Welcome to Global Perspectives, a new podcast featuring some of the sharpest minds in the world. We delve into the key concerns, opportunities, mindset, and practices of some of the most successful professional money managers, entrepreneurs, and world class personalities today.
This episodes special guest is Brent Johnson of Santiago Capital.
*Two of the most powerful forces at play in markets today
*Stock and flow of the money supply; Why the flow is so essential
*The key design flaw of the current debt based monetary system
*How continued decrease in the velocity of money can create a compounding deflationary effect
*Velocity of money has been on a downward slope for 16 years which has forced the Fed continue to add to the money supply
*How the Basel III regulatory framework is compounding parking of capital and adding to deflationary forces
*How growth of regulation has created burden on small business reducing competition and raising the cost of entry into markets
*What is “velocity of money” and why it matters to inflation
*Why quantitative easing has led to a situation where inflationary forces could accelerate faster than central banks expect
*How inflation is closely tied to psychology and not just creation of new money
*The case for why zero to negative interest rates are having the opposite effect to what central banks expect
*Trump is a wild card for market psychology
*Why Trump could be highly inflationary
*Global demand for US dollars could push the USD continually higher over the next few years
*Why and how a strengthening dollar could cause its own demise
Listen to the original audio of the podcast here
Global Perspectives Episode 1
Alex Stanczyk and Brent Johnson
Jon: Hello, I’m Jon Ward, on behalf of Physical Gold Fund. We’re delighted to welcome you to the first podcast with Alex Stanczyk in the series we’re calling “Global Perspectives.”
Alex Stanczyk is the Managing Director of Physical Gold Fund. Alex is an expert in the physical gold industry, dealing with the logistics chain, from refinery to secure transport and vaulting. He has lectured globally to investor, institutional, and government audiences on the role of gold, both in the international monetary system and investment portfolios.
Alex: Hello, Jon. It’s great to be here. This is going to be a wonderful conversation today with someone whom I’m a big fan of, personally.
Jon: I’m sure it is. Our guest today is Brent Johnson. He’s the CEO and portfolio manager at Santiago Capital, a hedge fund that focuses primarily on bullion and other metals-related investments.
Brent has been creating and managing wealth-management strategies for high net-worth clients since the 1990s. Early in his career, he was a financial auditor for Philip Morris Management Company, and he went on to serve private clients for Credit Suisse.
Brent recognized early on the need for a robust precious metals solution for his clients, and that’s what prompted him to launch Santiago Capital. Since then, he has attracted a growing following as an expert on gold.
Now, in his spare time, Brent devotes himself to educating the public on financial and monetary issues. His work is often featured throughout the blogosphere, including Zero Hedge.
Brent: Hi, guys. Thanks for having me. It’s great to be with you today.
Jon: Now, Alex, over to you.
Alex: Okay, thanks a lot. Let me start out by saying, Brent, it’s great to have you on. One of the things that I find interesting about you is that you don’t follow the crowd. There are a lot of different analysts in the space. Interestingly enough (and you’re probably already familiar with this), the common theme that you see amongst analysts in the sector is that they all often parrot each other. I find it curious how that happens. It isn’t so often that you run across someone who has got some original thinking and original content.
You definitely fit that mold. I shouldn’t even call it a mold. You’ve broken the mold. You’re the person who looks at the whole situation in your own sort of way. I’m looking forward to what you have to say on a lot of these different levels.
If you don’t mid, Brent, let’s talk a little bit about your latest presentation. It’s called “Don Yuan.” Can you give us a quick summary of “Don Yuan” and what it means to you?
Brent: Sure, yeah. Thanks for the nice words you said, by the way. I’m excited to be able to come in and talk with you. I’ve been a fan of you and your work, as well. This is a great opportunity.
As it relates to “Don Yuan,” it’s a play on two of the biggest forces that I see in the world today. It’s not just market forces. It’s political forces. It’s social forces. It’s Donald Trump, “The Don,” and then China and the yuan.
Rather than “Don Juan,” I titled my latest presentation “Don Yuan,” because I really do see those as being the two primary forces right now. It’s kind of a funny play on words, but it’s actually a pretty serious topic when you really get down to it. It’s a very divisive topic, but it’s an important one. That’s a long way of explaining the “Don Yuan” title.
Alex: I understand. Let’s dig a little deeper into some technical areas that you had mentioned in your other series, “Step into Liquid.” One of the things that you talked a great deal about was stock and flow of the money supply.
A lot of people are familiar with this concept of stock and flow, but they may not understand why the “flow” part of the stock and flow is so essential and why it plays such a big role in your framework of looking at the world.
Can you talk to us about that and about why flow is so essential?
Brent: Yeah, absolutely we’ll do that, because it’s the key to everything. It’s funny, because I learned of this stuff in college, but I probably just learned it long enough to memorize it to pass whatever test I was taking, and never thought of the real-world implications of it. Then 10 to 15 years ago, I started looking at it closer. Ten years ago, when we started getting into 2007/2008 timeframe, I took a hard look at it. That’s when it hit me.
The stock and the flow goes back to a debt-based monetary system, where money, for lack of a better word, is loaned into existence. The way that our monetary system is designed has a severe design flaw in it. You can argue whether it was done on purpose or whether it was done by accident. We could probably do a whole hour just on that.
Regardless, the flaw is there. The flaw is that in a debt-based monetary system, where money gets loaned into existence, all loans have interest attached to them. If you loan money into existence, then at the end of the year, you need more money to pay the interest than actually exists.
Either the existing money in the system has to be circulating – or the flow, for the lack of a better word, has to be flowing – at a fast enough rate where that money can change hands and satisfy everybody’s interest payment.
If that flow is not flowing at a high enough rate to where the interest gets paid, then loans go into default. It’s like a daisy chain. It starts cascading all the way back to the base money from which that money was loaned into existence to begin with.
You look back, and all the central banks are like this. They’re all based on the same design. For this argument, let’s just look at the United States. The monetary base is around $4 trillion. About $2-2.5 trillion is reserves at the Fed, which isn’t flowing. That money just sits there as the banks’ reserves.
Then there’s about $1.5 trillion of physical currency. That’s money that actually exists. That’s the base money. All the other money is basically digital money, ones and zeroes, that’s loaned into existence and it shows up on a ledger somewhere that says, “You have this money,” etc.
If you look at the total banking system, the banking system has – depending on how you measure it — say $15 to 16 trillion of banking assets. If $4 trillion is base money, then that means there’s $12 trillion of money loaned into existence, and some other assets, etc.
Anywhere from $10 to 12 trillion is loaned into existence. There’s interest attached with that $10 to 12 trillion.
Alex: A lot of interest!
Brent: Right. If that money isn’t circulating, those loans go into default. You can think of it similar to a collateral account on a brokerage account. If you buy on margin and whatever you buy doesn’t go up, then the equity gets eroded and you have to resupply the collateral, or else the whole account fails.
It’s very similar. If GDP and money velocity are not high enough, there are not enough transactions going on to satisfy all those interest payments. Well, then the Fed has to come in and plug the hole and add money back to the collateral, which is the base money.
That’s the stock and the flow. If you look at the velocity of money, it really started in the late ‘90s, probably around – this would be a great question for Jim Rickards, who I know you’re very close with. It all started around the ’98 crisis, with Long-Term Capital Management, the Russian debt crisis, and the Asian currency crisis.
You can look at the velocity of money. Going back there, it’s been on a downward slope ever since then. Now, there have been a couple times where it’s turned back up for a year or so, but then it’s turned right back down. We’ve been in this downward motion for 16 years now, almost 20 years now.
You can go back, and you can look at the reserves, at the Fed, and the base money, and it’s ramped up since then. There’s a direct correlation. Money is not moving, and they have to continually fill up the collateral. That’s the essence of the stock and flow. That’s the essence of the flow in our monetary system.
The other part of it is if the money is circulating and there are no problems, the interest attached to it, even if it’s just 1% a year, it becomes an exponential system. It doesn’t matter. You can start with the number 1.
Alex: I agree.
Brent: If you take 1 x 1.01, year after year after year, it will eventually grow exponentially. It’ll turn straight up. Then you get the inevitable blow-up process that ends with a magnificent crash.
Alex: That’s the hockey stick on the chart.
Brent: Exactly. It doesn’t really matter whether or not the money is flowing or not flowing. That design flaw of the money loaned into existence is a catastrophic flaw, and it’s bound to fail.
Alex: Yes, I agree. We’re not talking about philosophy here. This isn’t about whether this monetary system or that monetary system is a good thing, or a gold standard is a good thing or a bad thing, or whether Keynes is a good thing or a bad thing. We’re talking about math right now.
Brent: If you believe in math, buy gold. Our monetary system, mathematically, certainly will fail. That shouldn’t really be a provocative statement. It’s just math. You can argue with math if you want to, but you’re going to lose.
Alex: You’re going to lose, absolutely. I totally agree. That’s something that I think a lot of people don’t realize about our monetary system. I think there are a lot of people caught up in this argument about whether Keynesian is a good thing, whether the gold standard is the way to go, or whatever, all those kinds of things.
I’m not going to argue that one way or another right now. If you just think about the math, that’s really critical. People need to understand that it’s going to change. It’s only a matter of time.
Alex: Let’s move on and talk about regulation. That’s been a big topic for the current incoming Trump administration, and I’m sure for business owners for years now, at least going on a decade, and probably longer.
The amount of regulatory creep that’s been occurring has been getting more and more intrusive, and not just in the United States, but globally. Our fund operates internationally. We’ve done business globally for a long time. We’ve seen the regulatory creep effect there and how that’s affecting things.
What do you think is going to happen as this creep continues to impact the banking system? How does this present a problem?
Brent: That’s a big topic. There are a lot of different ways it can be a big problem. There’s probably one area that I can focus on that will help explain it in a somewhat simple manner.
If you think back, after all the problems that happened, let’s call it, between 2006 and 2010: the run-up and the real-estate bubble, the explosion of the real-estate bubble, and then all the ancillary negative effects that happened for the couple years after the bubble popped.
The banks did a number of things wrong. We can just leave it at that. We don’t have to get into all that detail right now. They did a number of things wrong.
Alex: I think everybody agrees, yes.
Brent: The public bailed them out. Perhaps rightly so, the government said, “Well, we’ve got to go in and do something to make sure this doesn’t happen again.” Like all good government programs, they might even start off with good intentions, but they end up with a really bad result.
One example is the Basel 3 and Dodd-Frank requirements that are now imposed on the banks. It makes sense. The Basel 3 comes from Basel, Switzerland, where the Bank for International Settlements sits, as potentially the central banks’ central bank.
They are trying, on a globally coordinated basis, to establish a framework through which all these other central banks, governments, and monetary authorities can craft a global solution to keep this from ever happening again. Again, it starts off with good intentions.
The way that we can use it as an example is they thought, “Well, we need to make sure that the banks are adequately capitalized so that if we ever have another downturn, they don’t go through this big liquidity event where their capital evaporates and the public has to bail them out.”
In theory, that sounds pretty good. The problem is getting all these different countries to agree on the same thing. Then, of course, politics comes into it. They say things like, “You can hold these different securities on your balance sheet, but they’re all going to have different ratings. Of course, they give their own debt (the country’s debt) a zero-risk rating. You can buy a Greek bond, a Portuguese bond, a US bond, or a Chinese bond, and they’re essentially all given a zero-risk rating, which on the face of it is ridiculous, right? But that’s the rule.
The intention is good. That’s just one example of where banks can now hold risky assets on their balance sheet and say they don’t have any risk at all when, in fact, they’re carrying a lot of risk, especially when you look back.
I don’t know if there’s ever been a country in history that ever paid off its debt without inflating it away. The fact that you take the one entity, which is the government, which has never made good on a debt, and you give it a zero-risk rating, in my opinion, it’s a bit ridiculous. That’s just one example.
Let’s take it a little bit further. The framework for the US is Dodd-Frank. One area in particular that they took a look at was money market funds.
For several years, they have said that by October of 2016, money market funds will have to mark their book to market. Basically, what that means is for a long time, these money market funds were created as a way to provide short-term financing for banks and other big corporations. It’s almost like cash.
People that are invested in it, they kind of assume that it’s cash, so it always just keeps a par value. If you put a dollar in, it shows a dollar on your statement. But in actuality, these are bonds underlying these money market funds. Now, they’re very short-term bonds, but they’re bonds, and there is risk.
Occasionally – especially like in 2008 – there were some failures, and some of these money market funds broke the buck so to speak. They actually printed 99 or 98, rather than 100 cents on the dollar.
Well, in their infinite wisdom, the government said, “We can’t have that anymore. We’ll give you a few years to get on board, but by October 2016, you’re going to have to get these funds to market.”
That was the case for prime funds, which are corporate-backed funds, but not government funds. The government doesn’t have to mark their books to market, because, “We’re the government. We’re never going to default. We don’t have any risk.”
What you saw, the natural progression, is people who didn’t want to take that risk left prime funds, and they moved all their money into government funds. There’s been a big sea change from prime funds to government funds.
Perhaps on one level that’s good, but the problem is that now you’ve got even more people huddled and concentrated in one area – again, government funds – which, in my opinion, have in many ways more risk than a AAA-rated corporate bond does. That’s one example.
Not only that, but a lot of the banks that they’re trying to protect against, they used to get their short-term funding from these money market prime funds. Now that those money market prime funds are gone, they don’t have that competition. There’s no competition between prime funds and prime funds anymore. They’ve lost one area of financing, so the cost of financing has gone up.
You can look at things like LIBOR. If you look at LIBOR between July of last year and October of last year, it almost doubled. A big part of it was because of this movement in the money market funds. Now you’ve got a higher concentration of funds, a higher cost of funds, and a lot of people concentrated in an area that perhaps has more risk than they otherwise think it has.
That’s just one example of how regulatory good intentions end up being long-term bad solutions. That’s probably the easiest way I can explain it.
Jon: Thanks, Brent. Just talking of concentration, do you have any observations about the whole phenomenon of “too big to fail,” of the largest banks simply getting larger and larger and, in that respect, becoming unassailable?
Brent: It’s really true. You’ve seen these banks get bigger and bigger. I don’t have the market capture right in front of me, but they’re much bigger now than they were in 2008.
If you total up all the fines that the banks have paid between 2008 and 2016, it’s something like $300 billion. Now, name me another industry where that industry can pay $300 billion in fines, still be in business, and still have their profits going higher. You don’t pay $300 billion in fines if you’re treating your customers well. What other industry can do that to their customers, stay in business, and grow? It’s ridiculous.
Alex: Yes, it’s crazy.
Brent: On the face of it, it’s just absurd. Another example where this is becoming a problem is that as regulations have gotten more intense and more severe, part of the reason the big banks have gotten bigger is they’re the only ones that can afford to hire the lawyers to comply with all these rules and regulations.
The smaller community banks or regional banks, who didn’t have anything to do with the problems that caused 2008/2009, are the victims of it, because they’ve now had to implement new regulations and procedures, and they’ve had to hire ten lawyers instead of one lawyer, etc. They basically can’t compete against the big guys, so they either go out of business or they sell to the big guys, and the big guys just get bigger again.
Not only that, but then you’ve got a big national bank, perhaps, representing a small manufacturing facility in Dubuque, Iowa. The big national bank has no idea what goes on in Dubuque, Iowa. Maybe they can’t even make that good of a decision of whether that company deserves better credit, worse credit, or a loan.
You’ve gone away from community banks serving small businesses to these mega-banks trying to write rules and regulations that apply, black and white, to everybody, when it’s really a grey world.
I see big problems with all these regulations. I’m a free-market guy. I think the free market solves all the problems. People say, “Yeah, but if you don’t have regulations, then all these banks would have gotten away with murder.”
No, they wouldn’t have. They would have been bankrupt. They would have been gone, and the problem would have been solved. It’s a cute way of looking at it, but I still believe in capitalism.
Alex: This is an area, Brent, where you and I largely agree. The problem, as you explained it, feeds on itself. It’s raising the cost of entry into the market by creating all these regulations, so smaller businesses really can’t compete.
The problem with that, obviously, is if there’s no competition, then there’s nothing that’s going to be keeping these guys honest, if they can get away with it.
Alex: If we can circle back around to our earlier topic for just a minute, I think that it might be helpful for our listeners to know a little bit more about velocity of money and what it means. Not everybody understands that. You and I, in the industry that we’re in, we get that. We understand what that means.
As far as velocity of money, the last chart I looked at from the Fed, the current velocity of money, it hasn’t been this bad since maybe 1971 or ’72. It’s absolutely horrible. I think sometimes people wonder, “Since the last global financial crisis, we’ve printed up trillions of dollars. Those dollars have been injected into the economy, but we aren’t really seeing inflation.”
All the Keynesians are coming out, going, “Look, money creation doesn’t create inflation after all.” The part they’re leaving out is the whole velocity part. What does that mean? What happened there? We had all these trillions of dollars injected into the system, but we really haven’t seen much inflation. What’s going on with that?
Brent: There will be people out there that will say, “What are you talking about? We’ve got inflation. House prices have doubled. The stock market has tripled. My Thanksgiving dinner cost me $150, rather than $89.”
I think there has been inflation, and while there has been some consumer price inflation, in general it’s been more asset price inflation than consumer price inflation. A big part of that is, again, the way the monetary system is designed.
The way it’s designed is the central banks give the banks the money. Then the banks give the money to main street. There’s not a system where it goes from the central bank to main street. The mechanism by which it goes to Main Street is loans, that money creation that we talked about earlier.
Again, if you look at all the QE (quantitative easing) that we’ve done, the bailout packages, etc., however you want to define those packages, it was done as a way where the central banks bought assets from the banks. In exchange for taking those assets from the banks, they gave the banks cash.
The banks did not then loan it out into the market, as the central banks were hoping that they would. You can make a big argument. Did they not loan them out because they didn’t want to, because they wanted to keep it for themselves and collect interest on it? They actually get paid by the central bank just to hold onto it.
Or was there no demand? Was the consumer so tapped out that there was no demand for the loans? I think that would probably be a whole other hour-long topic in itself.
Brent: Regardless of whatever the reason is, that money did not flow to main street. That is what I was talking about earlier. As velocity fell, the reserves of the banks at the Fed increased. It’s almost a one-for-one correlation.
Now, a lot of people will say, “That’s why we haven’t had inflation. You shouldn’t worry that it’s not inflationary because it’s just in the banks.” Technically, that’s correct, but it’s very disingenuous, in my opinion.
The reserves at the Fed are what the banks use as collateral to make new loans. Even though they haven’t made new loans yet, they’ve got $2 trillion in reserves now that they didn’t have ten years ago. On a 10:1 reserve-to-loan ratio, they need to keep one unit of reserves for every ten they loan out. $2 trillion of reserves could become $20 trillion in new money.
Ten years ago, the monetary base was $800 billion. Now it’s $4 trillion. On reserves of $2 trillion, they could loan another $20 trillion into existence. The total banking system assets right now are around $15 to 16 trillion. They could essentially double the size of the banking system on those reserves that have been given to them in the last ten years. If and when that happens, that would be highly inflationary.
It’s kind of like a dam being built. We’ve had all this liquidity flowing towards main street, but the banks built up the dam. All that flow, all that money from the Fed, is just building up behind this dam. It kept getting bigger and bigger. Now there’s a big lake there. That’s the reserve. It’s become this huge lake.
If that dam ever breaks, or if they ever open the levies on that dam and start loaning it out, that can lead to even higher pressure of that flow coming up. That can lead to even higher inflation, if and when it happens.
I can’t tell you for sure it’s going to happen. I think it is going to start to happen, for reasons that we can get into in a little bit. Those reserves that have been built up, that everybody says, “See, these aren’t inflationary,” they’re the tinder for the inflationary fire that can come later.
Alex: I totally agree. It’s interesting to me, because when there’s no velocity – in other words, people aren’t spending money and loans aren’t being made – then that creates what you were talking about, that big sucking sound in the flow of money. They have to continually add more dollars to the system to make up for that sucking sound, which is only making this lake bigger.
Brent: Exactly. You touched on the key to everything — the velocity of money. If the velocity of money picks up, then you’re going to have inflation, and maybe this flawed system can go on a little bit longer.
If they cannot get the velocity to pick up, then inflation is not going to pick up, growth is not going to pick up, and we’re going to be back to this deflationary death spiral. It all hinges on the velocity of money.
Alex: Here’s another interesting aspect of that. What a lot of people don’t realize is velocity is closely tied to psychology.
Alex: The thing that is guaranteed is that the psychology will not stay the same forever. It’s almost like a perfect setup. The psychology is going to shift at some point. When it does, we’re set up to unleash that gigantic dam.
Brent: That’s exactly right. In many ways, inflation is more psychological than it is economics or math. It’s just pure psychology. This is where I think the Fed has really gone wrong, and I alluded to this in one of my recent presentations.
What I mean by that is if we go back a year, the Fed raised interest rates in December of 2015 and indicated they were going to raise two or three times in 2016. Well, got into spring of 2016; they didn’t do it. Got further into the spring, and they didn’t do it. Got into the summer, and they didn’t do it. Got into the fall, and they didn’t do it.
They were rapidly losing credibility. Not only that, but in Europe they tried negative rates. In Japan, they tried negative rates. All this talk of they were going to raise three times, and they couldn’t even raise once. They’re like the little boy who cried wolf. They kept saying, “It’s coming. It’s coming. It’s coming.”
In the summer and the fall, the Fed kept saying, “We’re going to go slow. We’re going to slow. We’re not ready yet.” But the market – and maybe that was psychologically driven – started to say, “You know what? Negative rates are ridiculous. Interest rates are at 5,000-year lows. We’re at negative-to-zero-percent interest rates. Do we really want to buy bonds at negative interest rates?”
I think the peak was in August or September. I think Austria issued an 80-year bond at a negative rate.
Brent: It’s just absurd. Then there did start to be some growth prospects pick up. Some inflationary signals started to pick up. Then Trump won. Trump’s policies, I believe, are inflationary policies. I believe it for different reasons than a lot of other people believe it, but I believe they are inflationary policies.
In the last 60 days before the last Fed meeting of the year, rates really started to rise. Stock prices started to rise. Inflationary pressures started to rise. I think that allowed them to raise rates. In that way, I think the market front-ran the Fed and allowed the Fed to raise. I’m not sure the Fed wanted to raise, but I think they had to raise. That’s going back to the psychology.
I think for the last two or three years, with the Fed saying, “We’re going to keep rates low,” and other central banks saying, “We’re not only going to keep them low; we’re going to go negative,” this is their ivory tower, some PhD economics department psychology, telling them, “If we lower rates, people will borrow more.”
I think in the real world, the central banks are supposed to be the smartest people in the room. They’re supposed to be the financial geniuses. Well, the financial geniuses are telling me that things are so bad that we’re going to have negative rates. Why would I go take out a $1 million loan and build a new plant? Why would I hire that new person, if all the smart people in the room are telling me things are so bad that we have negative rates? I’m just going to wait, and when things finally get better, then I’ll hire.
I think that low rates and negative rates are actually deflationary, as opposed to the ivory-tower opinion that it’s inflationary. Now that rates started to pick up and the Fed raised, I think the market bailed them out. I think for them to keep this momentum that they’ve got, they have to keep on the raising-of-rates train.
I think if they now go back and say, “Oh, we’re not going to raise anymore. We’re going to slow down,” then they lose all momentum and we go back into that deflationary environment.
From a psychological perspective, if you’ve been sitting on this cash and you’ve been waiting for the time, you haven’t built that plant, you haven’t hired that person, or you haven’t invested in that new project because the rates are low and maybe even going lower, maybe even going negative. You’re saying to yourself, “I’m just going to wait until we get through this and things get a little bit better.”
Now if rates start to rise, maybe on the first rate rise you don’t do anything. But on the second one, you’re probably going to start going, “Maybe things are getting a little bit better.” By the time the third or fourth raise comes along, or by the time the market takes interest rates higher (even if the Fed doesn’t), now that CEO, asset allocator, or investor, says, “Holy cow, things are starting to take off. I need to make a move.” Then you start to see that velocity of money pick up. Then it becomes a self-fulfilling prophecy to the upside.
That’s where I think Trump comes in. I think Trump is such a wildcard that psychologically, he may change behavior in the market. Not because he’s magic and not because he’s our savior. Not because he’s this new-found hope that America is going to be great again.
He’s going to do things differently. Rightly or wrongly, he’s going to do things differently. He’s going to put some policies in place that I think are inflationary. I think if the central bank follows his “lead,” for lack of a better word, and continues this upward projection of interest rates, then we might get some change of behavior, and we might get that velocity of money to pick up. With all those reserves that have been built up, inflation could pick up rather quickly.
Jon: Brent, can I ask you just one thing about Trump? You mentioned that you, like many people, see his policies as inflationary. I think for most people, they’re thinking about his plans for massive infrastructure spending. But you indicated you had a slightly different angle on this.
Could you explain why you think his policies are inflationary?
Brent: Yes. This is probably where I start to differ from the typical market observer, or maybe even the typical gold investor, for lack of a better word. I don’t want to speak for anybody else. I’m certainly not trying to put words in anybody else’s mouth, but I think the common view in the precious metals community is one of the main reasons you buy gold is that fiat currencies are fundamentally flawed. The governments will print them to pay for their bad debts, and that currency will be inflated away, so you need to own precious metals as a way of protecting that purchasing power.
Over the long term, that’s certainly a very valid reason to own precious metals. It may be the top reason to own them. That said, I don’t think that it’s the best reason to own gold right now. I think it will be in the future.
Right now, I think that Trump’s policies are inflationary because I think they are going to lead to a stronger dollar. I think we’re going to be in a unique point in time where the stronger dollar leads to higher inflation. I know that sounds a little off or different. Let me explain to you why.
I believe that we’re going to get into an environment where the dollar, gold, and potentially even the Dow are going to rise together. I don’t think we’re there yet, but I think that’s what’s going to happen in the years ahead. But there’s a window of time that we need to go through to get to that place.
I think the strong dollar is here. Now, it may weaken a little bit over the next month or so, or maybe even over the next quarter. I don’t think it will, but if that were to happen, I think it would be a short-term thing.
I did this presentation over last summer. I called it, “Step into Liquid.” It listed all these different reasons that I thought the dollar would get stronger. I’m happy to share that with anybody that wants to see it.
I think the Trump policies are going to make that thesis that I had even stronger. Here’s the reason. Like it or not, the world is still on a fiat system. Like it or not, the dollar, as flawed as it is – and it’s extremely flawed – is still the world reserve currency. It will be the world reserve currency until the moment it’s not.
Regardless of how you view the dollar, institutions, countries, companies, corporations, people who trade, people who import and export, they need dollars to facilitate world trade. If you look at all the dollar debt in the world, we go back to this debt super-cycle. There are hundreds of trillions of dollar debt in the world.
Long story short, I think the supply/demand issue on the dollar is going to push the dollar higher. I’ll get into the reasons why here in just one second. A lot of times, people will say, “Yes, Brent, but they can print the dollar to oblivion. Therefore, they can give out all the supply that way.”
Absolutely true. But right now, they’re not doing it. In fact, they’re doing the opposite. They’re decreasing the amount of money in the world. They’re raising interest rates. They’re sucking all that money back into the US, as opposed to sending it out to the rest of the world. If they change course, then fine. But right now, they are not doing it.
If you go back to the supply/demand issue, like I said, there’s hundreds of trillions of debt in the world. Let me give you a few numbers. If you look just at the US debt, $20 trillion. The Fed owns $2.5 trillion of that. Let’s say it’s $17.5 trillion.
In addition to that, we talked about the loans in the banking system. The loans in the banking system are anywhere from $10 to 12 trillion. Let’s just call it $10 trillion. You put $10 trillion on top of $17 trillion. Now we’re at $27 trillion.
Now, outside the United States, entities, institutions, corporations – however you want to define them, outside the United States – have issued another $10 trillion of dollar-based debt. Put that $10 trillion on top of the $27 trillion we already have. Now we’ve got $37 trillion.
We haven’t even talked about US corporations at this point. So far, we’ve just talked about the US debt, the banking system, and the international entities’ debt. Let’s just use $37 trillion as an example. The average interest rate on the national debt is, I think, 2.25%. At $17 trillion, that would be, let’s say, $300 to 400 billion.
On the other $10 trillion that’s in the banking system, let’s just assume for the sake of argument that they can get the same rate as the risk-free rate of 2.25%, which is ridiculous. But let’s just pretend they can. That’s another $250 billion of interest payments.
Then we take the international $10 trillion. Again, let’s assume they can get the same rate as the US, world reserve currency, risk-free rate of 2.25%. There’s another $250 billion a year. Now we’re somewhere at $800 to 900 billion a year in interest payments alone for the dollar.
That is demand. That is $800 billion of demand for the dollar every year, just to pay the interest. Without the velocity of money picking up, where are people going to get $800 billion to pay the interest payments?
The point is that there’s a lot of demand for dollars. We haven’t even talked about the demand for trade, for new trade, for new businesses. But just in interest payments alone, we’re approaching $1 trillion a year in global demand for dollars.
Now let’s bring that back to Trump’s policies. It’s a combination of Trump’s policies and the Fed. The Fed, when they were providing QE and they were giving dollars to the world that would then either get loaned into the banking system or the banks would use them as collateral to make trades, more dollars were being provided to the world. The spigots were open, for lack of a better word.
Now, rates are going up. It’s costing more money. Not only are we not providing new dollars to the rest of the world, but we are saying it costs more to service the ones that there already are.
Trump is talking about putting up border tariffs, where any goods coming into the US would have to pay some kind of a tax. That means prices are going higher. That means even though the dollar would get stronger, the prices of commodities would go up. Now we’ve got a potentially stronger dollar and some higher prices.
Also, if you think about it, he has said that he would like to build the wall with Mexico, for example. Mexico, they’re not going to want to pay for the wall, but he’s going to try to negotiate tougher treaties with them. Whether he can do it or not, I don’t know, but he’s going to try to negotiate tougher treaties. In other words, he wants to send less dollars to them and more of their stuff to us.
The point is that he wants to provide less dollars to the world and more dollars to the US here. That’s a strong-dollar positive. Let’s suppose rates continue to go up – and I think they might. They might not, but I think for the central banks of the world to have any chance, I think we need rates to rise. That’s the only way to get the velocity of money going.
If rates go up here, and they stay flat in Japan or Europe, or they go even more negative in Japan or Europe, asset allocators should bring more money to the US just to park it in dollars and get some kind of an interest payment, rather than zero interest payment. That alone makes the dollar more expensive.
Then another Trump policy is he wants these corporations, who have these big cash balances, to bring that cash back to the US. The reason they don’t is that right now there is very unfavorable tax treatment. If he says, “Listen, you bring the cash back. We’ll charge you a one-time 10-15% tax on it, rather than the current 40% rate,” I can imagine a lot of people are going to bring that cash back.
That makes the dollar stronger. Then the interest rates go up even higher. More capital is drawn to the US. Not only that, but as the dollar gets stronger, if we go back to the $10 trillion that the international entities own, it’s even harder…
Basically, they took out big loans, and they were involved in currency speculation at the same time, thinking their currencies would appreciate against the dollar. Now it’s gone sideways on them. Now they’re upside down. The dollar is getting more expensive. It’s even harder for them to service that debt. They go into a decline, which makes us look even better on a relative basis, which makes the dollar go even higher.
Alex: It’s a self-feeding process, isn’t it?
Brent: You can get into the vicious circle, where the dollar goes higher. Unless the Fed reverses course and starts providing more dollars to the rest of the world, then you get into the situation where the dollar gets even stronger.
Then you think of a place like China, which is going through its own credit crunch, and is one of the biggest owner of treasuries. There’s all this money trying to get out of China. When the money leaves China, China has to take the yuan that’s trying to get out and give them dollars.
The way that they get the dollars to give the people that are leaving is to sell their treasuries to provide the dollars. If they sell the treasuries – and they’re the biggest owner of treasuries – then that pushes yield up on treasuries. Now interest rates are even higher, and the dollar goes higher again.
The point is that there are all these different forces. Because the world still uses the dollar as the world-reserve currency, and because the world still uses dollars to operate, there’s a supply/demand imbalance.
It’s very similar to the gold argument. Let’s say the argument with gold is that there’s not that much out there, and when the world realizes that you need gold, the demand is going to overwhelm the supply.
Then you say, “Yeah, but they can just print more.” You can’t print more gold, but you can sure print more shares of GLD, and you can certainly, out of thin air, create more options and futures contracts on the COMEX.
A lot of times, the gold community will talk about the fact that ETFs and the COMEX provides “paper gold,” which keeps the price from going exponential. Again, that’s a conversation we could spend two hours on.
The same kind of dynamics currently exist for the dollar. They can do that. They could print and provide as much currency as the world needs. But right now, they’re not doing it. Until they start doing it, demand is overwhelming supply, or I think will overwhelm supply.
That’s my whole “Trump is inflationary” perspective. I hope I made sense. I know I was rambling for a long time.
Alex: No, it makes total sense. Brent, I think you do some of your best work when you’re ranting there like that! That’s a really good argument for a strengthening dollar.
Part of your thesis is that a strengthening dollar is actually going to cause its own destruction at some point, or its own demise at some point. Do you want to talk about that?
Brent: Yes, right. It’s like taking steroids. It makes you stronger in the short term, but it also might kill you.
Alex: Right. Explain this. How does this happen? What does it look like when the strengthening dollar causes its own demise?
Brent: I think it doesn’t happen right away. I don’t think it takes much longer for the pain to start showing up in other places around the world. I could be very wrong on this, but for now, let’s assume that I’m right that rates start to rise in the US, the Fed continues on a path of raising rates, and we start to get a little bit of inflation in the US as a result.
If we take that as an assumption for right now, I think the pain starts to show up in China very quickly. I think the pain starts to show up in emerging markets very quickly. I think it’s not too long in Europe before they start to feel pain as well, because they’ve got a number of problems, Greece and Italy probably being two of the biggest ones, not to mention dealing with Brexit.
What I think happens is the dollar starts to escalate in price pretty quickly. A couple of Trump’s cabinet picks have made comments about how the strong dollar could hurt us short term, and the dollar actually sold off on that news. At one point, he said something like, “It’s nice to have a strong dollar for bragging purposes. For other than that, it doesn’t really do us a whole lot of good.”
There’s all this innuendo that Trump wants a weaker dollar. I think he has more negotiating power with a stronger dollar. I think these foreign countries and these different trade groups, he’s talking about getting us out of these different trade treaties, I think these trade partners are going to start to complain about the strong dollar. I think the IMF will probably start to complain about the strong dollar.
Without some kind of a policy – and not just talk… Trump can say something, and the dollar might trade down for a couple weeks, or a month or so. But unless he actually does something to weaken the dollar, the market is going react and it’s going to rebound.
I think it probably doesn’t take much more than a year or two years before a bunch of the trading partners, the IMF, some of the monetary authorities start to talk about how the strong dollar is not conducive to world trade and world growth. They may even have another Plaza Accord type…
I think without them having some kind of a Plaza Accord type of agreement, or some kind of a coordinated devaluation – everybody devalues against gold or something like that – I think it just goes until the strong-dollar grips the world.
That’s why I say I think the dollar and gold rise together. As these problems start to pop up, I think gold and the dollar will start to rise together as a safe-haven flight to both of those assets. Ultimately, the dollar debts will have to get bigger during all of this as well. For the velocity of money to pick up, debt has to grow.
We’re already way in over our heads on debt. The debt will have to get even bigger. Eventually, people will realize the debts can never get paid off. The currency in which all these debts are issued is going to have to be worthless. That’s when gold separates itself. Maybe at that point, people give up on fiat currency altogether. Then maybe we go from the strong dollar to a weak dollar because people just flee the currency.
That’s how I see it playing out. I would think that in the next 12 to 24 months, the strong dollar is going to start to hurt the global economy. I think initially they will try to do these small half-measures, at best. They’ll try to talk it down. I think eventually they’re going to have to do something more dramatic and permanent in order to combat the strong dollar.
Here’s the great thing about this argument. If I’m completely wrong and they reverse course, and they try to inflate away the dollar right now, I own a lot of gold and I should do very well in that environment as well.
I think it’s my job to try to stay as impartial as possible, and try to figure out what’s going to happen. It’s all about probabilities. Even if I think the probability of something happening is only 1%, I think it’s part of my job to figure out, “We know we think there’s only a 1% chance this is going to happen, but if that 1% chance was to happen, what would have to happen for that 1% to happen?”
I think part of my job is to think through that and focus on that 1%, even though I don’t think it’s going to happen, so if that does happen, I’m not totally caught off guard and I kind of understand the reasons why it’s doing that.
I think that’s one thing I would recommend to anybody. I think sometimes it’s very easy to get caught in an echo chamber. It doesn’t mean that the echo chamber is wrong. The echo chamber that you’re in may be 99% right.
But you don’t learn a lot in the echo chamber. You can learn a lot by listening to that 1%. Even if you vehemently disagree with them, listen to that 1%. Try to figure out where they’re coming from and figure out what kind of crazy scenario would have to happen for that 1% to happen. That way if it does happen, you’re not totally caught off guard.
Alex: Outstanding. You know what, Brent? I think we’ve got a new nickname for you. You are “The Tenth Man.” I don’t know if you’ve heard of the tenth-man principle. The idea there is if there’s a board of directors and the board consists of 11, and you’d be the 11th man. Ten out of the eleven all think one way. It is your duty to disagree and take the opposite position.
Brent: There you go.
Alex: I think that’s really great about the way you look at things, and look for things that everybody else really isn’t looking at. This has been a great discussion with you today. I want to be respectful of your time. I really appreciate you taking the time to talk to us about these things.
Brent: I appreciate you inviting me to come on. I love talking about this stuff.
Listen, I’ve been wrong a lot of times in my life. I’m going to be wrong a lot more times. I like talking to people like you and others that can agree with me on some things and disagree with me on some things. Just talking through it helps crystalize some things, but it also helps figure out where you might be wrong in some things.
I think the one thing I would say is when I really started studying this stuff and really started digging in, the reason that it brought me to gold – and I know you probably agree with this, as well – is that regardless of which way this goes, the flaw in the monetary system exists. That is a fact. It’s a mathematical fact.
Alex: It’s math.
Brent: Regardless of which way it goes, whether it goes south because of the deflationary forces, or whether it goes south because of the inflationary forces, gold cannot be deflated away, and gold cannot be inflated away. Gold is a constant. It’s an element.
That is the one part of your portfolio that, regardless of which way this resolves itself, will still be standing at the end of the day. I think that’s why it has to be the anchor of everybody’s portfolio, regardless of which way you think it plays out.
Alex: Totally agree. Brent, thanks so much for being with us today. We greatly appreciate your time. We’ll have to do it again sometime.
With that, Jon, I’m going to hand it over to you.
Jon: Thank you, indeed, Brent Johnson, for sharing your insights with us this today, and thank you, Alex Stanczyk. Most of all, thank you to our listeners for joining us in this first episode of Global Perspectives.
Let me encourage you to follow Brent and Alex on Twitter. Brent’s handle is @SantiagoAUfund, and Alex’s handle is @AlexStanczyk. Goodbye for now, and we look forward to joining you again soon.
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