QE, Margin Debt and Eurodollar Shortages

I’ll start with a chart on margin debt from Margin Debt and the Market: Up 2.4% in June, Continues Record Trend – dshort – Advisor Perspectives

I’ve seen some tweets on Margin Debt starting to roll over, but the latest data I have access to through google search shows a continued rise through the end of June. As you can see on the chart above, margin debt rolled over prior to both the 2000 and 2007 peaks.

A very interesting and important thing is happening with US treasury market right now as well:

Above you can see a chart showing foreign selling of US treasuries, latest data is May 2021. Source: Yet Another Key Warning Sign, Piece Of Strong Evidence: TIC & The Long Misunderstood History of Selling Treasuries – Alhambra Investments (alhambrapartners.com)

I’m a big fan of Jeff Snider’s work and I encourage you to look through his articles on the Market Research tab on that website. Basically, he explains how our Eurodollar system works.

Here’s the gist of it. Foreign countries build up reserves in US dollar assets – particularly US treasuries, but also in gold – when the dollar is weak. The world relies heavily on the US dollar for foreign trade, and they tend to build up debt in US dollars when it seems favorable. At the same time, US investment cycles tend to periodically flood into emerging markets seeking growth and then rush back out seeking safety. The ever-growing debt levels increase the foreign need for US dollars over time while the investment flows create periodic scarcity. When Eurodollars (US dollars held in the banking system outside of the United States) are scarce, it can cause defaults and wreak havoc on foreign economies, as in the Mexican Peso Crisis and Asian Financial Crisis of the 90’s.

Foreign reserve assets, particularly those denominated in US dollars, are sold to offset this scarcity in their home countries. This tends to be a sign of coming crisis because foreign CB’s can’t just sell these off indefinitely – it has limits just like tapping into a strategic oil reserve. Similar to the oil analogy, tapping these reserves only alleviates the pressure of a cycle rather than changing the supply & demand function; the hope is to get through until the market currents shift on their own.

In the chart above, Jeff Snider points out the repeating economic crises in the Eurozone throughout this last decade and how they relate to this period of chronic Eurodollar shortage.

Other articles talk about how the federal reserve does not create money through QE – it is mainly a ledger action exchanging bank assets such as mortgage backed securities and US treasuries for overnight reserve assets paying the fed discount rate. These reserve assets can be exchanged between institutional US banks and are counted as assets they can borrow against, but money is actually created through borrowing. There is a long rabbit hole to go down here, but essentially the US Central bank is not creating money to alleviate the dollar shortage, they are just encouraging large investors to borrow cheap and pour money into assets such as stocks, bonds, and real estate. Also, QE has a side effect of reducing the top-tier collateral (short-term US treasuries) from the system and forcing money to park elsewhere, which is why both the BOJ and SNB have been going as far as investing in both US commercial debt and US stocks.

How does this dynamic affect the performance of TLT?

I created the charts above to see how TLT (long-dated US treasuries) relates to foreign holdings of US treasuries. The 5-year chart seems to show that the foreign holdings of US treasuries corresponds somewhat with lower yields at the long end, but the 1-year chart doesn’t say much because the federal reserve reports this data quarterly. The dip in foreign holdings on the chart at the top right ends in Q1 2021 which corresponds with the March TLT low. I threw in the last few months of data with the rally in TLT because it’s there, but there is no corresponding data available for foreign holdings of USTs in that period.

There is an argument that the Fed’s QE tends do drive down interest rates over time, and this seems to hold up with the decade post 2008 but in a rough and volatile process. There are so many questions and uncertainties here it’s insane.

How much can long-term interest rates go down as they approach zero? How does the zero line affect the movements? Japan and Europe have both shown the possibility of negative nominal interest rates on securites going out for several years. UST bulls would point out the path of Japan since 1990 and shorting the Japanese long bond as the famous “widow-maker” trade. Here’s a chart: Japan Long Term Interest Rate, 1998 – 2021 | CEIC Data

Corresponding chart in US 10-year yields from Yahoo Finance:

You can see the implications here, if you believe we are following the path of Japan (which was endless bouts of QE and fiscal stimulus). The absolute bottom in US rates we saw so far was at 0.5%. A TLT bull would point out that Japan’s 10YR yield went negative and ours could too, while a TLT bear would point out the massive rate hike after the 10YR JGB plunged from 2% to a low of 0.5% back in 2002.

We know that the Federal Reserve does not want negative rates, which is why they quickly announced the reverse-repo program where they will essentially take unlimited money from US banks and pay them a 0.05% annual yield on it. We also know that this program has grown massively since announced, and that close to $900 Billion is currently taking advantage of the program.

We also know that the worldwide economy is still experiencing massive shocks, lockdowns, shortages of certain things, and transportation problems.

The most common theories I hear about these days are the following:

  1. Hyperinflationists. They go on about the Fed balance sheet, government defecits, and whatever rose in price lately, convinced that the currency is rapidly devaluing. Their understanding of the monetary system is incredibly superficial, and they show a complete lack of understanding about deflationary forces such as technology, demographics, and enormous debt levels. These guys drive me crazy when they focus on the horrors of wage growth being sticky when there’s been no real wage growth in my lifetime.
  2. Deflationists. They talk a lot about valuations, high debt levels, enormous margin debt and the fragility of our financial system. I identify heavily with this camp and it includes a variety of people such as Dave Rosenberg, Jeff Snider, Steven Van Metre and so on.
  3. Semi-inflationists. Raul Pal from RealVision is one of these (other big names are Cathie Wood from Ark Investments) and he put together an excellent argument on how the underlying economy may be weak and the debt levels may be high, but the federal reserve balance sheet is expanding the money supply by pushing more and more money into investable assets such as the stock market. He sees low overall growth, the continuation of a winner-takes-all economy, and the value of “network effects” which is pushing more and more money into both Cryptocurrencies and anything tech. He explains that it could all turn if the federal reserve tightens, but they will never do that because it would totally crash the economy. The result as they see it, is that we’re stuck in a society with an ever-expanding wealth divide and you have to either buy assets that are increasing in value or you fall further and further behind.

Argument #3 is the newest to me, and it is certainly compelling. However, I still have trouble with the idea of investing in tokens which have no intrinsic value and with the idea of piling into the same big mega-cap corporations that everyone else in the investing world is piling into. I also tend to believe that the federal reserve, while powerful, does not have complete control over interest rates and the economic system. It seems to me that they have been working ever harder to give the illusion that they have control when they are really just following what the market does. Just like 1990 Japan, our debt-driven asset bubble will pop at some point, I have no idea when that will happen, and many assets will remain in a manic rise until it does.

For now I’m still in the bonds-bullion barbell approach because I see precious metals and mining stocks in general as relatively cheap while I want some protection in the case of a deflationary bust. It’s a tough slog when momentum is outperforming, but I can sleep at night without worrying too much. On the bonds side, I don’t think that long-term yields can rise too much without pulling down the financial system and causing a cascade of defaults. On the precious metals side, I am still convinced they go up considerably in the next decade and I don’t think they have much further to drop. Gold can revisit $1600 or even $1200, but these dips will be bought and they’ll be as temporary as the gold price crash in 2008-2009.

Here’s where my portfolio left off:

  • DOWNSIDE BETS (31.6%)
    • 23.3% TLT Calls
    • 6.3% IWM Puts
    • 0.2% QQQ Puts
    • 1.8% EEM Puts
  • PRECIOUS METALS (42.6%)
    • 10.2% AG (Silver), mainly shares some calls
    • 8.0% SAND (Gold, Silver & others), all calls
    • 4.5% EQX (Gold), shares & calls
    • 4.5% SILV (Silver)
    • 4.3% LGDTF (Gold)
    • 3.9% MTA (Gold & Silver)
    • 3.4% SILVRF (Silver)
    • 1.5% WPM (Gold, Copper & Silver), all calls
    • 1.3% RSNVF (Silver)
    • 0.5% SSVFF (Silver)
    • 0.6% GOLD (Gold, Copper), all calls
  • OTHER COMMODITIES (17.4%)
    • 6.0% NOVRF (Nickel/Copper)
    • 6.4% CCJ (Uranium)
    • 3.5% UUUU (Uranium, Vanadium, Copper)
    • 1.5% BQSSF (Uranium)
  • CANNABIS (5.5%) split btw CRLBF, GTBIF & TRSSF
  • CRYPTO (2.3%) all ADA
  • CASH (0.5%)

Notable trades: I sold all my QQQ puts on Monday and used the money to buy Uranium miners. That turned out to be a good move. At the end of the week I couldn’t help but put a little into one QQQ weekly put because it gained so much and we’ve had past patterns of strong Fridays followed by weak Mondays in the past … patterns which have to do with hedging positions of market makers around options expirations. Overall I’m down 0.6% on the week. Have a wonderful and relaxing weekend!

About johnonstocks

I've been trading stocks since 2003, active on Motley Fool's discussion boards and using first Hidden Gems, then Global Gains. I no longer have the newsletters, but I keep up on the WSJ and read David Rosenberg everyday at gluskinsheff.com. Education: CFA level 2 candidate MBA-focus in Finance, Marshall, University of Southern California - expected Dec 2010. BS Mechanical Engineering, UC San Diego, June 2002
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