13 January 2018

On today’s show, we bring back a guest that often yields some of the biggest praise from our listeners. His name is Richard Duncan and this is the third time we’ve had him on the show. Richard comes with a wealth of knowledge and over 30 years of experience working for organizations like the World Bank, the IMF, large-cap asset management companies, and many more. He’s the author of three incredible books that discuss macroeconomics and how the world of finance functions in a fiat world.

During today’s discussion we’re going to talk about the bond market and how it’s yield is potentially creating an environment for the stock market to potentially go even higher. Richard outlines some interesting points about how central banks are going to act in 2018 and what that means for overall market movements. So with that, let’s roll.

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  • Why and how the bond yield curve can signal a stock market high.
  • Why the FED is shrinking its balance sheet with 1 trillion dollars.
  • Why US’s trade deficit is the reason why the US dollar is the world’s most dominant currency.
  • Where commodities are heading in 2018.
  • Ask The Investors: How do I avoid confirmation bias?


Disclaimer: The transcript that follows has been generated using artificial intelligence. We strive to be as accurate as possible, but minor errors and slightly off timestamps may be present due to platform differences.

Preston Pysh  0:02  

On today’s show, we bring back a guest that often yields some of the biggest praise from our listeners. His name is Richard Duncan and this is the third time that we’ve had him on the show. 

Richard comes with a wealth of knowledge and over 30 years of experience working for organizations like the World Bank, the IMF, large cap asset management companies, and many more. He’s the author of three incredible books that discuss macroeconomics and how the world of finance functions in a fiat world. 

On today’s discussion, we’re going to talk about the bond market and how its yield is potentially creating an environment for the stock market to potentially even go a little bit higher. Richard outlines some interesting points about how central banks are going to act in 2018 and what this means for the overall market movements. So with that, let’s get started.

You are listening to The Investor’s Podcast where we study the financial markets and read the books that influenced self-made billionaires the most. We keep you informed and prepared for the unexpected.

All right, everyone. Welcome to the show. We are very excited to have Richard Duncan back with us.

Richard, this is the third time you’ve been on the show. We’re really excited to have you back.

Richard Duncan  1:18  

Preston and Stig, thank you very much for having me back. I’ve really enjoyed the last two conversations we had.

Preston Pysh  1:23  

Well, it’s likewise and I know our audience really enjoys hearing from you. We wanted to start off this episode talking about some current events.

Since Stig and I have been doing the show, the market was really flat for maybe the first year and a half, two years. Then recently in the last year, the market has just been going crazy here in the United States. It’s been going up a lot and when we look at maybe some of the reasons why it continues to go higher, an argument that a lot of people are making is it is related to the bond yield curve.

Before we get to the question, let me explain what the bond yield curve is to the listener so we can kind of level set everyone and we’re on the same playing field here. The bond yield curve is nothing complicated. All it is is a chart, where you have the interest rate over on the Y axis, the up and down. Then on the left to right is the term of the bond. So short term bonds are over on the left side of the chart, and as you go further to the right on the chart, you got your 30-year bonds out there. 

When you would picture how this chart would look, it’s positively sloped. So down on the or at least it is today. Over on the left side of the chart, the line is lower. Then as you go to the right, it goes up and it gets higher and higher because your 30 year bonds have a higher yield than your short term bonds that are just one month out there.

When we talk about a bond yield curve, when you get close to a recession or at a stock market high, historically, the bond yield curve has become flat, where during the last recession, a three month note was 5.5% and the 30 Year Treasury was also at 5.5%. So that really doesn’t make much sense that your short term money would be at the same yield or return that you’d get on long term money. 

What this does is it causes a lot of problems for banks with the way that they manage their liquidity. Back to the original question here, and I know this is really long, and I apologize, Richard, but I’m trying to make sure everyone’s on page here with what we’re talking about. A lot of people are saying that the market is not going to have a correction until you see the bond yield curve start to go flat, where the short term rates and the long term rates are at parity with each other. 

Do you agree with this narrative? How much more do you think this could move? I guess, what are your thoughts on the bond yield curve? Do you think that that has any impact on the stock market?

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Richard Duncan  3:46  

Well, yes, I do think it does. I mean, as you said, traditionally, when the yield curve inverts, that most of the time is followed by a recession. So it’s considered an important leading indicator for the economy. 

Now, the long end of the yield curve, the long term interest rates in the 10-year government bond is the most important one. That is something that the Fed typically cannot control. However, the big question is what is going to happen to the 10-year government bond yield? 

Right now, the 10-year government bond yield is about 2.4%. Now, is it going to go lower? Or is it going to go higher? Well, if it goes lower, then the yield curve would invert, and that would suggest that there would be a recession. 

Though, it’s not at all certain, in my opinion, that it is going to go lower. In fact, it seems to me more likely that rather than the yield curve inverting, it is going to start seeing the 10-year bond yields start moving higher also. 

Why? Because the Fed is reversing quantitative easing. So instead of…I think your listeners are familiar that the Fed for a long period of time, created money and bought government bonds. When they did that, that pushed up the price of the bond and they’re still at very low levels. 

Now, rather than printing money and buying bonds and pushing interest rates down, the Fed is doing exactly the opposite. They are essentially selling bonds. It’s a little bit more technically complicated than that, but the effect is the same. You can say they are selling bonds. 

So when they sell the bonds, that tends to make the bond price go down, and interest rates go up. So starting in October, they started reducing their bond portfolio by $10 billion every month. Now, starting in January, they’re going to reduce it by $20 billion a month, and then starting in April by $30 billion a month, and then in July by $40 billion a month. 

By October, $50 billion a month, so that’s going to be extreme monetary tightening. Selling so many bonds will depress the price of the bond and push the interest rates up on the bond. So the long term interest rates should move higher, rather than moving lower.

Also, along the same lines right now in Europe, starting this month, instead of printing 60 billion euros every month, ECB is only going to print 30 billion euros every month. Then in September, they may stop printing all together. This will stop putting downward pressure on European and US interest rates.


In other words, the global monetary position is tightening because the Fed is reversing quantitative easing, and the European Central Bank is doing much less quantitative easing. So the 10 year government bond yields in the US shouldn’t move higher, and the yield curve shouldn’t invert. 

Preston Pysh  6:42  

Very interesting. So now when we go back and we look at what they did leading up to the 2008 crash, call it from 2007-ish on. They were just adjusting the federal funds rate. There was none of this quantitative tightening occurring. Correct?

Richard Duncan  7:00  

Well, yes, before the crisis began in 2007, they had never printed money on a scale that they did once the crisis started and quantitative easing started. They just tended to move the short end of the yield curve by moving the federal funds rate up and down.

Preston Pysh  7:18  

The reason I bring this up and I asked that question is because in the past, typically, as we’d see the bond yield curve, invert, as the short end of that would start coming up, you would almost always see the long end start getting bought and brought down to bring it to parity. 

What happens from an equity standpoint now if the whole yield curve is just all going up, and it still stays positively sloped? I guess we haven’t ever seen that in the last 35 years. What does that do to the equity markets since we haven’t seen something like this?

Richard Duncan  7:53  

Well, so just thinking about the long end, the 10-year bond yield, it’s now 2.4%, which is very, very low by historical standards. For instance, back in 1980 or 1981, when interest rates peaked at the time of the great inflation in the US, the 10-year government bond yield was 15%. So, starting around 1981, those bond yields came down and down and down until they are where they are now at 2.4%. 

The 10-year government bond yield, I believe, is the most important number in the financial world because all the other interest rates are set off whatever the 10-year bond yield is, plus some premium. So mortgage rates are determined by the 10-year government bond yield. Consumer credit is credit cards; car financing. Everything is based off a 10-year government bond yield. 

Now, as interest rates came down from 1980, up until now, and so they borrowed more and spent more and as they spent more that created economic growth and that drove the US economy for decades. A booming US economy drove the global economy for decades. 

So, the ratio of total debt to GDP in the United States in 1980, total debt to GDP in the data the entire country is a percentage of the size of the economy, it was 150%. But now, it’s risen to 370%. This means that debt and credit have been growing much more rapidly than the economy and fueling economic growth in the US. 

So now, if we begin to see that 10 Year government bond yield and move substantially higher, say if it moves past 3% or 4%, if it starts moving above 4%, because of quantitative tightening, then credit is going to become much less affordable. Then the Americans will have to borrow less and spend less, and that alone will be sufficient to make the US economy go into recession. 

Making all of that worse is the fact that as Interest rates move higher then stocks will become less attractive. Property will also become less attractive. If the mortgage rate goes higher, then people will not be able to buy homes. So home prices will fall and stock prices will fall, and you’ll have a negative wealth effect. So the Americans will not be able to spend as much because their homes and their stock portfolios will be less valuable.

Stig Brodersen  10:24  

So Richard, could you talk to us about the different rates here? We talked about the federal funds rate. We talked about the 10 Year bond yield, like how can we look at this and perhaps the way to go about this would be… What is controlled by the Fed and what is controlled by the market? How do these two interact?

Richard Duncan  10:44  

So yes, the Fed controls the federal funds rate. If it hikes the federal funds rate in the short term interest rates will go up along with the federal funds rate. So it has direct control over the short term interest rates. 

To be a bit more technical, right now, all the banks have bank accounts with the Federal Reserve System and they have a lot of excess reserves piled up in their accounts at the Federal Reserve. The Fed is now paying interest to the banks on their reserves. The reserves the commercial banks are holding at the Fed. So the Fed is paying an interest rate now of 1.25% on those reserves that belong to the banks. 

The banks are not going to lend anyone any money for less than 1.25% because that’s how much they can earn from the Fed by just keeping their money risk free on deposit at the Fed. So that’s how the Fed controls the short end. They’re paying interest on the deposits that the banks are holding at the Fed and there are lots and lots of deposits there. 

So, when the Fed next wants to increase interest rates, they’ll just pay the banks, 1.5%, and then 1.75%, and then 2%. That will determine the short end of the yield curve. The banks will not lend anyone the lower rate. So the Fed has direct control over the short end in that way. 

The long end is much more complicated. It depends on a lot of factors. For instance, supply and demand. If the economy is weak, then that suggests that there are very few investment opportunities. People will then tend to not  want to borrow. If people don’t borrow, then interest rates tend to fall. 

On the other hand, if the government has a very large budget deficit. Of course, the US does have a large budget deficit, and it’s going to become larger because of the tax cuts that just passed. If the government borrows much more, all other things being the same, that tends to push interest rates up. 

Still, another factor is what’s going on with the central banks outside the United States. For instance, China, China has the largest central bank in the world. It’s larger than the Fed in terms of its asset size. So for quite a long period of time for a couple of decades, the Chinese central bank, the People’s Bank of China, PBOC was printing its own currency. It was printing yuan, and it was buying dollars in order to prevent the yuan from appreciating. They didn’t want their currency to appreciate because China wanted to continue growing through export led growth. 

So all together, China created the equivalent of something like $4 trillion and used most of it to buy dollars. Once they had accumulated the dollars, they invested those dollars into US government bonds because they bought the dollars, their exchange rate from going up so that their economy could keep growing through export led growth. 

However, once they had acquired the dollars, they needed to invest them somewhere in order to earn interest on them. They invested them in US government bonds that pushed their yields down. In fact, it pushed them down so far that it blew the US into a bubble during 2004 to 2006.

They were printing so much money and buying so many dollars and buying so many US government bonds that the Fed lost control of interest rates and the US economy bubbled. The long end of the yield curve, and the Fed can’t control them all. 

Preston Pysh  14:32  

Does the Fed sit on a lot of the bonds on the long end of the yield curve, with respect to what they did with the Operation Twist? 

Richard Duncan  14:39  

When the Fed started its quantitative easing, itt already had a lot of government bonds. 

Preston Pysh  14:46  

Long term, you’re saying? 

Richard Duncan  14:48  

Well, some short and some long. Before the crisis, the Fed already owned $2 trillion dollars worth of government bonds. At that point,when they were buying these 10-year government bonds, they did have a very strong control over the bond yields. In other words, the more money they printed, and the more 10-year government bond yields they bought, the higher the bond prices went, the lower the bond yields went. 

So at that time during quantitative easing, they had a very direct control over the yields on the 10 Year government bonds by printing money and buying enough bonds to make those yields go anywhere they wanted. However, they’ve stopped during the quantitative easing.

Preston Pysh  15:29  

Now, I’m curious, the numbers that you quoted, what was it? $10 billion, $20 billion, $30 billion? Was that correct? For the bonds that they’re getting ready to put back on the market?

Richard Duncan  15:38  

That’s right. They published a schedule of their intentions of shrinking their balance sheet. In the first three months, that would shrink by $10 billion a month, the second three months by $20 billion a month, and then $30 billion, $40 billion, and then $50 billion a month.

Preston Pysh  15:53  

So what does that equate to in yield? Are we expecting that to equate to in yield? Has there been any kind of analysis on that because at the end of the day I don’t know if that’s a meaningful amount relative to how many there are outstanding and with the market size and the bond size is, and what that might mean for price action? So I’m curious, do you feel like that’s a meaningful amount?

Richard Duncan  16:16  

Yes, that’s a very large amount within two years that would shrink the Fed’s total assets by something like 25%. It would reduce their size of their assets by more than a trillion dollars

Preston Pysh  16:30  

By adding $10 billion to the number every month?

Richard Duncan  16:34  

That’s right. 

Preston Pysh  16:35  

Okay. Now, the next question becomes, because, I mean, we’ve seen how this Fed’s acted for the last four years, and anything that they say, they probably have to say it 10 times before they do one action. So what level of assurance do we really think we have that they’re actually going to do this?

Richard Duncan  16:55  

Well, they started announcing this, I think it was back in June. They started doing this in October. So this program has already begun and it’s now from $10 billion a month, this month, they will contract their balance sheet by $20 billion. So we’re now at the $20 billion level. This is taking $20 billion. 

We always talk about the Fed creating money. This is the Fed retiring money or making money that exists now disappear. They’re making dollars disappear. They’re sucking dollars out of the financial markets and that means there will be less dollars left in the financial markets and therefore, other things being the same, asset prices should fall.

Stig Brodersen  17:37  

So, Richard, I would like to speak about a very related topic here when we talk about bond, bond yields and those different central banks here. I would like to start off talking about the US dollar because as we covered with you in the previous episode, it does enjoy a lot of benefits being the dominant currency in the world, including persistent trade deficit. 

The US dollar also provides our financial models with a source of liquidity and foreign capital inflows. Now, what would happen as we have seen, I’d say gradually, if commodities are being priced in other currencies, and do you see this change to continue over the next few decades?

Richard Duncan  18:24  

Yes, I hear a lot of people now talking about the possibility that someday oil will be traded in some other currency than dollars. I think that might be what you’re referring to, commodities being priced in some other currency. Most of these people are very keen gold bugs. They either have enormous positions in gold, or in some way they make money through encouraging people to buy gold. 

So I think you have to always take that into consideration when people are talking to you. you have to think about what they’re trying to sell you. Are they trying to sell you gold? Of course, if they are, they’re going to make arguments that will support that even though the arguments may not be so strong.

The reason the US is the reserve currency of the world is because the United States has an enormous trade deficit every year. Roughly this year will be something like a half a trillion dollars. That means countries like China, sell their goods in the United States, and they get paid in dollars, and they take those dollars home.

[It’s] so that the current account deficit if it’s $500 billion this year, and it’s going to throw out $500 billion into the global economy. That will be $500 billion more than there were last year. The US has had an enormous current account deficit.

Now going back to 1980, the world is absolutely drowning in dollars. [The] dollar is everywhere. Now, that’s the reason we’re on a dollar standard. It’s not as though China has suddenly decided to buy oil from Russia and pay for it in RMB, Chinese currency, instead of paying it with dollars. That’s not going to have very much impact. 

What that means would be that Russia instead of getting dollars, Russia would be paid in a Chinese currency and they would have to do something with that Chinese currency, like buy Chinese government bonds. They really don’t want to do that, because it’s a very risky investment. So maybe they will, maybe they won’t, but the US is never going to start buying oil denominated in RMB or anything other than the dollar. 

So as long as the US continues to have such an enormous trade deficit, the dollar will continue to be the global reserve currencies simply because there’s so many dollars in the global economy. 

China, on the other hand, has a very large trade surplus. So it’s not throwing any new Chinese currency into the global economy, relatively speaking. In order for the RMB to become a more of a reserve currency, China would need to run a very large trade deficit like the US does so that other countries would own RMB, but that’s not happening and it doesn’t look like it’s going to happen anytime soon. So we’re going to remain on the dollar standard, far into the future, as far as I can see.

Stig Brodersen  21:17  

Can the market lose faith in the US because I guess like, for people listening to them, they would say, “Oh, we just need to have a lot of deficit, and the larger the deficit, the more our currency would be a dominant currency”? It might seem kind of intuitive. What would happen if the market would simply lose faith in the US dollar by then? 

Richard Duncan  21:36  

Well, in order for China, for instance, to have a trade deficit, that would mean that it would have to buy a lot of things from other countries. If it bought a lot of things from other countries, it would no longer be able to keep all of its factory workers employed because it would be buying fewer things domestically. 

Suddenly, China’s unemployment rate would go up to a very high level and there would be social unrest in China. So China is not going to flip from a massive trade surplus to a massive trade deficit anytime, probably within our lifetimes. That’s not going to happen. 

Now, China’s central bank probably already has somewhere near $3 trillion in dollar assets that they hold primarily in US government bonds. Now, people say, “Well, China could just suddenly dump those bonds and that would be the end of the dollar standard.” What does that mean, dump the bonds? It means they have to sell them? Are they going to sell them to the Dutch investors or to Middle Eastern investors, to Russian investors? 

It doesn’t matter, whoever they sell them to those people are then going to have dollars and they’re going to have to keep their dollars invested in US Treasury bonds. So there’s no easy way to crash the dollar standard. If you sell dollars, it’s like selling farmland. Sell farmland. It doesn’t disappear. Someone else owns it. It’s the same with dollars.

Stig Brodersen  22:52  

After listening to you and after hearing the sustainability of a dollar-based system, the one that we have right now, does it mean it will become less problematic in the future? Or do you think that there is an alternative solution to the current monetary system that we have?

Richard Duncan  23:11  

I don’t think that there is an alternative to the current system that we have. A lot of people talk about the possibility of returning to a gold standard or an SDR standard. Let me explain why that would have disastrous consequences. 

For instance, if we were to go back to a gold standard, then that would mean that the United States would have to buy all the things that imports and pay with gold, as it used to have to do when we were on a gold standard. So the United States only has so much gold, and it has a very large trade deficit, especially with China. 

The United States trade deficit with China is $1 billion a day, so it wouldn’t take very many months of a $1 billion a day trade deficit. If we had to pay with gold, the United States would run out of gold very quickly. That would mean that it could no longer buy anything at all from China. 

Therefore, China’s export driven economy, which is already suffering from extraordinary excess capacity across every industry, if it suddenly was no longer able to have a trade surplus of a billion dollars a day with the United States, and China’s economy would absolutely implode in such a spectacular manner that mankind has never seen before. 

So, the last thing China wants is to return to a gold standard, or any other standard that does not allow the United States to buy things from China. That is the rate of a billion dollars a day in terms of a trade surplus.

Fiat money allows countries like the United States to buy things on credit and that benefits the sellers. So the sellers are very interested in ensuring that this fiat system continues. They’re not at all interested in wrecking it because they understand it would destroy their economies. 

Preston Pysh  24:59  

Fascinating. Alright, so Richard, we’re curious, is there anything that you have… A lot of people have a narrative that they’d like to discuss, or something that’s… We just started 2018 and it’s a brand new year. Is there something that maybe you’ve been working on or that something that you’d like to discuss that’s near and dear to you?

Richard Duncan  25:19  

Well, two things. I mean, in terms of what I think is important, we’ve already touched on what really matters most, I believe, for this year. In all respects, it’s what happens to interest rates, because we now have the Fed reversing quantitative easing. They are shrinking their balance sheet. This is radical monetary tightening. 

The same thing is beginning to occur in Europe and so we’re moving from a period of extreme loose monetary policy to what can only be described as radical tightening. 

Now, of course, before things run out of control, they would stop quantitative tightening. They would stop, pause. If things really started to crash too violently, then they would launch another round of quantitative easing again. 

They would have QE 4 to push them back up, but the risk is that at the very least, we could experience quite significant volatility in the stock market and the financial markets this year as the Fed test the markets to see how far the Fed can go in terms of and creating money without creating an economic and financial sector crisis. That’s the big thing. 

Stig Brodersen  26:30  

Richard, how much do you think is *self reinforcing in the sense that you’re contracting the money supply and the market will respond, but because perhaps the market will respond, you will see kind of like a snowballing effect. Is that something that you expect to happen?

Richard Duncan  26:45  

Well, yes. So once the stock market starts to fall, I mean, for instance, if the stock market falls 10% and looks like it’s going to keep falling, then I would expect the Fed to stop the quantitative tightening, put it on pause. If the stock market were to fall 20%, I believe the Fed would launch another fourth round of quantitative easing and push it back up. So I have no doubts about it. 

The Fed is managing the economy by the amount of money they’re creating or destroying. They don’t intend to allow it to crash. But at the same time, they’re now acting. We have to look at when all of this fiat money system started and why it started. It’s been going on for decades, for instance, in World War II. 

At that point, the government had to take over complete control over the economy to fight the war. It issued enormous amounts of government debt and the Fed financed it. That was a very important role the Fed played in allowing the United States to win the war. 

Ever since World War II, the government has managed the economy with the help of the Federal Reserve. During these times, even since the early 70s, when the The Bretton Woods system broke down, afterwards, money was no longer backed by gold in any way. This allowed an extraordinary explosion of credit in the United States and all around the world for the next several decades. 

That explosion of credit literally pulled hundreds of millions, if not billions, of people out of poverty all around the world. It created the world we live in. Everything in our modern world is a result of shifting from a gold standard to fiat money standard, and the explosion of credit followed it. So the world has been transformed by the system. 

The problem is in 2007, the United States got to the point where it was so heavily indebted to the private sector that they couldn’t continue borrowing anymore. In fact, they couldn’t afford to repay the debt that they had already borrowed, and the households started defaulting on their debt. 

At that point, the financial system started to fail. If the government had not intervened, all the banks in the United States would have collapsed. All the savings not only in the US but all around the world, the entire global financial system would have collapsed. All the global savings would have been destroyed. It would have been a complete meltdown of the global economy with the most likely outcome would have been widespread starvation. 

So this time, they reacted in a completely different way than they did at the time of the Great Depression. The time of the Great Depression, the Fed was already in existence, and it didn’t print money on an enormous scale and reflate the US economy. It could have, but it didn’t. 

This time, Ben Bernanke, who had studied the Great Depression, believed that if the Fed printed enough money and bought enough government bonds, he could reflate the economy, make all the banks solvent again and prevent a new Great Depression. That’s what he believed. He tested out his theory and he was right. He did reflate it. So we haven’t collapsed into a new Great Depression. 

However, the global economy still remains a very big bubble. It’s a bubble because there’s too much credit in the world relative to the income, the amount of money that people actually earn. There’s too much debt and not enough income to service the interest on the debt among the private sector, so that really means that only the governments have the ability to borrow and spend more aggressively to keep the global economy from shrinking, and perhaps spiraling into a downward depression. 

That’s why the US government had to increase debt by $10 trillion over the last 10 years. They were able to do that because the Fed monetized one third of it. The Fed essentially brought up $3.5 trillion out of the $10 trillion of new government debt that the government issued. So it was this combination of government spending, being financed by paper money creation that prevented us from replaying the 1930s. 

So in this respect, the central bank played a very crucial role, not only in financing World War I and World War II and the Cold War, but this time in preventing this fiat money system from imploding into the Great Depression. 

The question is what policies will we have now to ensure that the economy doesn’t once again experience the financial sector crisis the way that it did in 2007, given that the private sector is still very heavily indebted and really can’t continue taking on more debt? 

Stig Brodersen  31:44  

Richard, it is really evident listening to you how the money supply is controlling so many different parts of the economy. Which time period would you say is the time period where monetary policy has the least and most significant impact, and why is that?

Richard Duncan  32:00  

So, that is a complicated, complex question that really requires a very long answer I think. But I would say that the time when the Fed was least effective was during the early first few years of the 1930s when it didn’t take actions to stop the bank failures. 

By 1933, when President Roosevelt took office, the banking prices were so systemic that he declared a National Bank Holiday and closed all the banks in the country. By the time they reopened, 25% of them never did reopen. So that was the time when monetary policy was the least effective because the people running the monetary policy didn’t know how to work it at the time. 

The time when it was most effective was during World War I and World War II. It allowed the US government to borrow as much money as necessary to fight and win the war. The Fed printed the money necessary to finance government borrowing and allow the government to borrow at very low interest rates.

Stig Brodersen  33:08  

And where do you think we are in that given the current conditions that we have now is much higher policy effective today compared to history?

Richard Duncan  33:17  

So you could say that, in a sense, the crisis of 2008and the Fed’s response to it was almost the same sort of pattern that occurred during the two world wars. There was a crisis. The government had to borrow, in this case $10 trillion to ensure that this crisis didn’t overcome our country, and the Fed made that possible by printing $3.5 trillion in buying government bonds and holding the bond yields. Interest rates at very low levels, so that the economy could be replated. It was a very effective policy. 

Here we are nine years later, the unemployment rate is 4%. The household sector net worth in the United States is something like $40 trillion higher now than it was in 2009. It’s gone up 75%. The wealth of the country as a whole, the Americans, all their assets, minus all their debt, as household sector net worth is now $40 trillion more, 75% more than it was in 2009. At least a third more than it was in 2007, before the crisis started. 

So the policy has been very powerful and the only reason that they’ve been able to get away with this printing $3.5 trillion in the US, and now Europe is printing very aggressively. Japan is printing very aggressively. The reason they have managed to get away with that this time, is we have a global economy and because we have a global economy, the global economy is very deflationary. 

It’s deflationary because you no longer have to pay someone in Michigan $200 a day to build an automobile. You can now pay someone $10 a day in China or Vietnam, so the cost of labor has collapsed. 

In the past, we had relatively closed economies. So if the Fed printed a lot of money, then very quickly, all of the workers would have jobs. Wages would start going up sharply and all of the factories would have full capacity utilization. So their prices would go up and we would have a wage inflation spiral that led to very high rates of inflation and even hyperinflation. 

What has changed now is we no longer have closed domestic economies. The US just doesn’t buy cars built in Michigan. The US can buy anything it wants anywhere in the world it wants. In this world we live in, 2 billion people live on less than $3 a day, so that means we have generations of extremely low cost labor that allows the government just to have much more government spending and allows the central bank to have much more paper money creation than would have ever been possible before globalization began around 1980. 

Now, we have a big global economy with enormous excess capacity and a pool of extremely low cost labor. So that explains why there’s no inflation despite all the paper money that has been created.

Preston Pysh  36:19  

I’m kind of curious how that plays into commodities moving into the coming year. A guy that we track pretty closely [is] billionaire, Jeff Gundlach. He’s suggesting that commodities are going to do really well here in 2018. Would you agree with that idea?

Richard Duncan  36:34  

When the dollar goes down, commodity prices go up. When the dollar goes up, commodity prices go down. Look, throughout history, there’s a very, very solid correlation. 

So what’s likely to happen? Of course, between around the middle of 2014 and the first quarter of 2015, I believe, the dollar became very much stronger and that caused commodity prices all around the world to fall very sharply. That was a period when oil went to $26 a barrel. That did extreme damage to the commodity producing countries like Brazil, and of course to their currency values. 

It also caused damage to a lot of corporations around the world who trade in commodities or are involved in mining or oil production. So their corporate profits fell, and therefore their stock prices fell. 

But now, the dollar, it’s stabilized for a while. At the moment, very mysteriously, it’s weakening. It actually is becoming weaker over the last several months. As a result, oil is moving higher and gold is moving higher. 

Now, for me, I can’t understand why the dollar is weakening because as I’ve said, the Fed is now conducting very aggressive monetary tightening by reversing quantitative easing and [conducting] withdrawal [of] dollars from the global economy. 

[The] fewer dollars there are in the global economy, [the] supply and demand [are affected]. If there are fewer [quantities] of something, it becomes more expensive. So the dollar should appreciate. Instead the dollar is weakening. 

I still believe that as the Fed continues with this tightening schedule, where they will be removing $50 billion a month, destroying $50 billion a month starting in October, that should cause the dollar to strengthen. If it does, then it’s going to cause gold and oil and all the other commodities to fall. 

Preston Pysh  38:29  

Alright, Richard, we are so thankful that you took time to come on the show. I know every time you come on, I learned a ton. I’m speaking for Stig, but I’m assuming Stig is a ton right there with me. He’s smiling, saying yes. 

We want to give you an opportunity. We know that you’re currently working on a video that you’re going to have available on your Macro Watch website that goes through the history of the Fed. It also goes through the history of monetary policy. It sounds fascinating. Tell people a little bit more about what you’re doing there and then also tell people about your website Macro Watch. 

Richard Duncan  39:04  

Okay, well, let me just say to begin with, I always really enjoy coming on this program. You guys ask such good questions and allow enough time that we can really go into these things in enough detail to make them make sense to anyone listening. I really enjoy being on your program. Thank you for inviting me again. 

As you know, I publish a video newsletter called Macro Watch. Every couple of weeks I upload a new video, which is essentially me doing a PowerPoint presentation describing something important going on in the global economy, and how that’s likely to affect the stock market, the bond market, interest rates, commodities and currencies. 

Well, this time I’m working on something I’m really excited about. It is a complete history of the Fed, and therefore a history of US monetary policy, starting from the time the Fed was established and in 1914. What I’ve done is I break this into seven different periods. For each period, there are two charts that I discuss. 

One shows how much the Fed’s assets increased during that period, which tells us how much money they created. The other chart shows how the composition of the feds assets and liabilities changed during that period. 

By looking at the change in the makeup of the Fed’s assets, and the change in the makeup of the Fed’s liabilities, it tells the complete story of how the Fed evolved. Initially, the Fed was just intended to be a relatively passive institution that would serve to prevent banking sector crises. 

There had been a very severe banking sector crisis in 1907. In order to prevent that from recurring, Congress created the Fed in order to act as a lender of last resort and times of banking crises, but it wasn’t intended to be a very active institution. It was just going to take a passive role. 

However, the very same year, the Fed started operations, World War I began. That completely transformed the purpose of the Fed suddenly, it was no longer passive. It became very active because it had to finance the government’s war expenditures and war debt. 

So by going through seven periods, and looking at the way the Fed’s assets changed, that tells us the history of the US monetary policy. That’s extremely important because now the Fed is the most important instrument along with US government debt, and the way that the United States government manages our economy, governments manage economies. 

Now, laissez faire was something that was happening in the 19th century. It has very little relevance to our world. Now, the governments manage the economy. You want to understand how they’re managing it and what that’s likely to mean for your investment portfolio and your investment strategy, then you have to understand monetary policy. 

So, I would like to offer your listeners a 50% discount to the subscription to Macro Watch. Macro Watch costs $500 a year. But if you visit my website, which is RichardDuncanEconomics.com. Go to the website, click on the subscribe button. It will ask you a coupon code. 

If you use the coupon code “history,” type in “history,” it will give you a 50% discount. So, that will give you a one year subscription for $250.  With that, you will get one new video every two weeks. Plus, you will also have access to now there are 40 hours of Macro Watch videos in the archives, which you can begin watching immediately. So I hope you’ll take a look.

Stig Brodersen  42:48  

Great hand off, Richard, and again thank you so much for coming on the show.

Preston Pysh  42:53  

All right, so this is the point in the show where we take a question from the audience and this question comes from Radi.

Radi  42:58  

Hi, Preston and Stig. This is Radi from Jakarta, Indonesia. I’ve been listening to your podcast for a couple of years now. I’ve learned so much from you guys. Thank you for all the great work you guys are doing and educating us. 

One of the things that I really appreciate about you guys is how open minded you are to gold as an investing option. Even though I know Warren Buffett won’t touch gold at all. So my question is, how do you guys stay open minded to new ideas so that you can make the best investment decisions? Thank you.

Preston Pysh  43:37  

I mean, this one’s really easy for me. I’ve just been wrong so many times that I have to be open minded at this point. How about you, Stig? Let me hear your response.

Stig Brodersen  43:46  

Oh, I’ve definitely been wrong, at least as many times as you, Preston. One thing that I would like to take away from this discussion is what’s your thought process whenever you start doubting yourself. 

One thing I’ve learned from studying all these billionaires is how he should see the advice, say the bear case for someone who is bull, and vice versa because those arguments that you will find from people who really believe something, but still can pinpoint something and can go wrong. They’re typically a lot more thoughtful. 

There is nothing more [of a] waste of time than if you meet someone who is saying, “This is the best thing in the world. These are the 10 arguments why it’s the best thing in the world and there are no downsides whatsoever.” Chances that you can use the arguments for anything is probably not that high. So that’s the first part in response. 

The other thing about Warren Buffett and how he’s talking about gold, I think Warren Buffett is very open minded. But I think he’s very open minded in his own niche, his equities. If you just think about the story when he met Bill Gates and Bill Gates talked about these amazing questions that he never got about his company from anyone else. 

Specifically, Buffett asked simple questions like who’s the biggest rival? And why and what are they doing better than you? Or how much cash do you keep on the balance sheet? And why do you keep that level of cash? And what’s your opportunity cost of that? 

So I think someone like Warren Buffett, yes, he is super open minded, but you probably won’t see him invest in Bitcoin or something else that he doesn’t know anything about because I think he’s also right that if you try to be a 5% expert in 20 different asset classes, you’re probably not going to be successful in the first place.

Preston Pysh  45:32  

You know, one of the things that I think about a lot whenever I start developing a really strong opinion on something and I feel like I’m kind of getting in the military, we call it target fixation. That’s whenever when you’re flying a helicopter, you get so fixated on a target, that you’re coming down, and you actually fly the aircraft into the target because you’re so fixated on it. 

So I think for a lot of people, whenever they invest, sometimes they get target fixation. Maybe they think the market is going to go down and then they’re right and then they just keep piling into it, or on the upside, they keep piling into it as it’s going higher and higher and higher. They get fixated on the fact that they’re right. They stop asking themselves, “Why am I wrong?,” which goes back to the story of Ray Dalio. 

So we covered this when we talked about his book, but back in 1981, Ray Dalio literally lost everything. Let me tell you up to that point, he was doing really well for himself. He was a master at derivatives, and he was a master at commodities and currencies and things like that. 

In 1981, he had an opinion, he stuck with that opinion. He basically had convinced himself that there was no way he could be wrong, and he was dead wrong. He lost everything. I think about that, because when I think of people that are really smart out there, Dalio is definitely one of the top people on the list. The thing that I remember distinctly from his book is him saying, “I stopped asking myself why I’m right, and I started asking myself, ‘Why am I wrong?’” 

Having been wrong so many times in the market in different positions and things like that, that is one thing that I can honestly say I’ve developed a keen appreciation for is always asking myself, okay, so why am I wrong? And how could this really turn into a bad position? 

If I pile more money into this even though my head, and you’re always kind of got your guard up for being wrong? I think that that’s really important for people to develop that skill, especially if you’re new to the markets. I mean, if you’ve been investing since 2010, all you kind of know is that the market goes up.

I would tell those people to be very careful, and to really kind of start asking themselves, how could I be wrong? 

All right, so thank you so much for submitting your question for submitting your question. We’re going to give you a free course on our website TIP Academy. It’s our intrinsic value course where it teaches you how to go through and figure out the intrinsic value of a company. There is an Excel calculator. With this, it helps you determine the value of a single stock pick. We’re just really thankful for people like you for submitting your question. 

If anybody else out there wants to submit a question on the show and get it played, potentially win a free course, go to asktheinvestors.com. You can record your question there and hopefully get it played on the show.

Stig Brodersen  48:10  

Alright, guys, that was all the Preston and I had for this week’s episode of The Investor’s Podcast. We will see each other again next week.

Outro  48:17  

Thanks for listening to TIP. To access the show notes, courses or forums, go to theinvestorspodcast.com. To get your questions played on the show, go to asktheinvestors.com and win a free subscription to any of our courses on TIP Academy. 

This show is for entertainment purposes only. Before making investment decisions, consult a professional. This show is copyrighted by the TIP Network. Written permission must be granted before syndication or rebroadcasting.


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