Bob Elliott: The Case for The Contra Currency
Bob Elliott of Unlimited Funds joins the podcast to talk about why gold can be better than bonds, why the economy hasn’t hit a recession yet, and what it’ll take to make asset prices fall. Bob and Keith discuss central bank gold leasing vs. true gold leasing, the junk bond conundrum, and more!
Additional Resources
Bob’s Twitter
GiveWell
UnlimitedFunds
The Case for Gold Yield in an Investment Portfolio
Keith’s R>I Theory
True Gold Leases
Keith’s World Travel
Invest in Gold Better Than Ray Dalio
Podcast Chapters
[00:00:07]: Subscribe!
[00:00:18]: Bob Elliott
[00:01:03]: Passion for systematic strategies
[00:02:08]: GiveWell
[00:04:06]: The role of gold as a financial asset
[00:06:33]: The contra-currency
[00:09:01]: Global view of gold
[00:10:03]: Why we overlook gold
[00:12:36]: The benefits of including gold in a portfolio
[00:14:03]: Gold outperforming bonds
[00:16:38]: The absence of financial incentives to promote gold
[00:17:46]: The potential for gold to earn interest
[00:18:56]: Government vs. private gold leasing
[00:23:09]: The unpredictability of rates
[00:25:40]: The slow-motion impact
[00:26:04]: The Lag
[00:28:25]: Delaying higher interest rates
[00:33:59]: The Asset Price Problem
[00:37:43]: Yield Curve Implications
[00:44:14]: Challenging the Mild Recession
[00:48:08]: The Compliance Mentality
[00:52:20]: The Unseen
[00:55:26]: Diversifying assets
[00:56:43]: Bob’s Question
[00:57:15]: Find Bob!
[00:58:16]: Monetary Metals
Transcript:
Benjamin Nadelstein:
Welcome back to The Gold Exchange Podcast. My name is Benjamin Vern Nadelstein. I’m joined, as always, by founder and CEO of Monetary Metals, Keith Weiner. Our special guest today, Bob Elliott. Bob is the co-founder, CEO and CIO at Unlimited Funds. Bob, how are you doing today?
Bob Elliott:
Good, thanks for having me.
Benjamin Nadelstein:
Bob, super excited to have you. Could you please just quickly share your background for anyone who might not know you or not follow your just awesome, awesome Twitter account.
Bob Elliott:
Well, thank you. I appreciate that. My career has really been almost 20 years as a systematic investor. I spent almost 15 years at Bridgewater Associates, which is the world’s largest hedge fund developing systematic investment strategies from a global macro perspective across all the major asset classes. And then after I left Bridgewater, I had a quick stint running a systematic venture capital firm, which used big data to find interesting opportunities. Then I’m back into the public markets with what I’m doing now at Unlimited, which is really about bringing hedge fund replication approaches and getting those into an ETF structure so that the everyday investor has access to the same sophisticated investment strategies that big institutional investors have.
Benjamin Nadelstein:
Bob, you did not mention something called GiveWell. I’m going to give you a little bit of time to talk about that. And maybe is there a connection between GiveWell and Unlimited if any of the ideas have swapped over?
Bob Elliott:
Yeah, during my time at Bridgewater, I also was involved in getting the charity evaluator GiveWell set up, its initial form, as well as serving as the chairman of the board as it became, went from a group of friends trying to figure out how to do charitable giving more effectively to a more institutionalized organization. Today it’s amazing. I think in the last year it’s allocated almost a billion dollars have gone through give well oriented or directed charitable giving, which is incredible. The core idea there is there’s a lot of evaluators for charities, although most of those evaluators do it based upon how exactly the money is spent, not whether or not it works. And GiveWell is really focused on how do you make the greatest impact for every dollar that you’re giving. And the result is that some interventions that you might not come to mind as the top things on your mind, like rehydration salts or malaria bed nets are highly cost effective, make huge impacts on people’s lives in a way that wouldn’t necessarily be at the top of your mind, but if you’re looking for the most impact per dollar spent, that’s really the way to do it.
How does that connect to Unlimited? More generally, it just connects to this idea of across a whole bunch of different avenues, my passion for how do you use quantitative decision making to make decisions better. It’s equally applicable that philosophies is equally applicable in investment management or hedge fund replication or charitable giving. They’re all different cases where your decision making can be improved through systematic strategies.
Benjamin Nadelstein:
Okay, so Bob, I want to start our first big picture here talking about gold. A lot of people obviously know monetary metals, what we do with gold. But before we get to any of the extra stuff, just talk about when did you first hear about gold as an asset and when did you really start to take it seriously as, Oh, whoa, this is not just a shiny pet rock?
Bob Elliott:
Gold is a financial asset, I think. I try to feel like it’s been really at the foundation of any investor who comes to the markets or strategic investing from a macro perspective. And the reason why that is is gold has a unique role as a financial asset in the macroeconomic system, as a contra-currency, and as essentially a hedge to inflation. A hedge to inflation. So the way you can really think about gold from a macro perspective is gold is typically non-interest-bearing money. And as a result, you can really think about it two different ways. It’s non-interest-bearing money that cannot be devalued in any meaningful way. And so the way that you think about that is gold often trades, spot gold often trades to the high side as interest rates fall and to the low side as interest rates rise on paper money. And the reason why that is is because as paper money gets more yield, gold looks incrementally less attractive. And as paper money gets less yield, gold looks incrementally more attractive. And then the other way to think about it is as a counter currency, particularly as a storehold of real wealth. And so as a result, many of the ways to think about it is in cases where there are meaningful inflationary pressures, particularly at tailed outcomes.
Not really like if inflation goes from 2-3 %, no one really cares, but as you start to get to more tailed outcomes, tailed risks, gold starts to trade very effectively as a contracurrentcy and a reflection of elevated inflation expectations. And so, for instance, if you’re an environment where there might be a meaningful currency depreciation, a typical emerging market, a balance of payment shock. Those are areas where gold can meaningfully serve as a storehold of wealth against a high inflation environment where paper currency is being depreciated.
Benjamin Nadelstein:
And Keith, you’ve been traveling all around the world now. Can you speak a little bit about how other countries view gold and that contra-currency idea?
Keith Weiner:
I mean, I saw what Bob just described. And visually in Turkey, where I’ve been told by somebody who I think knows and I trust that every person who has any degree of savings in Turkey would have at least 10 grams of gold, and that the average person would have a lot more than that. I had a chance to go to the Grand Vazard in Istanbul. And everywhere you go, there’s gold shop after gold shop after gold shop. And I’m told that there are fewer spice merchants and fewer carpet vendors and fewer this and that and the other thing and more and more gold shops there. In India, which I visited, they’re completely gaga for gold, as you can imagine. Something just blew up on Twitter, at least to my awareness yesterday, that there’s a huge premium in Shanghai for gold, which is now… You have to take these numbers with a grain of salt because people overstate them. Like in April of 2020, people were saying that the spread between London and New York was over $100. We have the sub-millisecond resolution data that we corrected for the clock, so we can prove the exact moments and time.
The spread was more like $25, which is already the world is coming to an end, but it wasn’t $100. But what people are saying is that the spread in Shanghai right now is well over $100. And they think this shows some the dollarization theme. Actually, what it shows is people in China are going gaga for gold to the point where they’re exporting their dollars to buy the gold, which is concerning to the People’s Bank of China because they’re trying to manage the decline of their currency and they want to hold on to as many dollars as possible. They don’t want those dollars to be sent away. Same thing in India. They don’t want people to buy too much gold, so they constrain it, they limit it, they tax what out of it. India is a 15 % tax on gold to be imported. So the price of gold in India is effectively 15 % higher. So in these places, people are buying gold because it’s obvious why you don’t want to hold the Indian rupee. It’s obvious why you don’t want to hold the Turkish lira. It’s obvious, perhaps not on to it, but it’s obvious in China why you don’t want to hold the Chinese euro.
And gold is the… I mean, they buy dollars. Absolutely. Everybody who can get their hands on dollars gets their hands on dollars, but they buy gold as well. And what’s intuitively obvious to them is as much less obvious if you’re sitting here. We Americans live in the most incredible bubble of our own making, and we like it that way. Dammit, we like it. And in any suggestion that maybe this is a bubble that we’re contained in. You can see the cognitive dissonance going on. But the rest of the world, they take gold very seriously and very differently than we do here.
Benjamin Nadelstein:
Yeah, Bob, you wrote that very few advisory firms recommend holding gold, despite obviously empirical evidence that it works, anecdotal evidence that it works, and just the global demand for gold outside of the US. Why do you think that is? And what do you think about what Keith said about this global understanding of gold that Americans lack in our bubble?
Bob Elliott:
Well, I think most advisors have built their portfolios, and not just advisors, but the everyday investor have built portfolios based upon the core concept that we’re going to be in perpetual disinflationary dynamics, high growth disinflationary dynamics in the US context, basically a repeat of what we’ve seen over the last 30 or 40 years, which was really beneficial to stocks and bonds. But those sorts of dynamics are unlikely to persist certainly forever. And if anything, 2022 was a bit of a wake-up call that they may not persist. They may shift faster than many people expect. And I think it’s interesting that you see so many professional investors think of gold as the asset that only real oddballs invest in. When I think actually, if you went back and you talked to people who traded markets in the ’70s, gold is a highly viable front of mind asset. It continues to be a highly front of mind asset today. And it’s not just the need for such a transition between a secular disinflation to a higher environment of inflation. Gold actually does well also in significant disinflationary environments, and that’s because the central bank needs to print a lot of money.
And as a result, you see gold typically outperforming paper currency in those environments as well, which is super applicable to what’s been happening in the US over the course of the last 15 years. And so very few people, if you inquisit an advisor, you ask them, How has gold performed since the financial crisis? Basically, they’ll look at you, they’ll eyes glaze over and they’ll say, Oh, it must be terrible. The answer is like, No, actually, gold has done a lot better than bonds since the financial crisis. Gold has been competitive in terms of returns with equities over the last 15 or 20 years. But people aren’t thinking about that. And that just makes no sense from a portfolio construction standpoint, why you wouldn’t hold an asset that is so clearly diversifying, has obvious fundamental properties that are different from the rest of your portfolio and has had a pretty good return to boot.
Keith Weiner:
And if I can just interject one thing, the elephant in the room is that if the client buys gold, then they were withdrawing from the managed account and the advisor is not getting a fee on whatever gold that the client holds outside the system. And so there’s a perverse incentive there as well.
Bob Elliott:
Yeah. I think advisors have tools at their disposal, relatively efficient tools like ETFs that they can buy gold, they can buy the IAU ETF, and it’s efficient and with the click of a button. There’s no reason why they can’t have exposure, why they can’t easily get exposure to gold for their clientele. I think, frankly, it’s just outside of the core domain of what people have learned in terms of how to think about asset allocations in a way that doesn’t make sense. I always like to bring up this fact. If you look back over the last 75 years in the US and you basically look at every period, over a 12-month period where stocks have fallen, what you find is actually gold outperforms bonds more often than not. And that’s a pretty compelling portfolio construction point, which is like this asset outperforms bonds. Bonds are considered the diversifier to stocks.
Keith Weiner:
The bonds are to the counterweight.
Bob Elliott:
Right. Right. Right. But gold outperforms bonds more than 50 % of the time, and yet you basically hold all your risk in bonds and none of your risk in gold. It just makes no sense. Why would you operate a portfolio that way?
Keith Weiner:
We did a white paper looking at the case for gold and gold yield in the portfolio. But all the major wealth management groups and major banks over the decades have that have done this research and we just replicated it, which is what happens if you take a standard 60-40 portfolio, 60 equities, 40 bonds and put four % gold into it. And what you get is less volatility, smaller draw downs, better sharp ratio. And so from that perspective, an institutional money manager or a professional advisor is neglectful, I’ll just say that without casting any dispersions to just completely ignore it. I mean, the math is what it is. It doesn’t require it. Gold doesn’t have a sales proposition. There’s no gold ink that’s selling it, per se. Anyone can look at it. And the fact that they’re not doing it, there’s some ideological blinders on.
Bob Elliott:
Right. Actually, I was at Future Proof this week, which is a big wealth management conference. The biggest advisor, wealth management conference of the year. And whenever I talk to advisors, I basically start off and I basically say there’s three ways that you can improve the sharp ratio of your portfolios: gold, commodities, and diversified alpha strategies. Those are the three ways that you can do it. I was sitting there thinking like, look, we’ve got literally 3,000 people who are at this conference, and there’s literally not one person in that conference who is advocating that advisors professionally advocating that advisors add gold to their portfolio. Why is that? Well, there’s no who benefits, right? Who’s selling the product? I mean, iShares has an index product, essentially, right? There are some products out there, but there’s no one who is walking into an advisor’s office and saying, Instead of that 38th dividend-weighted fund that you’ve seen this week, how about you invest in the one thing that is meaningfully diversifying to your portfolio? No one’s doing that. I always find it funny whenever I’m talking about go buy gold ETFs or find ways to get gold to your portfolio.
People look at me like, Are you getting paid for this? I’m like, No, nobody gets paid for it. That’s the problem. Nobody gets paid to pitch gold in a portfolio, right?
Benjamin Nadelstein:
Well, I love looking at gold too, like Keith, you were saying, if you just looked at three different variables and you took away the names, it didn’t say stocks, it didn’t say bonds, it didn’t say gold on them. It just did X, Y, and Z. And you said, hey, you have a financial obligation or a duty to get me the best returns with the mix of these assets. But they didn’t know what those assets were. Guaranteed, gold is going to be in there. They’re going to just do a couple of math problems, go, well, if we add a little more Z and a little less Y. And when you put the labels back on, that’s when people’s blinders come back in. And so, okay, I want to ask something now. So, Keith, Bob started off, he said, okay, maybe a good way to think about gold is it’s a tail risk against inflation and then, of course, non interest-bearing asset. So, Keith, I’m going to give you a second. We’re going to beat up on Bob in public. So tell us quickly. Okay, I’m a private person. I’ve heard from huge people like Warren Buffett that gold has no yield.
So quickly explain the little logo behind me and how someone could earn interest on their gold.
Keith Weiner:
Well, I’m happy to take this off, but at the same time, don’t want to overly promote the Monetary Metals on the podcast. This, but yeah, we pay interest on gold. And if you look at that research about what gold does in the portfolio with no yield, the scenario becomes significantly sweeter if you impute a three % interest rate to the gold versus either no return or cost to carry, it becomes sweeter. And so, yes, with respect, Mr. Buffett, you were correct when you said what you said, but no longer it’s now a yielding asset or it can be. You can to deploy it to get a return. Anyways, I don’t want to overly promote, monitoring metals here, but.
Benjamin Nadelstein:
Right, Keith, so the way that monetary metals, one option is to earn interest through gold leasing. And so, Bob, asked me, whoa, whoa, whoa. I’ve heard of gold leasing before. Isn’t that something that governments do? So, Keith, you probably be the expert. What’s the difference between a private, true gold lease like Monetary Metals has and a government gold lease, which we think we’ve heard of before?
Keith Weiner:
That’s an interesting question. And unfortunately, there are certain words that are overloaded that can have more than one meaning. And it isn’t clear that the word has more than one meaning. And even when people realize that, it isn’t necessarily clear when the meaning is switching from one context to another. So what the central bank world and the big billion banks often use the word leasing, they don’t want to acknowledge gold as any money or monetary asset. So there’s a a political, we used to call it political correctness, but for example, it’s now it’s called Woke, back when I was in university, that people dance around and invent the most elaborate, eventhe language, or I remember a significant other when that term came into use. And then you can’t even say pet anymore. Now it’s a domesticated canine friend. And on and on and on with these words to obscure what it really is. Okay, I’ve got a dog and he’s on a and we’re walking the dog and he’s going to lift his leg and water the bushes, right? No, it’s a domesticated canine friend and we’re going on adventure or whatever the I don’t know what the term was for that.
So they say the word lease because they want to treat it. So gold is regulated under the US law as tangible property, not as money. And so we’re leasing it. But what the central banks were doing, and I don’t think largely anymore, but this is historically, let’s say, in the 1990s, there was a big contango. The forward curve was very steep in those days. So if you sold the forward, there was a big return to be had. And then as it came to maturity, you’d buy back that contract and sell it again. And you were pocketing, it could be 70, 10 % a year back in those days doing that. And so they’re getting a return on their gold, which they regard as a dry or dead asset. This is a financial play. It’s a financial arbitrage. And whatever else one could say about it, it’s an unsavory thing, let alone it’s a fact on the price. It’s not a good or healthy or happy thing that this is a byproduct of the Fiat currency system and how the gold market works under Fiat currency. What we’re doing is quite different that there are companies that are obliged to have physical gold as inventory work in progress.
A picture of a refiner. Every day they’re buying raw gold and broken jewelry, and then it gets melted and dissolved in the reactors and all that. And then they’re selling finished investment grade bars on the other end of the refinery. But there’s always a certain amount of work in progress or a jewelry manufacturer or a jewelry retailer, for that matter. These are businesses that have gold there. And so what we’re doing is leasing them that inventory that they don’t have the price exposure. They have the capital that they need to finance it, but they don’t have the price exposure. And unfortunately, the same word lease is used in both context and the unsavory conversations of the former. There’s a risk that it rubs off on the latter, but they’re two very different, very different things.
Benjamin Nadelstein:
So, Bob, I want to ask you a couple of questions now about central banks, what’s going on with the economy. So when the Fed, the US Central Bank, first raised interest rates, most people said, no chance this is going to stick. We’re not raising rates and not for long. And they kept raising and kept raising and kept raising. And now we’re at five % or maybe even more interest rates. And most people would have said, okay, if the Fed raises rates at five %, you might as well just light the economy on fire because there’s no way that puppy is going to survive. And yet when you look, unemployment remains low, inflation falling, going back to where central banks want inflation to be. Most people would have not predicted this. They would have there’s going to be massive losses. So, Bob, first, did you predict that there was going to be a blow-up event? And if so, how did we get to where we are now?
Bob Elliott:
Well, I think if you go back almost exactly a year ago, there were a number of different classic models that suggested that there was, I believe the words were, 100 % probability of recession to occur over the subsequent 12 months. And I think a small subset of us, myself included, looked at the economy, looked and understood the fundamental dynamics of the economy and said this cycle will likely end in a recession environment, and that is probably likely what is necessary to bring inflation durably back to the Fed’s mandate, but it’s going to take a lot longer than most people expect. And the reason why that is, it’s a very important reason, is that the US economy really was fundamentally restructured, both following the global financial crisis to reduce leverage in the economy, which reduced its sensitivity to shifts and short-end rates. And then on top of it, the period of very low interest rates for a very long time and the money creation that came with it meant that basically all households who were borrowers were able to lock in two or three % yields for 30 years, and nearly every corporate was able to do the same.
And so the reality is the Fed is moving the short rate, which we’re all familiar with, but if you’re a homeowner right now and you’re living in your house and paying your mortgage, the interest rates could be 10 %. They could be 20 %. It doesn’t make any difference to that mortgage payment. And so that reduced the lever that the… That meant that the short-term interest rate impact was going to be a lot less than many people expected. Now, that’s not to say that there’ll never be a recession or that the Fed’s tightening monetary policy won’t have any effect. It certainly has had some moderate effect in terms of slowing down the economy and incremental credit borrowing, because incremental credit borrowing is at a higher rate than what the past credit borrowing was. But those sorts of dynamics, they take time to flow through. People have to basically spend down their elevated cash piles. Businesses that are loss making have to spend down their savings. Eventually, they then become borrowers, and eventually that interest rate is too high, and eventually it curtailes activitys, increases defaults. But that’s the thing that what we’re seeing is playing out over the course of a few years, not six or nine months.
Benjamin Nadelstein:
So, Keith, I think that does jive with your R&I theory, which is that, hey, not everyone is immediately affected. You got to think on the margin. When does that first person go to Barrow and go, Oh, Jeez, 8 %. That doesn’t look so friendly. So do you agree with Bob that, hey, we are seeing this play out? It’s just a slow motion crash instead of, okay, we click the button, five %, and therefore.
Keith Weiner:
Yeah. I think you could probably write a whole book on what’s a Milton Friedmann who said that there’s variable, you said leads and lags. I’m not sure if it’s leads, but there’s certainly lags and long and variable. You can write a whole book on the various different lags that occur. One of which, which I’ve talked about a little bit, I think, is employers. There’s been so many little head fakes of either threats of rate hikes or threats of recession. And that employers over the last 15 years or so have been quick to, in some cases, too quick to do layoffs. Because if you’re going to have a downturn or recession, the key is the big employer is to tear down all your costs early, then go all the way down to the bottom with your cost trim. And then as soon as there’s a sign of return, then aggressively ramp and steal market share from the other guys that are still smarting or the economy got inside their decision loop. They’re first trimming their expenses at the bottom, which is when you should be expanding. And every time an employer did this over the last, what, 14 years, they’ve been burnt.
The Fed has absolutely trained Pablo’s dogs that when you think there’s a recession, there isn’t going to be if you do lay off, you’re going to regret it. You’re going to be going back to the people you just laid off and offering them huge bonuses and big raises to come right back on. And so this time around, I think employers have been much more reluctant to do any layoffs or they’ll do attrition. So when people age out and retire, maybe they’re replacing at this lower rate. So I think that’s one factor. Another that has just been puzzling me. I don’t think I’ve written a lot about this. Why is the spread between junk bonds and treasuries not blowing out a lot more? It hasn’t really blown out at all. In fact, it’s very very tight. And I just felt there has to be some perverse mechanism behind the scenes. So, for instance, after Silicon Valley Bank, when the Fed became highly conscious of the incredible losses on a market to market basis, the banks were all sitting on those treasuries they may have bought in 2020 when the 10 year treasury was at 0.65 % interest rate.
And now here we are at 4.2. That represents a 25 % loss in principal value, something like that on that bond. So what has the Fed done? As they said, we’ll take these bonds on repo. Now it’s full recourse, as the Fed says, but of course, that has no teeth to it. There’s only one year limit, which, of course, has no teeth to it. And the banks are paying a punitive interest rate. We’ll see how long that lasts. But effectively, the banks are putting off the bonds to the Fed as if they’re still at a 0.65 % interest rate. And so this is a way of delaying. Maybe the Fed would argue if they were confronted with this, they’re trying to engineer a soft landing. Maybe that’s the term they would use. But they’re delaying the onset of the higher interest rates by cushing the banks. And the banks don’t really have to suffer the capital loss. Anytime this comes up, if the bank has a redemption, they just pawn it off to the Fed. But in terms of the junk bonds, this doesn’t explain junk bonds. And I’ve just been puzzling and puzzling about this.
I got a call last night from a buddy who is a private financial advisor and sells a lot of annuities and clever insurance structures for tax planning purposes and other things to clients. He had a call with one of the insurance companies that provides these products and somebody fairly high placed on the back office and not the sales end. And they were saying that they are right now getting… So the regulators are all over their balance sheet looking at every asset they have, and every asset has a rating. Based on the rating, I mean, obviously the public markets, usually there’s a credit rating from one of the recognized ratings agencies and the private stuff, the regulators will give it ratings. Based on the rating, that determines how much capital haircut they have to take to hold that asset. So if you’re buying treasuries, there’s no haircut. And if you’re buying junk bonds, and normally there’s a very big haircut. Well, they’re getting essentially ratings, credits right now for own and junk. This is what came out of this conversation. And he said, Keith, this goes to what you’re saying. You’re so puzzled as to why junk bonds haven’t blown out.
Yes, because the regulators have given a perverse incentive to institutional investors to hold them and say, yeah, well, you don’t have to take a haircut or not as much of a haircut for owning them and you get a better return. You can recapitalize your balance sheet by getting a higher return and sitting there. And so the the Fed, on the one hand, does take a thing away by raising interest rates, but on the other hand, the Fed plus the other regulators are give a thing to try to mitigate. So do we have higher interest rates or do we not? Well, if you’re a bank and you have all these long term Treasury bonds on your balance sheet, effectively, not really. Every new bond you buy has a higher interest rate, but the old ones can be pawned off at the lower interest rates that you need, and therefore and mitigating all this. So I think we would have had a harder landing earlier if they weren’t playing all these games than we actually do. That said, I don’t think the games ultimately fixed anything. They just postponed it and the problem grows in magnitude while it delays.
I don’t know if that answers the question, but those are my stream of consciousness of this morning.
Benjamin Nadelstein:
Well, Keith, I know that we are obviously no big fans of central planning, to say the least. But in a way, isn’t this an interesting argument? One big fat number, 5 %, right? That is for every borrower, every institution, every business, wow, they have to deal with 5 %. And clearly that affects zombie companies and private lending and all these different things, all the same, if they all just have to touch this one financial gravity number at five %. But what you’re noting is that, well, these other regulators and central planning apparatus can come in and say, oh, well, don’t worry about the five % yourself. We’ll make it more like three or four for you, right? And that obviously has different effects on the economy than if everyone was dealing with that five % number. So, Bob, do you see that that difference in interest rates and, of course, the risks involved there in the economy, or do you see it a bit differently?
Bob Elliott:
Well, I think looking at it from a macro perspective, and I find it interesting, like the regulator loosening under the hood that Keith was talking about is consistent with some other things, some other anecdotal evidence or anecdotal dynamics I’ve gotten about it as well. But I think when I’m looking at it, I’m more looking at it from a top-down macro perspective. And if you think if you just take a step back in terms of where we are in this overall tightening process, like the US economy is running too hot, inflation is too elevated, it’s above the Fed’s mandate. It’s not on a clear path to fall to the Fed’s mandate. And the Fed has actually made a pretty good amount of progress on changing the price of credit, right? The price of credit, meaning how much does the incremental borrower have to pay to borrow? The answer is a lot. If you get a mortgage, you print a mortgage today, it’s almost 8 %. If you go get an auto loan, you’re paying 8 %. If you’re, I don’t know, even a company issuing a newly minted syndicated loan, you’re looking at 10 %, 12 %.
That’s very high, and that is hard. But the problem is that asset prices haven’t come down. And that’s a really important thing to think about, which is when I look at high-yield bonds and I look at those prices, and particularly if I look at the spread return, not just the treasury component, but the spread, I look at that and I say, Well, that’s basically at Hawks. That’s basically because you’re getting the yield on the spread and the spreads haven’t widened that much. In fact, they’re normal. Same thing is true in equities, which is that stocks right now are basically at all-time highs. They’re not far off of all-time highs. Typically in a recession, what you see is stocks fall like 20, 30, 40 %. That’s when stocks move, not 5 % off the highs. And so if you think about it, and I should also mention that houses for the everyday person who owns their home are still up like 40 % relative to pre-COVID. So okay, put that all together and the balance sheet of households, of investors is basically as strong as it has ever been, and that is creating a circumstance where they’re not being pressured to curtail their spending because asset prices are rising and so they can continue to disave.
Or if you want to go buy something, the reality is how are house prices so elevated at a time when mortgage rates would imply that you have to pay twice as much for a monthly payment than you did two or three years ago? The answer is what? People just pay cash. It’s not that complicated. If I have a bunch of equity wealth that has been built up through these elevated equity levels, I just sell the equities. I pay for cash in the house, and boom, there you go. I can pay the higher cost of things. I think that’s when you put the whole macro dynamic together. The Fed has solved the price of credit problem, but hasn’t solved the asset price problem. And until they solve the asset price problem or it gets solved on its own through market conditions, which is probably the more likely path right now, we’re not going to have a meaningful slowing in the economy and the Fed will not get the economy back to where it needs to go consistent with its mandate.
Keith Weiner:
There’s another thought that’s been developing in my head in the last couple of weeks, which is we have this epic yield curve inversion where the interest rate on long bonds has gone up, but not as much as what the Fed is forced for the overnight rate or even one-month or one-year rate. And the ultimate and long-duration asset would be a home or a stock, which both are arguably perpetuities. And so if you have an inverted yield curve, the perpetuity would have an even lower effective rate or in real estate a lower cap rate than, let’s say, the 10-year treasury or the 30-year treasury. And so what we’re seeing is a reflection of the same thing. The interest rate on really long perpetuities is even lower, and therefore the asset price is higher. And how does that get resolved? I’m not necessarily of the firm conclusion that it doesn’t get resolved, that the Fed is just basically stuck with an inverted yield curve until the Fed is going to be forced to back away and they can’t invert it anymore, hold the inversion anymore, rather than that the prices of assets necessarily has to come down and that the yield curve has to flip to normal the other way.
I’m talking about to the minds of this right now, and so you’re catching me right in the thought process of this. But it makes sense from an inverted yield curve perspective that real estate and equity should have effectively low rates, which means high asset prices. But that’s consistent with what we see in the treasury yield curve.
Benjamin Nadelstein:
Bob, please help my friend Keith out. Let’s talk it out here. What do you think?
Bob Elliott:
Well, I think that yield curve can mean a bunch of different things. One thing that it can mean is that there are times when you have an inverted yield curve where people are expecting meaningful easing of monetary policy because it’s just the future. The yield curve and forward interest rates are just the future path of expected monetary policy in a mechanical sense. I don’t think that’s the case here. I think what we have is what’s often described as a negative term premium, which means that trade-off between holding cash and holding duration, longer duration assets, is such that you’re likely receiving a meaningful negative carry by holding long-duration bonds in particular. And that is very unusual because if you think about how the world works, long-duration bonds have risk, cash has no price risk. I mean, it might get inflated away or something like that, but it has no price risk, bonds have price risk. And so you should see typically a positive yield premium that exists. And so I think getting into the nuts and bolts, how could that possibly be happening? Of course, part of it is that at various times there’s been some expectations of some Fed cutting, but I don’t think that’s the main dynamic that’s going on here, particularly as you look at twos versus tens.
What’s been going on is that for a variety of different idiosyncratic reasons, supply of long-dated borrowing has been very depressed over the course of the last nine months. That’s been through a combination of the fact that the federal government has not had to borrow both because they weren’t legally allowed to borrow during the debt ceiling problem, and then they switched to mostly issuing bills right after the debt ceiling. On a forward-looking basis, particularly starting in the fourth quarter, we’re likely to see significant increases in duration supply from the government. Now, usually the government is a countercyclical actor in the economy, and so pickup and issuance would happen when there’s a collapse in demand to borrow, and so it would be an offsetting pressure. But in this circumstance, it’s actually interestingly aligning with a pickup in others interest in borrowing. And the reason why that is is because basically lots of borrowers, as interest rates rose, they had locked in some financing and had chosen not to go to the market and issue additional bonds at higher yields. But that’s been in place for 18 months, something like that, 18 months to two years. There’s only so long you can go, is the reality.
These companies need to borrow, debt comes due, they need to roll over the debt, they need incremental borrowing. What we’ve seen interestingly right after Labor Day is the most amount of corporate bond supply on the long end that we’ve seen in a long time. You put those things together, and I think that’s really an interesting dynamic, which is like, well, what’s really going on here is we’re actually getting a pickup in duration supply, meaningful pickup in duration supply at a time when some of the other monetary policy dynamics like inflation is not yet beat. From a fundamental perspective, there’s still questions about bond yields. My guess is we’re likely to see that negative term premium shift meaningfully over the course of the next 3, 6, 9 months. That classic bear steepening driven by long end supply is not unheard of. It’s unusual, but not unheard of and likely to be the dynamic we’re seeing over the course of the next couple of months.
Benjamin Nadelstein:
In your opinion, let’s just take a hypothetical scenario, the next five years. What do you think is more likely? That interest rates are not going to fall below 5 % for the next five years.
Or
They’re never actually going to meaningfully rise above 0.5 %? So are we either going to be stuck in a high environment or a low environment in this hypothetical scenario? And then, Keith, I’ll ask you the same question.
Bob Elliott:
First of all, I’d say when you’re talking to a macro investor, they’re often thinking in a three and six month time frame and have… The good ones have great humility. What’s going to happen in five years? I have no idea. My confidence in that is very low. What I would say is my guess is we’re likely to see a lot more volatility than people are expecting. Basically, what it’s taken — and we’re still not there — is it’s taken a meaningful shift in interest rates to move to slow the economy. That path and that process is probably not yet done, and so we probably will need significantly… We’ll probably need another meaningful amount of interest rate rise on the long end to finally slow the economy. And so rates are likely to go higher than people expect right now in order to get the recession-type dynamic to start to emerge. Then I think the thing that’s interesting on the flip side is everyone is talking about how it’s been so hard for the Fed to slow down the economy. As a result, we have higher interest rates. Without thinking about, Well, if it’s hard for the Fed to slow the economy, it’s also hard for the Fed to stimulate the economy.
It’s very likely that we will experience a much harder landing than most people expect. When I hear people say, Oh, they’ll just be a recession, but it’ll be mild. My first thought is like, Why? Why will it be mild? Why won’t it be actually a lot worse? Because it’s been a lot worse on the upside to slow the economy. Why won’t it be harder on the downside to stimulate the economy? Which would then create a situation where we may have the type of disinflation or deflationary dynamics that we saw post-GFC. A lot of that fundamental situation still remains in place, and so could create a sharp move back down for bond yield. So up and then down with more volatility than most people expect.
Benjamin Nadelstein:
Keith, your way. Are we still in that fundamental issue of central banking? They got to go hard up a little bit more and then right back down?
Keith Weiner:
I’m certainly with Rob on the rising volatility. There’s a lot of different ways to look at this. And if you compare it to 2008, I think the Fed is hiking more than it did prior to that crisis. And I think there’s more certainly debt on the economy if not leverage. But on the other hand, I think there isn’t going to be any more Bear Stearns or Lehman or others. I think that Fed is and the other regulators are the term I would use to be hyper proactive. They’re looking for the slightest sign of anything, which is why asset prices, as we said, junk bonds, for instance, haven’t been allowed to collapse as they should, because the Fed is trying to tamp down anything that would really erupt into a crisis while at the same time trying to precipitate a landing of some sort, whether it’s soft, hard or mushy or indifferent. It’s one of those things where the trillion-ton rock meets the trillion-ton force. You know, which one’s going to win? I think in the end, reality reafferts itself, but that can take a long time. I don’t think there’s demand for credit to finance productive enterprise anyway, at these interest rates.
After all these years of zero interest rate, that pulls down the marginal return. This is my ours less than I’ours greater than I’ thesis. You push the interest rates down, you pull down return on capital across the board. Now here we are. What do all these companies going to do if they have to roll over their borrowings even at a 10-year treasury at 4.2, let alone if greater issuance and greater supply of long-term debt pushes the interest rate up to arguably where it should be, if you had a normal yield curve and the overnight rate is five and a half, what the hell should the 10-year be? Eight and a half or who knows what, right? And then if you’re a single-like credit or a double B or something like that, you should be a 10-plus easily in that world and then junk, who knows, at 15 to 20 or beyond, there’s no demand for credit. I mean, nobody can service the debt at those rates, which means you just have a mask of cascading default, which is what the Fed is trying. The Fed is trying to engineer higher interest rates without falling asset prices and without the defaults that come from either higher interest rates killing the zombies or falling asset prices and therefore killing the bank balance sheets.
So the Fed is trying to juggle this contradictory mess, but they’re hyper proactive and they’re looking for the first sign of crisis anywhere and tamping that down. So what’s ultimately going to win? I think crisis ultimately wins. Is that crisis within six months? I think market indicators right now are not suggesting that it’s imminent. And nor do I think it’s imminent that the gold price is going to explode to $3,000 or $5,000 eminently. Longer term, I would bet against the Fed being able to manage this because the perverse incentives grow and greater and greater, and therefore the perverse behaviors grow greater and greater. The macro potential regulators, that’s their real job is to run around, figure out what all the perverse incentives are, figure out what the banks are doing to game the system and then say, no, no, no. You have to vote. We were at that, not that. And they’re going to miss a beat because they don’t get it. These are sophisticated, complex systems that the regulators are the last people that are going to understand what the banks are really doing. You know, I have a funny anecdote completely in a different area, but this shows the mentality, the compliance mentality and how it doesn’t see the bigger picture.
So it’s from I think a CPA firm with an eye towards labor compliance or it might have been a labor law firm, sends me this email saying that some firms are reporting it’s a big problem that you’re non-exempt employees. These are employees that you have to pay an hourly wage and you have to have full compliance for the Federal Fair Labor Standards Act and then whatever the state versions there are. And so these employees are reading emails at night and then, of course, filling in their 10 cards, which in a lot of states, if you’re working at night would automatically be time and half at least, and maybe double time depending on various parameters. And so these companies are getting upset that employees are doing time and a half to read email at night and companies are paying for time and a half for that. So they’re saying, and this is the relevant part, they’re saying that, well, some managers are just saying, well, just tell the employees not to do email at night. And I’m just thinking, man, that’s the typical bean counter mentality. That’s a compliance mentality. Just don’t do that without any awareness that that might mean that customers are now going to be left hanging and projects are going to be late and there’s going to be consequences, the cost of which might be far greater than whatever you’re paying the hourly rate and that there isn’t necessarily the simple blanket compliance solution of no email at night.
That things are more complicated than that. And that’s the mentality of a regulator. And I’m not putting regulators down. They’re in a box. They’re given a set of rules, enforce the rules, and not necessarily encouraged to think broader outside the box. These are the rules. This is what you’re working with. And so do they understand the economic consequences of bifurcating the interest rate and saying, okay, if you’re a bank and you have bonds on your balance sheet, we’re going to effectively a special magical bubble just for you to live in where the interest rate is still 0.65 %. But for all new credit incrementally borrowed, as Bob said, then the interest rate is really going to be seven % or whatever. The people that are creating that perverse and don’t understand it, they’re just trying to tamp down a crisis. The macroprudential regulators to come along and see whatever perverse games the banks come up with and how they game this. Are they going to recognize it? Are they going to respond? And so you get this pressure building. When does the magma chamber blow? When does the Caldera wipe out life in the Northern Hemisphere or whatever the consequences of this may be?
Very hard to predict. Chaotic system. Slip stick dynamics or stick slip dynamics. Probably not in the next six months. I think that’s a reasonably comfortable prediction to make. But I think at the end of the day, the Fed is going to be forced to lower interest rates back to zero and beyond. But in the meantime, the regime of rising interest rates can prevail for some time longer. That’s my take on it.
Benjamin Nadelstein:
The one thing I liked about economics was they said, hey, most people when they walk around, they see the scene, right? Hey, look, the government just built a brand new bridge. And everyone goes, wow, this is great. I mean, there’s a new bridge, right? But the economist is that wet blanket who comes over and goes, Guys, we didn’t just get a bridge for free. There’s no shot that we all just got a bridge for free. And some people, yeah, yeah, taxes. I get it. I get it. But the economist’s job is to say, Okay, where did those laborers come from? Where did those resources come from? What was the opportunity cost of doing this bridge? What were all the unseen things that were happening? And of course, the simpler the project, the simpler the unseen. You can be like, Hey, listen, if you talk to Ben for 20 minutes and you paid him, yes, Ben got paid. But where did the money come from? What could have been doing otherwise? But with things like bank term funding facilities and zombie companies and all these really just intense dynamics, the unseen can be really complicated. And like you said in the very beginning, I mean, you could write a book about the unseen implications starting the last six months.
So, Bob, for the people who are going to continue following this and are going to be looking at the unseen, what’s something that we should be looking at? What’s an indicator? Where are places that we should be looking for those cracks that aren’t just, Okay, the banks are insolvent. Well, okay, the Fed can maybe deal with that. They’re looking for the next Lehman. Where should we be looking?
Bob Elliott:
That’s a good question. I think this thinking about the unseen and the complexity of the system, I’m reminded the day we’re recording here is the 15th anniversary of the failure of Lehman Brothers, which I was heading up Bridgewater’s research on whether the crisis was going to be a big deal or a small deal back 15 years ago, fortunately. I did the work and suggested it might be a big deal. So it’s on the right side of that train. Good call. But I think many of us who lived through that experience have a very tangible appreciation of the complexities of the system and also how interwoven, particularly financial intermediaries are and how things can move very, very fast. That happened in the course of days, not in the course of years. Anyway, it’s a day to reflect on that particular question for sure, and also on the failure of regulators to figure out that it was going to happen. When I think about on a forward-looking basis, the main things to be looking at here I think are interestingholdingly, I think, market-oriented. I think the markets are going to really give us a good lens into how these dynamics are playing with each other.
In particular, what we’re seeing with basically that duration supply, are we seeing interest rates continuing to rise? Those interest rates? The Fed is likely on the sidelines. They’ve said that they’re not going to do much more. Maybe they tighten once or more. Like, who cares? It doesn’t really matter. The real question is, do we get enough of a long end rise to start to hit asset prices? And that intersection between essentially how stocks are performing relative to how bonds are performing, I think it’s going to be really important to understand the financial conditions and whether we’re getting enough of a market-based tightening in order to create a turn in the economy because that’s really what we’re all looking for. And the way you’d see that is as long as bonds are selling off, but stocks are rallying or selling off less, that is an indication that we’re in an environment where the tightening has not done enough to really meaningfully slow down the economy or hurt asset prices enough. But as you start to see stocks move down faster than bonds, that’s really a great indication to say that this is probably the dynamic where things are starting to turn.
I think in that context, both of those stories are around stocks not doing well and bonds not doing well. I think it’s particularly important for investors to be looking outside of traditional stocks and bonds to find other assets. I actually think, again, today’s market action, not to get overfocused on one day, but I think it actually is a really good indication, and it’s actually reflective of what we’ve seen over the last six weeks or so, which is a sell-off in bonds, a sell-off in stocks. But two areas that you see that are not underperforming: gold and oil, the two most diversifying assets to any one strategic portfolio, gold and oil, are continuing to rally. That is a toxic combination for those investors who are stuck on 60, 40, but a real opportunity for those investors who can look for diversification and get into things like gold and oil to be able to navigate through this environment. I think we’re probably going to see more of days that look like today that people are unprepared for, for a variety of reasons, than days when 60, 40 is going to do well. And so that’s going to be a really challenging time, I think, over the next three or six months for most investors.
Benjamin Nadelstein:
Bob, second to last question here. What’s a question I should be asking all future guests of the Gold Exchange Podcast?
Bob Elliott:
How much gold do you have in your portfolio?
Benjamin Nadelstein:
Okay, I like it!
Keith Weiner:
Good one.
Bob Elliott:
That’s a simple question. My answer is between 10-15 % at any point in time. Okay, Bob. And that’s in your investment portfolio, right? Obviously, people hold gold for jewelry and stuff, but your true investment allocation to gold.
Benjamin Nadelstein:
And of course, the secret gold that’s down in the basement or under the garden somewhere, I don’t tell anybody about it. Okay, so Bob, before we go, I just love your work. You’re a great thinker. People have to follow you. They got to be reading your stuff. And if they want to learn more about you, Unlimited Funds, where can they find you?
Bob Elliott:
Yeah, I run a pretty active Twitter on macro, on a day to day in terms of what’s going on and at least what I’m seeing likely to transpire. That’s at Bobby Unlimited on Twitter. And then if you’re interested in what we’re doing at Unlimited related to hedge fund replication and whether those strategies might be the right thing for your portfolio, definitely check out what we’re doing, unlimitedetfs. Com, where you can find more information about our our products.
Benjamin Nadelstein:
Bob, I want to thank you so much for coming on to the Gold Exchange Podcast. It was a blast. Hopefully nothing bad happens in the economy, but in case it does, we will be watching your Twitter feed with with peeled eyes and hopefully we’ll see you back on the podcast.
Bob Elliott:
Awesome. Thanks so much for having me. It was great to meet you all.
Benjamin Nadelstein:
Thanks so much, Bob.
Keith Weiner:
Good to meet you, Bob!
Additional Resources for Earning Interest in Gold
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In this paper, we look at how conventional gold holdings stack up to Monetary Metals Investments, which offer a Yield on Gold, Paid in Gold®. We compare retail coins, vault storage, the popular ETF – GLD, and mining stocks against Monetary Metals’ True Gold Leases.
The Case for Gold Yield in Investment Portfolios
Adding gold to a diversified portfolio of assets reduces volatility and increases returns. But how much and what about the ongoing costs? What changes when gold pays a yield? This paper answers those questions using data going back to 1972.
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