The Financial System Cracks
Is This the End of the Long-Term Debt Cycle?
If you have spent much time on Crypto Twitter (CT) or Financial Twitter (FinTwit) in the past couple of weeks and months, you have undoubtedly heard about the stock, bond, and currency market volatility. It has been a truly historic year across financial markets.
The Federal Reserve is raising rates aggressively (the fastest pace ever % wise), causing other central banks to follow and the dollar to skyrocket higher compared to all other major currencies (DXY reaching 20-year highs). Japan has been intervening in its currency + bond market, and the UK’s inflationary policy triggered a selloff that forced the Bank of England to bail out pension funds. Yeah… It’s a lot. Not to mention the war in Ukraine, increasing tensions between US and China, and the energy shortage crisis.
“Risk happens fast” is a famous phrase that was a crucial lesson in the 2008 financial crisis, and it has been going around more and more this year. Another saying that goes hand-in-hand is “gradually then suddenly.” When we look at the chaotic global environment today, it looks a lot like the end of an era, to put it nicely. To put it bluntly, it looks like an unsustainable system reaching its inevitable end, probably in dramatic fashion. The question we all have is, what happens next?
While no one can know for sure, historical lessons can point us in the right direction. Some of the world’s leading global macro experts have been the primary sources for this research article. The likes of @LynAlden, @LukeGromen, @DariusDale, and @RayDalio, are excellent at studying historical data and applying it to today.
It’s beneficial for all investors, including us crypto folks, to take the time to think about such things because these macro forces are what drive all asset classes’ performance currently, and perhaps, more importantly, they are shaping the world we live in. Hence, the end of an era atmosphere as times are changing.
By understanding the big-picture state of the global financial system, we can prepare mentally to keep calm and focused on our lives and goals, as everyone else is blindsided and unprepared. Also, financially, we can mitigate losses and potentially profit from the crisis.
A brief overview of the Long-Term Debt Cycle
The theory was popularized by Ray Dalio, Founder of Bridgewater Associates. For a comprehensive and beginner-friendly explanation of the concept, see this linked section of the video by Ray Dalio and his team.
The long-term debt cycle (LTDC) begins and ends roughly every 75 to 100 years. The end of the last cycle started in 1929, known as The Great Depression. The new LTDC was designed in 1944 in Bretton Woods, New Hampshire, and was put in place in 1945 when World War II ended. This was when we began the US-dominated world order and when the dollar became the world reserve currency.
Probably not coincidently, all LTDCs but one involved a major war. The last cycle, WWII, was the biggest by some measures. It involved and affected every sovereign to such a degree that the whole world synced up cyclical factors when it came to an end.
For example, the baby boomer generation resulted from men returning home from war all at once. Still now, and for over a decade, the largest generation of all time has been leaving the labor force for retirement, which profoundly impacts economies’ productivity and governments’ liabilities.
After WWII, economies were destroyed and dysfunctional. The one exception was the US, and because of this, they were able to design the new economic and financial system on their terms. That system has had a good run but is beginning to break and won’t last as it is.
The world is now roughly in the same end phase of the LTDC.
We know we are near the end of an LTDC when government debt becomes much greater than what its country produces (GDP) and when interest rates (Federal Funds Rate) reach “the zero bound.” This happened in the US and in most of the world in response to the Great Financial Crisis (GFC).
Dalio found, “In virtually every case, the government contributes to the accumulation of debt with its actions and by becoming a large debtor itself. When the debt bubble bursts, the government bails itself and others out by buying assets and/or printing money and devaluing it. The larger the debt crisis, the more that is true. While undesirable, it is understandable why this happens. When one can manufacture money and credit and pass them out to everyone to make them happy, it is very hard to resist the temptation to do so. It is a classic financial move. Throughout history, rulers have run up debts that won’t come due until long after their own reigns are over, leaving it to their successors to pay the bill.”
After decades of kicking the can down the road in response to every economic slowdown, we’ve come to the end of the road. The default playbook for years has been to lower interest rates to escape difficult economic periods.
But now we have a structural (not transitory) high-inflation environment. Central banks’ only tools to fight inflation is raising rates and maintaining, if not offloading, their balance sheets of mainly US Treasuries and other sovereign bonds. They are both blunt tools that will lead to a deep recession.
Where We Are Today and What’s the Playbook?
TLDR: The world is in a sovereign debt bubble combined with high inflation. The highest probable outcome is a volatile and prolonged period of financial repression. This involves debasing currencies, deflationary busts, and bondholders losing money in real terms as inflation persistently exceeds the yield in bonds (via yield curve control). In other words, governments will choose to inflate their debts down to manageable levels over a long period. It can last upwards of 10 to 20 years. The US, throughout the ’40s and ’50s, is the closest analogue, and Japan is a leading example this time around. It will be an era of geopolitical relationship restructuring within a trend of deglobalization (think countries onshoring manufacturing away from China, less global trade, more self-reliant, etc.) Internally, governments will face political revolutions and reform.
When it comes to government debt, the most relevant statistic is Debt-to-GDP.
The amount of debt a country can safely take on depends on its GDP or economic output. The problem is there’s no one stopping governments from issuing more and more debt, which inevitably will outpace their productivity. For reference, Japan has a Debt-To-GDP of over 250%, Italy over 150%, and the US over 120%.
A global economic reset is coming.
“We’ve just had a period of 14 years where we have built up leverage on the assumption that we are in a non-inflationary world and bond yields are staying low. But now we are taking bond yields to pre-2008/09 levels. What does that do to leverage in the system? Leverage is everywhere.” — @JulianBrigden.
Treasury bonds are fixed-rate U.S. government debt securities with a maturity range between 10 and 30 years. U.S. sovereign debt is typically regarded as risk-free since it is backed by the government’s ability to tax its citizens, and they can also print the difference.
Therefore treasuries are the backbone of the entire US financial system, and because the US holds the world reserve currency, USTs are also crucial to global financial stability. It becomes the benchmark risk to reward investment relative to all other asset classes. Stocks, real estate, private equity, etc., compete with government-issued debt.
Something is going to break.
We are in the breaking phase of the bear market. But what will break first? Let’s define a break as something that causes more government and central bank intervention that is contrary to their plan of tight monetary policy. The BOE bought 65 billion pounds of UK Bonds. While simultaneously trying to raise rates to fight inflation in the double digits.
Many world-class investors and economists agree that because the Fed is looking at lagging data to make their policy decisions and only has a blunt tool of interest rates, they will continue tightening until something breaks. While the Fed says they won’t stop raising rates until they see confirming evidence inflation is coming down towards their stated 2% target, other parts of the world are showing cracks before the break. Betting on this break occurring first and that it will cause the Fed to pivot and possibly the government to pass more relief bills is saying that eventually, something has to give that will be big enough to make its way back to the US.
As a side note, often, this intervention is not solely done to save that entity; “too big to fail.” Instead, it is done when central planners believe letting that entity fail would cause an unacceptable and catastrophic impact elsewhere (cascading liquidations). The threshold to backstop failures is dramatically lower when debt levels are this high.
A common flaw of human nature is recency bias. Recency bias shows up whenever a systemic crisis begins to emerge as many look at past crises from their lifetime to inform the one unfolding. Naturally, this means people are drawn to the recent stories of Credit Suisse and Deutsche bank getting caught offside in this bear market.
The banks aren’t in the picture for what’s likely to cause a contagion because they don’t lend any money these days (relatively). Due to that being the GFC’s initial domino, banks have become risk averse and are limited by increased government regulations.
The sovereign bond market is the problem this time, but we don’t know for whom yet. As we covered earlier concerning US treasuries, sovereign bonds underpin all asset classes and work in tangent with currencies to facilitate a functioning financial system (in a fiat system). It is the “pristine” collateral, a reserve asset for sovereigns, and a substantial portion of retirees’ net worth.
This year, we’re living through a historic collapse of sovereign debt. Government bonds have long been considered the safest investment for conservative investors. But this has been the 4th worst year for Government bonds in more than three centuries:
The rapid repricing in the bond markets has yet to show up bad enough within a sector (between banks, pensions, private equity, foreign owners of treasuries, etc.) That is, not to the degree that causes the captain of the ship, the US central bank, to reverse course.
What are the Fed’s options?
The US is left with two realistic options: Default on the debt, or pay it off with printed money over time. Countries that can print their currency to pay debts will choose to do so.
The Fed and other central banks pivoting while inflation is still hot around the globe is not a pretty outcome for them. They risk a complete loss of credibility and a massive outflow from sovereign debt into hard assets like gold, bitcoin, commodities, etc. But it just might be the better option.
It won’t look the same as the stimulus injected into the economy in the Covid crash of 2020. Central planners have learned what happens with careless money printing (inflation.) Instead, it will be much more targeted and involve new or changing laws to buy more time and keep the system afloat.
We’re still going to have a sovereign debt crisis anyway we look at it. That’s just what happens when governments spend as they have. Central banks will end up owning much of the debt, and currencies will debase massively.
A lot of people who thought they were going to have a comfortable retirement are going to be disappointed. If you have parents with a 60/40 portfolio (60% stocks to 40% bonds), you may need to adjust to the idea of them relying on you soon. But hopefully, it will happen at a more reasonable pace to allow a smoother transition.
Letting everything collapse is worse.
@StackHodler puts it well, describing a few of the current systemic risks.
“Even if the Fed has room to tighten, Europe and Japan do not. The Fed may not cause systemic risk at home, but they are close to breaking Europe, Japan, and some systemically important Swiss Banks — all of which would have spillover effects in the US.
That probably doesn’t justify a preemptive pause or pivot from the Fed’s perspective. They will be reactive to a crisis. But we’re already seeing the cracks emerge: The Swiss National Bank and European Central Bank have used the Fed Dollar Swap Lines in the past two weeks. The Dollar Swap Lines are a way for foreign central banks to access dollars when they’re in a pinch.”
US treasury market functioning is the Fed’s greatest concern regarding systemic risk. Because treasuries are crucial to the financial system, they must remain liquid. They can’t allow price movements like we recently saw in the UK’s market, or things can quickly get out of their control.
The below picture is from this Twitter post by @StackHodler.
Is this the end? Or can they kick the can once again?
The last time we saw sovereign and total debt levels so extended, combined with sticky-high inflation, was in the late 1920s. So the big question is, will this near-term cycle’s “breaking phase” initiate the long-time coming reset of the global financial system?
Or will central planners be able to kick the can down the road yet again? They would do this the only way they know how, via more of the same that got us into this problem in the first place and only exacerbates it when it inevitably comes back. There are other tricks they have up their sleeve, however. One is the previously mentioned stealth QE, which also only buys them more time. There is no easy way out and no avoiding something that looks like a reset.
A third outcome to consider is a slow death. @Raoul Pal believes it is more likely than not that rather than the system resetting with a bang as most people see it, it will instead go out with a whimper. He also views this path as the least worse option as it gives us time to build out crypto as a new financial system.
For investors, the question is, will this look like a repeat of the 2020 Covid-crash V bottom that leads to another bull market/risk-on environment for stocks and crypto? Probably not, at least not the same.
Many big tech and unprofitable growth companies had their time in the limelight and are still historically overvalued (when looking back further than the past 40 years of systemic debt accumulation). If not this, then what assets would benefit the most? We don’t have time to go into detail, but we will leave you this from Lyn Alden.
“There are a lot of attractive risk assets for the long-term out there that I’m keeping an eye on, such as Latin American equities (esp Brazil), Indian equities, gold equities, bitcoin, energy producers, a variety of cyclical value equities in general (commodities), and sectors like biotech and (during the current defensive environment), health care.
When the Fed runs into difficulty trying to tighten policy more and has to pause or pivot, then many of these assets would likely become very attractive, and I’d probably want to add them to the portfolio or increase my positions.”
Conclusion
In 2022, many of the largest economies have Debt-to-GDP levels over 100%. With ageing populations, economic inefficiencies caused by government bureaucracy, and a lack of political incentive to take the path of short-term pain for long-term gain, there’s a near-zero chance the debt will be paid off with increased economic output. However, through a period of deleveraging, reformed political and monetary systems, improving demographics, and technological innovation, we will eventually see a new and improved era.
