a fully free market, this problem doesn’t arise. Regional bottlenecks and problems will be solved by entrepreneurs shifting the process and adapting the supply chain in order to satisfy the demands of their customers. However, this beautiful free market process requires freedom and it gets salvaged, when the state enters the picture. Politicians are not held accountable by market forces and customer demands, instead they strive to gain votes and power.

And this is the problem we are facing now. It significantly started throughout the Covid pandemic, with governments implementing wrong-headed interventions in the economy and the global supply chains.

The Pendulum is Swinging Back

Given the character of the global economy as we have established so far, it follows that if the free market is not allowed to function properly, then countries are required to increase their self-sustainability. And this is what we are witnessing now.

It now seems likely that the world economy really will split into blocs, each attempting to insulate itself from and then diminish the influence of the other. With less economic interconnectedness, the world will see lower trend growth and less innovation. Domestic incumbent companies and industries will have more power to demand special protections. Altogether, the real returns on investments made by households and corporations will go down.

— Economist Adam Posen (President of the Peterson Institute)

With Russia’s invasion of the Ukraine and most of the world taking part in the conflict by economic sanctions, the pendulum now finally seems to have reversed and swing back from Globalization towards Nationalism.

BlackRock CEO Larry Fink puts it as follows:

The Russian invasion of Ukraine has put an end to the globalization we have experienced over the last three decades. We had already seen connectivity between nations, companies and even people strained by two years of the pandemic. It has left many communities and people feeling isolated and looking inward. I believe this has exacerbated the polarization and extremist behavior we are seeing across society today.

And here is Atlanta Fed President Raphael Bostic:

The tragic war in eastern Europe will further momentum toward reorienting production and supply networks away from pure cost minimization and toward resilience and risk tolerance. Supply chain disruptions [also] caused by the coronavirus pandemic prompted business leaders to start diversifying supplier locations and firms, increasing inventories, and bringing production closer to final markets to maximize reliability. Think of it as a shift to just-in-case inventories from just-in-time.

I think that many people have a hard time comprehending, what ramifications such a development will have on the way we have become used to living.

On the surface, it sounds good to be more self-sufficient and not to rely on complex supply chains and good relations with other countries, which might not always behave the way we would like to. Isn’t it better to be able to build domestic supply chains, maybe with some close allies, to produce everything that is essential by ourselves?

Probably there are a lot of people who have such a vision.

The first question would be: What is essential? Already regarding this question, there will be a huge problem. Imagine the opinion division and chaos, that would transpire, when a government directed economy tries to find the right answer to this, seemingly simple, question.

The next question would be, whether we would also be willing to bear the consequences of the resulting decisions?

Is it okay for us to reduce our standard of living to a large extent?

Because gaining self-reliability necessarily comes with some trade-offs. One of them is the market efficiency through the division of labor. As bad as the connotation of ‘market efficiency’ has become, it is what helps us to make progress and improve our standard of living.

The question is, how far will the public acceptance and political implementation of this trend go?

Another question will be, whether all countries will be taking this road, or will it just be one puzzle piece of the changing world order?

My takeaways from studying economic theory and history are, that free trade is the paramount source of prosperity. Furthermore, spending tons of time thinking about these issues, lead me to predict, that those countries who resist the trend of closing down and instead stay open and collaborative, abstain from military entanglements and engage in trade, will be the winners of the coming years. They will be making progress and improving the standard of living of their population.

Imminent Supply Chain Issues

If we look at the current situation with the war in Ukraine, the first aspect that becomes obvious, is how dependent the world is on Russian energy.

Here is a chart that shows how much some countries rely on importing Russian oil:

It instantly becomes obvious, that many countries source a substantial amount of their oil from Russia — some countries import 100%. In addition, it also becomes obvious that besides some countries, which are political allies to Russia, especially European countries, are the main buyers of Russian oil.

When it comes to natural gas, it is a similar picture.

In recent years, Europe has put a huge emphasis on becoming less dependent on fossil energy. Especially Germany stands out in this quest. I talked extensively about Germany’s disastrous energy policy in the January issue, since it is a perfect case study of how central planning leads to disaster. Essentially, through “Green ideology” over the last decades, Europe has increasingly made itself more and more dependent on the Russian energy supply.

Michael Schellenberger has outlined this political dilemma in a recent article, which was brought to my attention in Howard Marks’ most recent Memo. (BTW, I highly recommend subscribing to his Memos, they are always a treasure source of logical economic analysis).

How is it possible that European countries, Germany especially, allowed themselves to become so dependent on an authoritarian country over the 30 years since the end of the Cold War? 

Here’s how: These countries are in the grips of a delusional ideology that makes them incapable of understanding the hard realities of energy production. Green ideology insists we don’t need nuclear and that we don’t need fracking. It insists that it’s just a matter of will and money to switch to all-renewables—and fast. It insists that we need“degrowth” of the economy, and that we face looming human “extinction.”

[…]

it was the West’s focus on healing the planet with “soft energy” renewables, and moving away from natural gas and nuclear, that allowed Putin to gain a stranglehold over Europe’s energy supply. 

As the West fell into a hypnotic trance about healing its relationship with nature, averting climate apocalypse and worshiping a teenager named Greta, Vladimir Putin made his moves.

While he expanded nuclear energy at home so Russia could export its precious oil and gas to Europe, Western governments spent their time and energy obsessing over “carbon footprints,” a term created by an advertising firm working for British Petroleum. They banned plastic straws because of a 9-year-old Canadian child’s science homework. They paid for hours of “climate anxiety” therapy. 

While Putin expanded Russia’s oil production, expanded natural gas production, and then doubled nuclear energy production to allow more exports of its precious gas, Europe, led by Germany, shut down its nuclear power plants, closed gas fields, and refused to develop more through advanced methods like fracking. 

The numbers tell the story best. In 2016, 30 percent of the natural gas consumed by the European Union came from Russia. In 2018, that figure jumped to 40 percent. By 2020, it was nearly 44 percent, and by early 2021, it was nearly 47 percent. 

Quite true unfortunately. Now Europeans have to deal with the consequences.

Howard Marks put the numbers on a table:

Europeans are now realizing it the hard way, that their dream of green energy might be farther away as they thought. If they want it or not, they are still painfully dependent on fossil energy.

Over the last weeks, we have seen European politicians going to find new potential energy sources (mostly in countries which are usually also criticized by the same politicians for their human rights issues).

And Germany is not only running its lignite coal plants at full power, it is now even in the process of extending these operations (lignite coal is environmentally the most harmful energy source).

Another crucial supply chain issue, that will probably show off a bit later, is the situation with food. Not only are Russia and Ukraine important suppliers of wheat and other agricultural products, but they also produce some crucial goods at higher production stages. Furthermore, there was already a substantial shortage of fertilizer before the war even started. These shortages have already led to massive price increases in various food commodities.

Once more, the problem is, that in a complex supply chain, things are interrelated. A shortage in input “A” leads to a shortage in input “B”, which prevents the production of input “C”, which is required for the production of “D”, “E” and “F”. And so forth.

Additional restrictions on the economy, imposed through, war, sanctions, Covid-lockdowns, export restrictions etc., will exacerbate the magnitude of the supply chain shortages.

In a financial crash, the correlation between all asset classes converges to one. The coming crash in global food supply will be driven by a similar phenomenon across virtually every input into farming – they are all spiking to historic highs simultaneously, supply availability is diminishing across the spectrum, and the time to reverse the worst of the upcoming consequences is rapidly running short.

— Doomberg

We have seen massive asset price increases for quite some time. General inflation is a more recent appearance. The spike in energy prices is the current inflation story. The next might be food.

Food is the most substantial good for human survival and a substantive price increase would affect the ones who are already in a bad economic situation the most. If people have difficulties buying food, they might turn to radical measures, populism and violence.

Globalization is Good and Free Trade is Important

I think that most people take the standard of living that we have achieved in the developed world to some extent for granted. Therefore, they are more eager to support policies which correspond with their ideologies and are not aware of how such policies might be threatening our economic well-being in the long run. Most people don’t realize that without globalization, we would be far poorer than we are today and our lives would look very different.

All interventions in the global economy, such as stimulus-packages, import-quotas, export-restrictions, tariffs and sanctions, might have unexpected and possibly detrimental consequences.

I will close this section with a quote that I believe is very crucial, when thinking about the macroeconomic landscape:

When goods don’t cross borders, soldiers will.

— Frédéric Bastiat

This quote, generally attributed to the French liberal economist Frédéric Bastiat, should make us very cautious, about whether we want to embark on the current route.

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The Fed – Between a Rock and a Hard Place

It starts getting interesting…

…difficult… sad… impossible… funny… I don’t even know, how to adequately term the position, that the Fed has maneuvered itself into, over the last decades.

What I know for sure, I definitely don’t want to be Jerome Powell. And if I were… I would immediately resign. Seriously.

He is talking though. He is trying his best to sound hawkish and represent a picture of someone in control and determined to fight inflation.

Last month, the Federal Reserve has finally started its tightening cycle, by raising the federal funds rate by 25 basis points.

The below chart shows, that the real rate (adjusted by CPI) is in a record negative area anyway. And that is based on the reported CPI rate. There are numerous reasons to believe, that the real picture is even worse.

To really get ahead of the inflation curve would require a far more substantial rate hike. The general consensus is, that the Fed will try to counter the inflation by 5-7 25bp rate hikes, maybe also some 50bp hikes.

Taking into consideration everything else going on, it is likely that the effective rate will continue to decline even more in the coming months, as the ramifications of the war in Ukraine and all the sanctions, as well as China’s lockdowns are making their impact on the inflation numbers. Hence, the Fed will likely be falling further behind the curve.

25 basis points each meeting… maybe 50 basis points… who are they kidding?

If the Fed would seriously intent to fight inflation, my estimate is that this would require a rate hike of 1000bp. Yes, the third zero is not a typo. I think raising the Federal Funds Rate to 10+% would be the required rate to seriously get control of the inflation — similar to Paul Volcker’s move in the early 80s:

It is quite obvious, that this is impossible. The U.S. government has now more than $30 trillion in debt. At 10%, it would theoretically (of course not immediately, but over time) have to pay $3 trillion in interest alone. That’s almost all of the money currently collected by taxes.

Furthermore, the stock market would crash immediately, alongside the overall economy with most indebted companies unable to refinance and thus going bankrupt. The ensuing spiraling effects would quickly bring most other companies into dire conditions too, leading to rapidly decreasing taxable income. And at that point, the U.S government wouldn’t even have paid any of its other liabilities and promises. Game over.

To me, it is quite clear that the Fed will not go that path. At some point they will step back from “fighting inflation” and pivot right back into quantitative easing — with massive QE numbers. Numbers that will let the Covid responses seem insignificant.

Therefore, I am quite confident that inflation will stay with us for the foreseeable future, and if things get totally out of hand, even a hyperinflation is something that is a possibility. But I think that the most likely scenario is just continuous high inflation for the coming decade. That is my base case outlook.

Another point is the talk about shrinking the Fed’s balance sheet. According to Federal Reserve Governor Lael Brainard, the Fed will be starting to reduce the balance sheet at a “rapid pace” in the beginning of May. Apparently, it is the plan to decrease it by not refinancing maturing bonds and thereby decreasing the assets at a rate of $95 billions a month. The number alone is an indication for me that they are very afraid of the market reaction of decreasing its purchases. It seems to be more about the narrative than the actual willingness behind it. Otherwise, why not a $100 billion? $95 billion is like a salesman trying to make the price appear as low as possible.

Moreover, at a “rapid pace”… with a rate of $95 billion per month, it would take more than 4 years to unwind the balance sheet back to the pre-covid level. What an incredibly rapid speed.

So far, the Fed has not even accomplished to keep the balance sheet net neutral for a month. In March it still increased by about $33 billion.

When the Fed doesn’t roll over its Treasuries, it means that other buyers must step in and purchase them. But given the current inflation, who would buy them at current rates? Especially now, when the U.S. government has made it obvious that it might confiscate these assets at any time. It would seem that the appetite for these Treasuries by other nations (especially those creditor nations that have been largely buying them, such as China), has significantly decreased.

I think that if the Fed actually starts to pursue this policy, rates will shoot up massively. In the beginning of April, we can already see some forewarning of what might be on the horizon. The bond market is already a bloodbath:Jim Bianco biancoresearch.eth @biancoresearch2/4 How extraordinary? The chart is the total return of the 2-yr note. So, the current 2-yr note and rolling at the new auction. Shown is YTD returns. Blue is 2022. Green is the best yr (1982), Red is the worst yr (2021). The thin gray lines are all the other yrs back to 1981. April 9th 202216 Retweets162 Likes

I focused the analysis here on the Fed, but the situation in Europe is quite similar. The EZB is likely to generally follow whatever policy the Fed implements.

The US Dollar Indicator

The U.S. dollar index (DXY) was established in 1973, after the U.S. had left the gold standard and after the termination of the Bretton Woods Agreement. Previously, the value of the dollar was measured in (and backed by) gold. At least on paper.

Technically, the index measures the value of the U.S. dollar compared to a basket of other currencies. Currently, it includes 6 other currencies, out of which the Euro has, by far, the largest weight:

The objective of the index is to show the strength of the dollar compared to the main trading partners of the U.S. The index has only been updated once, in 1999, when the Euro replaced a couple of previously included European currencies. Arguably, considering its objective, it would make sense to include other currencies, such as the Chinese Yuan and Mexican Peso, since they have become far more important trading partners of the U.S. over the years.

Here is a chart of the index:

In the beginning, it was set at a base value of 100. Since then, it has shown many movements in both directions. It will rise, when the USD strengthens in comparison to other currencies and it will fall, when the USD loses value. For instance, if the index goes from 100 to 90, it means that the USD has lost 10% of purchasing power in comparison. Currently, amidst all the inflation news and worries about the overheated American economy, we have seen the dollar strengthening in comparison to the currencies it is measured against, reaching the original parity level of 100 just a few days ago.

In recent years, there has been a lot of talking about trade wars and countries manipulating their currencies. I will not get into that here, but basically all countries have been in a quest to devalue their currencies, to boost their exports, which is part of the story that has led to the current inflation levels.

Generally speaking, a weak currency benefits the exporting companies and a strong currency benefits importers and consumers. Hence, if the DXY goes up against the Euro, it means that Europeans will find it more expensive to go on vacation in the U.S., while BMW will likely sell more cars to American customers.

So, why look at the USD as a key economic indicator?

• It provides a general idea about the state of the U.S. economy.
• Commodities are mainly priced in USD.
• It is the most used fiat currency for international transactions:Bar Chart Source: statista.com
• It is also considered a safe haven, hence a rise in the USD indicates more uncertainty and risk awareness in the global economy.
• On the other hand, when the global economy is doing well, investors generally tend to feel more comfortable to invest in more risky currencies.
• The most important point is, that the USD is still considered to be the reserve currency. Therefore, it is the most held reserve currency by central banks.

The last point is crucial to comprehend. A falling USD does not only mean that American products become cheaper in comparison, it also means that most of the assets held my central banks loose in value. And these assets have increased massively over the past 20 years:

This chart — courtesy to sucher.eth — shows the massive increase of global reserves throughout the last two decades. And the elephant’s share of this amount is denominated in USD.

Excluding gold, there are roughly $12 trillion of global reserves held by sovereigns, about 59% of these reserves are claims in USD.

The US Dollar Index can also be traded using futures and options. For example, to bet against the USD, or as a hedge instrument against betting on more risky currencies.

Finally, who wants to guess what the following chart shows?

It is the 10-year chart showing the ‘strength’ of the USD, as measured against the most probabilistic future reserve currency — Bitcoin.

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Yield Curve Inversion

Throughout the last days there has been a lot of commenting and discussion about the yield curve inversion. Hence, I think this is a good time to take a dive into this topic.

In the February newsletter, I wrote about the importance of the interest rate. The yield curve is an associated subject. For everyone who isn’t familiar with the concept of the interest rate and what implication it has on the economy, I recommend to read up on it first.

What is a Yield Curve?

The concept of a yield curve is actually quite straight forward. The time value of money tells us that, all things being equal, a sum of money in the present is more valuable as the same amount of money in the future. Why? Simply because the future always entails some uncertainty.

Accordingly, to account for this uncertainty, there is an interest rate attached to the money that is lent out.

It should also be obvious, that the longer the lending period is, the higher is also the uncertainty of whether the lender will be able to pay back the principal. Hence, it follows that the longer the lending period is, the higher is also the interest rate that should be required to compensate the lender for the risk.

In addition, investors are also faced with evaluating the credibility of the bond issuer, as well as the general market environment and other investment opportunities.

Consequently, there are three factors that determine the interest rate:

1. The market environment:
   → High inflation (or future inflation expectations) require higher compensation.
   → The availability of attractive investment alternatives will push the rate up.
2. The risk of default by the lender:
   → A ‘B’ rated (junk) bond should pay a higher yield than a ‘Triple-A’ bond.
3. The duration:
   → A 10-year bond should generally pay a higher yield than a 1-year bond.

The yield curve depicts the interest rate of bonds at different lengths to maturity:

The longer the duration of a bond is, the more vulnerable it is to inflation, changing rates, or default. A normal — or natural — interest rate should therefore be upward sloping. Further, the mostly watched yield curve is the one of the U.S. Treasuries. These are perceived as the least risky bonds, with the highest market capitalization and offering the highest liquidity. Therefore, the yield curve of them is viewed as peculiarly important for gauging general future economic developments.

Note also, that it is usually a concave sloped curve. This can be attributed to the fact that the farther away the maturity date is, the less variation is in the uncertainty of final redemption. Phrased differently, if you trust someone to be able to pay you back in 5 years, you are likely to also trust that person to be able to pay you back in 10 years.

What is an Inverted Yield Curve?

If the interest rate between a bond with short duration and a bond with long duration, from the same institution, is very different, then the yield curve has a rather steep slope. On the other hand, when the spread between the rates of different maturity (duration) narrows, analysts will say that the yield curve is flattening. The shape of the curve will tend to look horizontal:

This might be interpreted as a warning sign, since this trend might lead to the inversion of the yield curve.

Thinking about the concept of the yield curve as we have examined so far, theoretically it doesn’t make any sense for a yield curve to invert. Why would someone assign a lower risk premium to a bond that has a longer maturity. And nonetheless, although not often, it occasionally happens. And generally it is not good news for the underlying economy.

The emergence of an inverted yield curve can be graphically displayed, when the curve becomes downward sloping:

To get a more practical idea about what the current talk is all about, let’s take a look at the Treasury yields over the past view trading days:

I highlighted the 2-year and the 10-year Treasuries, because these are the two yields that most focus is on, when it comes to the yield curve invasion. As you can see on Friday, April 1st, as well as the following Monday, the 2-year Treasury had a higher yield than the 10-year Treasury. (Actually, the inversion first happened a few days earlier).

When you look at the numbers more closely, you can actually see that all sorts of funny things are going on all over the spectrum between the 2-year Treasury yield and the 30-year Treasury yield.

Putting these numbers in a chart shows the following yield curves:

We are back in the funny world of finance.

The curve definitely does not look like it is supposed to. It actually looks quite funny. Swinging up and down in waves.

You get a higher 7-year yield, a lower 10-year yield, then an even higher 20-year yield, followed by an even lower 30-year yield… It’s a roller coaster ride.

The chart also shows how the yield curve has changed over the past trading days. We can see, that the longer duration Treasuries have slightly adjusted upward, mitigating the inversions throughout the curve a little.

One explanation is, that the market has just been taken aback and is confused about the Fed’s recent move. They are still grappling with the implications of what is going to be unfolding in the coming months. Thus, it might take a few days until there is some consensus among Treasury buyers and sellers, which will resolve the confusions and at some point settle in a normal sloping yield curve.

Another possible explanation would be the following market sentiment:

• there is little or no default risk.
• but current inflation is super high and therefore lenders request a high rate, to compensate for it in the short term.
• However, the Fed might get inflation back under control within the next months, causing rates to fall again. Hence, locking in the higher rates now.
• (Or alternatively: a recession is on the horizon and the Fed will be forced to push the rates lower again.)
• After that, the inflation will remain super low, justifying a 2-3 yield for a 10-30 year time frame.

Additionally, there are of course also many investors who invest in long-term bonds without any objective to hold on to them until they mature. They might simply bet that the rates will be pushed down again soon, so they can sell at a higher price.

Whatever, is going on in the current bond market, we are living in funny times.

Historic Importance

Here is a chart of the 10-year minus 2-year Treasury yield:

This is the mostly watched yield comparison and as can be seen in the chart, the inversion of the curve over the past 50 years, has always been followed by a recession (recessions are indicated in grey).

As you can also see in the chart, the previous 6 recessions always occurred a few months after the yield curve inverted, mostly 1-2 years later, when the yield curve was already out of the inverted area.

The following bar chart shows the amount of months between the inversion date and when the recession started (the average is 20 months):

An explanation for this phenomenon is the working of the banking sector. Banks usually make most of their money by borrowing at short-term interest rates (when customers make deposits and put money in their checking accounts). Then, they lend them out at higher (usually long-term) rates, for instance, to finance corporate loans, mortgages, auto loans, credit cards, student loans and so forth.

If the yield curve inverts, this has significant impacts on these banking operations and banks will be more reluctant, to facilitate loans. The reduction in lending activities causes a slow down in economic activity, which in turn might result in a recession a few months down the road.

While it has been a perfect indicator over the past 50 years, it is of course not a certainty, to necessarily have a recession, following an invasion.

Moreover, it also needs to be noted, that this especially applies to the U.S. economy. Other countries might have had yield curve inversions throughout this time-frame, without necessarily experiencing recessions in the following years.

Yield Curve Control

Yield curve control is, when a central bank intervenes in the sovereign bond market, by precisely capping interest rates at certain target thresholds along the yield curve. If the market does not provide the necessary willingness to buy enough bonds, the central bank will step in and buy whatever amount is required to keep the rate at the desired yield.

Japan has been embarking on controlling its yield curve for years. Back in 2016, they started by capping the interest of the 10-year government bond at 0.25% (bonds with shorter duration have been trading in negative territory for years).

In recent years, the idea of pegging rates along the yield curve and thereby providing more security to potential bond investors, has frequently been introduced. Proponents of yield curve control are usually pointing to Japan, as the success story of such a policy. But there are certain risks that go along with such policies. The WSJ is on the topic:

Japan is presented as a success story for this price control on capital. Introducing the rate target allowed the central bank to scale back the mammoth bond purchases that marked earlier bouts of quantitative easing. The BOJ now maintains ultralow rates without having to intervene in the market on an ongoing basis.

But that is true until the moment it isn’t—at which point the central bank gets dragged into potentially limitless bond purchases. Australia’s central bank last year abandoned its pandemic-era experiment with yield-curve control when investors began to test the peg. Reserve Bank of Australia Governor Philip Lowe admitted the RBA might have had to buy the entire float of some government bond issues to maintain its rate cap. The BOJ avoided this fate this week, but one day it might not.

And…

Another major unknown is the yen exchange rate. It’s hard to predict how the rate might shift if Japan continues with looser monetary policies when other major economies tighten. It’s much harder than it used to be to guess if a stronger or weaker yen will be good or bad for businesses and consumers.

We have recently seen that the yen, which is usually regarded as the ultimate save haven currency, has significantly weakened against other currencies throughout recent turmoils (As can be seen in the chart, I put in the Key-Indicator Rundown section).

In essence, what the Fed and ECB have been doing is not too much different. They have also stepped in, buying enormous amounts of sovereign bonds, mortgages and even private debt in some instances, in order to support the bond market.

Doing an outright yield curve control is just one step further down the path of central bank intervention and the debt monetization.

I think that we might see this topic coming up more often, as the long-term bond yields keep trending higher. The causation could be that a) foreign countries are incentivized to divert their reserve assets and b) more and more institutional investors (big pension funds, mutual funds, insurance companies etc.), who have been the domestic bolster support of the bond market so far, realize that they are the ones in the slaughter house of an unsolvable debt situation and start to increasingly divest their funding and put it in other assets.

If that happens, the outcome might not be as rosy, as it has been for Japan so far. As stated before, no matter what the Fed does in the short term “to fight inflation”, I see huge and aggressive debt monetization on the long term horizon.

How to Evaluate the Current Inversion?

As I tried to emphasize in the February newsletter, interest rates are tremendously important for the economy as a whole and it therefore also affects everyone of us. Our time preferences and decision making is tightly related to the economy, which each of us faces in our daily life.

The circumstance that the yield curve has partially inverted and is, in general, far flatter than it has been in previous years, provides investors with some insights of where we are in the business cycle.

In the later stages of the business cycle, with high inflation, a quickly rising public debt burden, a war in Ukraine and a yield curve that hints at the possibility of a recession on the horizon, requires investors to be cautious.

It is not sure whether we are about to enter a recession, but given everything going on, I definitely wouldn’t bet against it.

I think that a conservative approach and a well diversified portfolio position, with focus on assets that cannot be diluted — such as bitcoin, gold, commodities, real estate and some diversified value stocks — should be in a good position, to do well in either case.

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Best regards,

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Disclaimer: The content of this newsletter is for informational and educational purposes only. It contains my personal views and opinions, which are not to be taken as direct investment advise. All investments have risks and you should do your own due diligence before making any investment decision. If you require individualized advice, to review your unique situation and make a tailored advice for you, then contact a certified financial planner or other dedicated professionals.