Introduction

Silicon Valley Bank (SVB) was a unique institution in the values it strove for and the customers it served, which separated its identity from other, larger banks that exist throughout the world. Established in 1983, the company developed for about 40 years before its demise. It was able to IPO in 1988 and expanded across the globe into areas such as Israel, the U.K., China, Canada, Germany, and Denmark. The bank was built to help advance innovation throughout economies. Their website pushes this message frequently with slogans such as “the financial partner of the innovation economy” and “advancing innovation for a better world” (Silicon Valley Bank, n.d.). This meant that SVB catered to a smaller and more niche clientele, mainly consisting of venture capital firms, startups, and wealthy individuals. While one can argue that it was essential that SVB existed for these clients as it provided a banker for this ecosystem, it also left the company exposed to the ebbs and flows of the startup and venture capital world. More so, without proper risk management, potential downturns or stress would expose the bank to failure as risks materialized. As discussed below, the fall of SVB revealed systematic risks that all banks face; however, the individual characteristics of the company’s clients, assets, and liabilities caused the second-largest bank failure since the fall of Washington Mutual Bank in 2008, as shown in Figure 1. To dig into this, several areas will be examined, such as the regulatory environment, the effects of COVID-19, accounting designations, the macroeconomic landscape, inadequate risk management, a concentrated funding base, weakening profitability, and government intervention.

Importance of Regulation on SVB’s Frame

The regulatory stature in the background of SVB’s failure serves as an excellent explanation of why the company could operate the way that it did. The most crucial regulation for the bank came in the form of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) installed during the financial crisis in 2008 via the Obama administration. This law was a flight toward regulation in the wake of fear and banking contagion spreading throughout the economy at the time. Dodd-Frank heavily regulated the financial industry and prevented it from making riskier investments that could expose its capital to more significant losses in the future. While covering the bill would take up too much space and time, it is summarized quite nicely by Niall Ferguson in his book The Ascent of Money as he writes:

Dodd-Frank was a near perfect example of excessive complexity in regulation. The Act required that regulators create 243 rules, conduct 67 studies and issue 22 periodic reports. It eliminated one regulator and created two new ones. By 2014, according to one estimate, the total number of new restrictions associated with Dodd-Frank (27,669) exceeded the restrictions generated by all the other legislation passed under the Obama administration. (Ferguson, 2008)

Some would argue that it was because of increased regulation like the Dodd-Frank Act that banks became less competitive as an investment causing their growth and innovation to slow. This is suggested by comparing the financial sector to the overall market since 2008 in percentage appreciation terms, as shown in Figure 2. However, this is a discussion for another time.

The importance of the Dodd-Frank Act concerning SVB comes with a rule implemented upon the Act’s inception. Specifically, it required banks with more than $50 billion in assets to take annual stress tests given by the Federal Reserve. These tests would examine a bank’s balance sheet and ability to stay liquid or solvent in the event of an economic contraction of varying levels. The Act also created the Financial Stability Oversight Council (FSOC) and the Consumer Financial Protection Bureau (CFPB), which oversaw the supervision of the Act. While SVB would have been subject to these tests in 2008, the bank never had to conduct them due to legislation changes in 2018 under the Trump administration. The Reduced Regulatory Burdens for All but the Largest Bank Holding Companies Act eliminated the need “for bank holding companies with less than $250 billion in assets to comply with most aspects of the ‘enhanced prudential standards,’ including resolution planning, stress testing, and single-counterparty credit limits” (The Harvard Law School Forum on Corporate Governance, 2018). If one examines the size of SVB’s assets before failure, curious enough, it was right under the threshold at $212 billion. In effect, legislation changes in 2018 removed the need for SVB to conduct stress tests as extensive as the larger banks in the U.S. are required to do, along with having more relaxed supervisory on the health of its balance sheet. This regulatory frame allowed SVB to take on more hidden, individual risks that supervisors missed before its downfall. As discussed in the next section, these risks were only enhanced as COVID-19 stimulus introduced trillions of dollars of liquidity into the system.

The Effects of COVID-19

Around $5 trillion was given to different sectors of the economy over COVID-19 times; such areas included households, restaurants, airlines, hospitals, local governments, and other institutions. More importantly for the topic of SVB was that businesses received $1.7 trillion, and “more than nine million small businesses – generally those with 500 employees or fewer – collected loans through the Paycheck Protection Program (PPP)” (Parlapiano et al., 2022). Needless to say, a ton of money flooded the system, with many businesses and individuals flush with cash. More so, front and long-end rates were dropped from lowering the federal funds rate and quantitative easing. This allowed for cheap money, which boosted the stock market, and even more so boosted the size and quantity of equity offerings that SVB’s clients could complete. Due to this, one can see a massive increase in the bank’s deposits post-pandemic as most of these startups needed to place their newly acquired dry powder somewhere. To increase this funding, SVB sometimes required startups to hold most of their cash with the bank for it to conduct business with them. For example, “CNBC has reviewed six agreements that companies signed with SVB regarding financing or credit solutions. All required the companies to open or maintain bank accounts with SVB and use the firm for all or most of their banking services” (Goswami, 2023). In simple terms, to gain a loan from SVB, a company would need to hold their cash there as well, most likely forcing an even greater amount of deposits to flow into the bank, as shown in Figure 3.

As these deposits came into SVB, the bank realized that the opportunity to loan was diminishing compared to the vast amount of funding it received. More so, because the bank operated in such a niche sector, its knowledge of whom to loan to was more concentrated, further narrowing the options. For instance, when looking at SVB’s loan book, one can see just how focused it was on the technology and venture capital sectors, as shown in Figure 4.

Rather than push to invest in startups or firms they felt would not give the desired return, SVB decided to park the funds from depositors in ultra-safe assets. However, while one may think there should be no issue with doing so, it comes down to the specific characteristics of the assets they invested in and the macro environment that affected them, which will be discussed in the following sections.

The Importance of Accounting

SVB’s strategy of piling funds into safe assets such as Treasuries or Agency asset-backed securities (ABS) was common for banks following the 2008 financial crisis. Due to increased regulation, as discussed earlier, banks must also hold a certain amount of high-quality liquid assets (HQLA) on their balance sheet. The number of HQLAs banks buy is dictated by their Liquidity Coverage Ratio (LCR), which has to maintain a level above 100%. The LCR measures whether the bank can meet stressed outflows of deposits for 30 days or more. Calculating the LCR is simply the stock of HQLA the bank holds divided by the net cash outflow over 30 days, equaling greater than 100% . Of course, Treasuries and Agency ABS meet the criteria for HQLA due to the high liquidity and low credit risk associated with these securities (both are usually rated AA to AAA). However, even though the perceived risk of these securities is low, the way that SVB handled investing in them exposes idiosyncratic risks the institution took.

SVB’s latest 10-K shows that by the end of 2022, the bank had a massive bond portfolio valued at nearly $120 billion. One can see this increase in Figure 3 as securities increased along with deposits. Comparing these bonds against all the bank’s assets, it was a staggering 57% compared to an industry average of 24%, as shown in Figure 5. This had several implications for the bank’s profitability as these long-term fixed assets decreased in value as interest rates rose, as discussed in a later section. While other banks may hold fixed securities, they will also have a more considerable amount of loans that usually have a floating rate which will adjust to a rising rate environment, keeping profitability stable.

It is crucial to break down this bond portfolio to understand it better. Accounting is prominent in how this portfolio is laid out on the company’s financial statements. There are two distinct categories that the securities purchased can be placed into. The first is Available for Sale (AFS), meaning the company purchased these investments to sell them later in the future. The accounting treatment of AFS securities considers the fair market value as time goes on and will record unrealized gains or losses that will affect the company’s asset and equity values depending on the change. The second is Held to Maturity (HTM), meaning the company purchased these securities to hold them until maturity. The accounting treatment of HTM securities differs from AFS in that the investments' fair market value is not considered when showing the value of assets and equity as time progresses. Instead, the HTM category is kept at book value with no fluctuations taken into account, with a separate category describing any unrealized gain or losses that investors can view. However, these unrealized changes are nonimportant due to the nature of HTM, as the securities already have a set amount of return and value that will be realized once they expire. With these two distinctions, SVB could separate its bond portfolio into each category and disguise any changes under the larger HTM section. Investors never seemed to pay attention to this accounting manipulation until the macro landscape changed.

Yield Up, Price Down

A macroeconomic issue that usually occurs with hot economies began to rear its head again when deposits were flowing into SVB. Inflation grew massively as the U.S. economy, pumped by COVID-19 stimulus, began to overconsume, creating supply and demand imbalances throughout several sectors. The effect was the Federal Reserve’s choice to take decisive action to control skyrocketing price rises by lifting its benchmark rate by 500 basis points (as of the end of March 2023) and conducting the offloading of its balance sheet through quantitative easing. The effect was a rise in yields across the curve that has not been seen in the past decade, as shown in Figure 6.

On the asset side, this is when the trouble began for SVB. Thinking about how bond math works, one knows that as rates rise, the pre-existing bonds on the market have their price drop due to better-yielding options becoming available. This is precisely what happened to SVB’s extensive portfolio of AFS and HTM securities, as they were bought when yields were still low. Looking at the AFS side first, one can see that it was a much smaller portion of the overall portfolio sitting at a book value of around $28 billion of the $120 billion. Most of the securities were comprised of Treasuries ($17 billion), with Agency MBS making up the second largest allocation ($7.7 billion). One can also see a relatively sizeable unrealized loss of around $2.5 billion, driven by these securities having both lower yields than the present market offered and having longer maturities in the range of one to five years for the Treasury allocation and over ten years for the MBS allocation. With greater maturity comes more duration, which measures how sensitive a debt security’s price will be to changes in interest rates. The larger duration meant more significant losses on these investments as rates rose. Figures 7 and 8 illustrate the size of the AFS side, the unrealized losses, and the duration it was exposed to.

While a review of the AFS side’s size, duration, and considerable unrealized loss was startling, a glimpse of the larger HTM side is what eventually caused panic. SVB had around $91 billion of the $120 billion portfolio dedicated to the HTM allocation, with a shocking amount of $57 billion in Agency MBS. Worse, most of these MBS had a maturity of over ten years, meaning the duration was substantial, driving the disturbing $15 billion unrealized loss. Figures 9 and 10 display the HTM size, unrealized losses, and maturities.

It is essential to compare the HTM losses to the bank’s capital, which was around $16 billion, as shown in Figure 11.

The unrealized losses on the HTM side accounted for 93% of SVB’s capital, which would have been destroyed at any time if the portfolio were to be liquidated in the event of stress. Such a high exposure to losses made SVB stand out as other banks had not committed such a massive portion of their assets to securities. This becomes apparent when one compares the percent of assets in securities, as discussed before, with the unrealized losses as a percentage of capital, as shown in Figure 12.

While SVB is an outlier in how it invested its deposits in longer-duration securities, it exposed a systematic risk that all banks experience as rates rise, which is a decrease in the worth of the ultra-safe assets they hold. For instance, Figure 13 shows the fall in value across the financial sector of institutions with AFS securities. This makes sense, as banks are required to hold these assets to comply with regulations. However, banks also manage risk using financial derivatives such as interest rate swaps to hedge against interest rate exposure. Most banks with large AFS bond portfolios take part in these swaps as an insurance policy; however, when one looks at SVB, it seems they sold off their insurance right before trouble began, which begs the question: why?

Inadequate Risk Management

Interest rate swaps effectively transfer unpreferred types of payments for a preferred type via a switch. For instance, there is a fixed-floating swap that allows the party receiving fixed payments from their investment (think of a traditional bond) to transfer that cash flow to another party that, in return, will pay floating from an asset they hold (think of a Treasury Inflation-Protected Bond (TIP)). There is also floating-fixed, which is just the opposite of the example given above, and floating-floating, where two floating rates are exchanged. The point is that banks like SVB can use these instruments to hedge against changes in interest rates by engaging in a fixed-floating agreement so that as rates rise, they receive a floating rate that adjusts along with them. For HTM securities, the importance of these hedges is diminished since HTM assets are planned to be held until the securities expire. More so, these swaps are also marked at fair value, meaning their volatility with changes in the market will affect the P&L of banks, which is unfavored by most institutions and viewed as not worth the insurance on the HTM side. However, most banks with extensive AFS bond portfolios will engage in these swaps, or instead; they will hold very short-maturity securities such as three-month Treasury bills that have minimal duration. The Financial Times (FT) explains this relationship between the value of swaps and rates concerning the two accounting categories very well:

So if rates rise then a bank makes money on the hedge (receiving a higher floating rate than what it pays in fixed), but the bonds stay at par (if kept in the HTM account). If rates fall then they lose money on the hedge (receiving a lower floating rate than what it pays in fixed), but it can shift bonds from HTM to AFS and sell them at a higher price. That means it basically becomes a directional bet on interest rates that flows straight into the income statement, something most banks abhor. (Wigglesworth, 2023)

While SVB’s duration management was sorely lacking, the bank did seem aware of this issue as they had hedges on their books in early 2021. More so, the bank felt the impending rise of rates the Fed was signaling due to increasing inflation. The CEO, Daniel Beck, addressed that by saying:

…We’re certainly positioning at this point for the potential for higher rates. So in the quarter, we put on close to $10 billion worth of swaps on that available-for-sale portfolio. And we’re going to continue to do more to protect against that, to mitigate the impact of potential further rate movement. (Wigglesworth, 2023)

The company’s financial statements accurately reflect Beck’s promise at the time. However, if one fast-forwards a year, all these swaps seem to have just vanished. By the end of 2022, only $550 million of swaps were left, meaning the rest had been sold, as shown in Figure 14.

Why did SVB take off their insurance? Especially if, at the beginning of 2021, it felt rates would rise. Well, it turns out that as time progressed, rates did rise and began to affect SVB’s clientele of tech startups and VC funds as cheap money no longer existed. The slowdown of the fast-moving startup world was apparent as investors moved away from high cash flow promising growth opportunities to more stable value plays. A great example of this change is shown in Figure 15, showing the number of equity offerings substantially slowing as the Fed signaled and then raised rates throughout 2021 and 2022.

To SVB, this meant fewer deals were available for their clients, and less funding in deposits would flow through the doors. In turn, profitability most likely started to weaken as tech startups needed more of their deposits back (discussed in a later section), there were fewer loans to give out to attractive opportunities, and their bond portfolio was yielding less than the market was giving. These factors resulted in a move to sell their interest rate swaps, leaving SVB open to massive interest rate risk. At the beginning of 2022, SVB started to unwind the derivatives first by selling “$5 billion of AFS hedges to book a $204 million gain, and in the second quarter it dumped another $6 billion of hedges to lock in a $313 million gain” (Wigglesworth, 2023). If one thinks about it, the gains make sense because as rates rise, these hedges become more valuable, meaning they can be sold at a greater price than purchased. However, the point of these hedges was never for speculation but for insurance. SVB seemed to lose sight of that fact in the attempt to sell their protection for a small boost in their profitability to cushion the pain from the macro environment. In simpler terms, the bank sold its protection for a small gain in exchange for exposing itself to the probability of significant losses that materialized. Management suggested that these sales were part of a transition to focusing on “downrate sensitivity” (Wigglesworth, 2023). The company was essentially attempting to call the peak in interest rates while cushioning its profitability. Curiously, management was sort of right in that rates on the long-end 10-year Treasury peaked at around 4.25% in October of 2022. However, this did not prevent the rise in unrealized losses nor the equity investors or depositors from noticing. Once they did, the lack of insurance was not there to protect the bank from the spark that caused the institution's failure.

A Concentrated, Shrinking Funding Base

The heavily concentrated depositors that made up the liability side of SVB’s balance sheet felt the effects of the changing macro environment the most. As rates rose, money became more expensive, causing deals to slow and startups to burn through cash quicker. This caused a need for their deposits which the bank had to hand over. Another critical point is that most of SVB’s depositors were businesses instead of consumers. This matters because as rates rise, companies are more willing to move their deposits to a higher yielding option, such as a money market mutual fund, instead of a bank that is holding deposit rates low to keep net interest margins (NIM) level (NIM is just a bank’s returns from its assets minus what it pays its depositors or to its debt holders). With rising rates, SVB’s NIM was shrinking as its cost to keep depositors increased. For instance, “in the fourth quarter of 2021, its cost of deposits rose 2.33 percent, from 0.14 percent in the final quarter of 2021. That’s bad but not lethal: the company’s interest-bearing assets yielded 3.36 percent in the fourth quarter, up from 1.99 percent, rendering a tightening (shrinking profitability) but still positive spread” (Armstrong, 2023). These combined factors made deposits slip; by the end of 2022, they decreased by $16.1 billion. However, this fall was not the most dangerous thing about SVB’s funding base. If one looked at the percentage of uninsured deposits, it could be seen that almost 88% were above the $250,000 protection the Federal Deposit Insurance Corporation (FDIC) promises to back up if a bank fails. This is extremely important as it incentivized a large portion of SVB’s funding base to flee if any trouble was suspected, as businesses knew they most likely would not get their money back if the bank fell. The breakdown of these deposits is shown in Figure 16.

Lighting the Tinder Box

As 2023 emerged, the bank most likely realized that deposit bleeding might continue and that profitability could suffer further. To remedy this, SVB attempted to switch some of its longer-duration assets in the bond portfolio with shorter-duration, higher-yielding investments. The decision to do so resulted in almost all of the AFS securities being sold to the larger investment bank, Goldman Sachs. Due to the sale, SVB was forced to record a $1.8 billion loss, and to patch that hole in its capital; it decided to work with Goldman Sachs to raise new equity in the amount of $2.25 billion. The choice by the bank to rearrange its portfolio sparked major concern from depositors and investors, who decided to take a closer look at the company’s financials. Once it was discovered that SVB had unrealized losses on its HTM securities of almost all of the company’s equity, panic ensued, and the dominoes began to fall. SVB rushed to meet withdrawals from depositors as equity investors sold stock as fast as possible. The bank encountered several obstacles while trying to stop the bleeding. The equity offering run by Goldman Sachs fell through as investors realized a run on the bank was materializing. Some may also argue that the equity offering would never have worked due to the lack of confidence behind Goldman Sachs, which never actually underwrote the deal. On the depositor side, SVB quickly found itself running out of cash and realized it would have to either sell its HTM assets or use them as collateral to acquire funding from lenders of last resort. The latter option was much preferred; however, as Wall Street Journal (WSJ) points out that on Thursday, March 9^th, the day the bank was experiencing its highest withdrawals and was attempting to borrow the cash, it ran out of time as the computers that process the transactions at the Fed close at 4:00 p.m. PT and do not open until the next day. The WSJ writes, “The Fed needed a test trade to be run before the actual transfer could occur. That took time and the Fed didn’t extend its own daily deadline of 4:00 p.m. PT for collateral transfers to help SVB. Time ran out on the bankers and SVB couldn’t get the money that day” (Miao et al., 2023). As a result, the bank could not acquire enough funding to stop the run and, on that Thursday, suffered deposit outflows of $42 billion, as shown in Figure 17.

The following day, Friday, March 10^th, it was announced:

Silicon Valley Bank, Santa Clara, California, was closed today by the California Department of Financial Protection and Innovation, which appointed the Federal Deposit Insurance Corporation (FDIC) as receiver … All insured depositors will have full access to their insured deposits no later than Money morning, March 13, 2023. The FDIC will pay uninsured depositors an advance dividend within the next week. Uninsured depositors will receive a receivership certificate for the remaining amount of their uninsured funds. (Scaggs, 2023b)

Government Intervention

The decision by the FDIC to take SVB into receivership and insure both insured and uninsured depositors effectively ended the bank’s 40-year history. The government’s choice to save SVB has been met with several viewpoints as discussions about moral hazard and too interconnected to fail clash. On the one hand, moral hazard has its place in this discussion as the poor choices by the management of SVB, which resulted in its failure, were quickly remedied by government intervention. However, it is vital to remember that in the event of bankruptcy, which the company entered on March 17^th (a little over a week after the initial crisis), equity investors usually get next to nothing while management is fired, and creditors obtain anything left from the sale of assets. More so, management is usually given a certain amount of company shares as a part of their compensation package, meaning they suffer heavily when the business they run goes under. In effect, management is punished by the loss of their jobs, equity, and credibility, while investors lose capital due to poor due diligence. On the other side, the government’s backing of depositors of both insured and uninsured nature adheres to the argument that SVB was too interconnected with the venture capital community to fail. A stronger argument for this would center around the psychology between humans and banking, where confidence is key. If the government had just let SVB fall, panic might have spread further and wider than the initial fear the bank’s failure caused. The backing by the government ensured that other liquid and solvent banks with proper risk management were not punished with unnecessary bank runs. That being said, the result of SVB’s failure has already dealt confidence damage that cannot be undone. It will most likely result in the increased cost of funding for banks as jittery depositors move their funds to either super large banks deemed too big to fail or to money market accounts yielding close to five percent (as of March 2023). Due to this, banks will most likely see a shrinking of NIM as profitability is squeezed from both the liability and asset side via tightening lending standards to keep a more significant amount of capital in case of deposit outflows. The result could trickle throughout the U.S. economy as lending slows, causing businesses and consumers to borrow less as it becomes more expensive. However, only time will tell if these issues materialize.

Conclusion

The fall of Silicon Valley Bank exposed systematic interest rate risk that all banks experience in a rising rate environment. As mentioned, most of these banks work to protect against these risks via shorter maturity assets or interest rate swaps. SVB did not. Through several individual choices made by the bank’s management, it exposed itself to unnecessary danger in exchange for short-term profitability that eventually resulted in its downfall. As a result, the FDIC took SVB into receivership before ultimately selling the company’s assets to First Citizens Bank. The story of SVB’s failure is one of the ever-growing importance of risk management within a financial institution. More so, SVB’s case emphasizes the importance of seeing beyond short-term profits to consider long-term threats that can destroy over 40 years of development.

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Note from Author

Hi everyone, I apologize for the length; there are multiple narratives that weave together with this story and I felt it was important to include them all. As always, I hope you enjoyed reading as I enjoyed writing! If you want to learn more, I have included both an annotated bibliography and works cited below that displays the sources used for this piece.

Annotated Bibliography

Armstrong, R. (2023, March 10). SVB is not a canary in the banking coal mine. Financial Times. https://www.ft.com/content/7cf4eb45-78b7-4e6e-b134-1f0b082ba203

Robert Armstrong runs Unhedged, offered by the Financial Times. He writes market commentary with his co-author, Ethan Wu, almost every day. When Silicon Valley Bank failed, Armstrong and Wu wrote several pieces detailing different aspects of the bank's failure. This article is an excellent example as Armstrong makes several points about the individual risks and characteristics that made SVB's failure self-induced and not a signal for banks everywhere being in danger of suddenly failing.

Dodd-Frank Act. (2018, August 21). History.com. https://www.history.com/topics/21st-century/dodd-frank-act

The Dodd-Frank Act was instituted in 2010 by the Obama administration. It was created to enforce heavier regulations and supervision on banks with assets over $50 billion. This held until 2018 when the Trump administration changed the law to allow banks with assets under $250 billion to have less scrutinizing enforcement compared to their larger colleagues. This article by History.com lays out the details behind the original Dodd-Frank Act.

FDIC | Failed Bank List. (n.d.). https://www.fdic.gov/resources/resolutions/bank-failures/failed-bank-list/

The Federal Deposit Insurance Corporation (FDIC) frequently releases U.S. bank data. In this example, the FDIC shows the number of failed banks with their size in both assets and deposits. One can examine that Silicon Valley Bank is second to the top of the list as Washington Mutual Bank, which failed in the 2008 financial crisis, was the largest bank to go under in U.S. history.

Ferguson, N. (2008). The Ascent of Money: A Financial History of the World: 10th Anniversary Edition. Penguin.

Niall Ferguson's The Ascent of Money is a detailed book describing the history behind the creation of money and its ability to improve economies throughout the globe. Ferguson instructs readers in the creation of debt, equity, insurance, housing, and other critical financial topics that exist in the world today. Ferguson also gives an account of the 2008 financial crisis, which occurred while writing the book, with a brief mention of the Dodd-Frank Act, which was seen as a rush to regulation by lawmakers after the spread of banking contagion.

Levine, M. (2023, March 22). Silicon Valley Bank Ran Out of Money. Bloomberg.com. https://www.bloomberg.com/opinion/articles/2023-03-22/silicon-valley-bank-ran-out-of-money#xj4y7vzkg

Matt Levine writes for Bloomberg Opinion and focuses on several topics within the finance world. His past experiences include being an editor of Dealbreaker, an investment banker at Goldman Sachs, and a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen, and Kratz. Levine is a highly talented and knowledgeable writer that followed the failure of Silicon Valley Bank as it occurred. He brought several fine points to the table, including the highlighting that SVB ran out of money due to the computer that processes transactions through the Federal Reserve closing at 4:00 pm PT, which was first revealed by the Wall Street Journal (article quoted within the paper).

Parlapiano, A., Solomon, D. B., Ngo, M., & Cowley, S. (2022, March 12). Where $5 Trillion in Pandemic Stimulus Money Went. The New York Times. https://www.nytimes.com/interactive/2022/03/11/us/how-covid-stimulus-money-was-spent.html

This New York Times article lays out the total amount of Covid stimulus the government provided in stunning detail. It breaks down where these funds went, such as households and businesses. The effects of this stimulus were apparent for Silicon Valley Bank as the cheap money that flowed throughout the economy gave markets a boost resulting in more equity deals being completed. In turn, SVB's clients of startups had more cash which they parked within the bank.

Peccatiello, A. (2023a, March 12). Banking Crisis? By Alfonso Peccatiello (Alf). https://themacrocompass.substack.com/p/banking-crisis

Alfonso Peccatiello writes a personal substack commentary named The Macro Compass, where he addresses macro events occurring throughout the world and the best way he feels to trade them. Peccatiello has managed money and has significant experience addressing macroeconomic changes and how they affect markets. This article discusses the failure of Silicon Valley Bank and some of the individual risks the bank took that ultimately led to its demise.

Scaggs, A. (2023a, March 9). Silicon Valley Tank(s). Financial Times. https://www.ft.com/content/c94279a4-4ec2-4a0c-86fb-be8375e12ef2

Alexandra Scaggs writes for the Financial Times and provided several excellent articles about the failure of Silicon Valley Bank as it occurred. This article discusses the fall in SVB's stock price as panic ensued before the bank's demise. Another report by Scaggs quoted within the paper discusses SVB being taken into receivership by the FDIC, which occurred on March 10th, a day after this article was written.

The Harvard Law School Forum on Corporate Governance. (2018, June 13). Rolling Back the Dodd-Frank Reforms. https://corpgov.law.harvard.edu/2018/06/13/rolling-back-the-dodd-frank-reforms/

This article by Harvard Law described the legislation change to the Dodd-Frank Act that occurred in 2018 under the Trump administration. The easing of the Act created an environment where smaller banks of assets under $250 billion, such as Silicon Valley Bank, could operate with less regulation and supervision. More specifically, the stress tests and balance sheet risk-taking restrictions were more relaxed than larger banks within the United States.

Wigglesworth, R. (2023, March 17). How crazy was Silicon Valley Bank’s zero-hedge strategy? Financial Times. https://www.ft.com/content/f9a3adce-1559-4f66-b172-cd45a9fa09d6

Robin Wigglesworth, via the Financial Times, writes this excellent article detailing in easy-to-understand how the elimination of hedging occurred within Silicon Valley Bank. Wigglesworth breaks down the relationship between interest rate swaps, accounting measures, and interest rates changing in the macroenvironment. He also displays the elimination of these swaps via SVB's 10-K. More so, he describes how combined with no hedging, SVB's liability side was highly concentrated and interconnected, eventually leading to quicker panic when the trouble started.

Works Cited

Armstrong, R. (2023, March 10). SVB is not a canary in the banking coal mine. Financial Times. https://www.ft.com/content/7cf4eb45-78b7-4e6e-b134-1f0b082ba203

Bloomberg L.P. (n.d.). Bloomberg [Dataset]. https://www.bloomberg.com/professional/solution/bloomberg-terminal/

Ferguson, N. (2008). The Ascent of Money: A Financial History of the World: 10th Anniversary Edition. Penguin.

Goswami, R. (2023, March 13). Silicon Valley Bank signed exclusive banking deals with some clients, leaving them unable to diversify. CNBC. https://www.cnbc.com/2023/03/12/silicon-valley-bank-signed-exclusive-banking-deals-with-some-clients.html

Miao, H., Zuckerman, G., & Eisen, B. (2023, March 22). How the Last-Ditch Effort to Save Silicon Valley Bank Failed. WSJ. https://www.wsj.com/articles/how-the-last-ditch-effort-to-save-silicon-valley-bank-failed-89619cb2

Parlapiano, A., Solomon, D. B., Ngo, M., & Cowley, S. (2022, March 12). Where $5 Trillion in Pandemic Stimulus Money Went. The New York Times. https://www.nytimes.com/interactive/2022/03/11/us/how-covid-stimulus-money-was-spent.html

Peccatiello, A. (2023a, March 12). Banking Crisis? By Alfonso Peccatiello (Alf). https://themacrocompass.substack.com/p/banking-crisis

Peccatiello, A. (2023b, March 14). Contagion Risks. By Alfonso Peccatiello (Alf). https://themacrocompass.substack.com/p/contagion-risks

Rosenthal, J., Simon, P., & Milonopoulos, G. (2023, March 10). U.S. Banks: SVB Situation More “SV” Than “B.” CreditSights.

Santilli, P., & Benedict, J. (2023, March 12). Silicon Valley Bank’s Meltdown Visualized. WSJ. https://wsj.com/articles/silicon-valley-banks-meltdown-visualized-3da2263b?mod=saved_content

Scaggs, A. (2023b, March 10). SVB: RIP. Financial Times. https://www.ft.com/content/cea7e32a-5ea3-4a6f-ab6d-1360a9de9557

Silicon Valley Bank. (n.d.). Silicon Valley Bank. https://www.svb.com/newsroom/facts-at-a-glance

SVB Financial Group - Financials - SEC Filings. (n.d.). https://ir.svb.com/financials/sec-filings/default.aspx

The Harvard Law School Forum on Corporate Governance. (2018, June 13). Rolling Back the Dodd-Frank Reforms. https://corpgov.law.harvard.edu/2018/06/13/rolling-back-the-dodd-frank-reforms/

Wigglesworth, R. (2023, March 17). How crazy was Silicon Valley Bank’s zero-hedge strategy? Financial Times. https://www.ft.com/content/f9a3adce-1559-4f66-b172-cd45a9fa09d6

Personally, this is one of the last authentic speeches delivered by a US president warning of greater spheres of influence internally within the US.

A vital element in keeping the peace is our military establishment. Our arms must be might, ready for instant action, so that no potential aggressor may be tempted to risk his own destruction. . . . American makers of plowshares could, with time and as required, make swords as well. But now we can no longer risk emergency improvisation of national defense; we have been compelled to create a permanent armaments industry of vast proportions. . . . This conjunction of an immense military establishment and a large arms industry is new in the American experience. . . .Yet we must not fail to comprehend its grave implications. . . . In the councils of government, we must guard against the acquisition of unwarranted influence, whether sought or unsought, by the military-industrial complex. The potential for the disastrous rise of misplaced power exists and will persist.

And this is essentially how the world has operated since the 1960’s till 2020: multiple industries lobbying and vying for power to influence consumers, with the US government acting as their personal legislative arm. In doing so, our leaders (I’m referring to those in developed nations) have stolen what is not rightfully theirs to lift themselves and these industries to unnatural heights. Through monetary and fiscal policies that have propelled growth and productivity to present levels, they have not only stolen wealth and prosperity from our children and our children’s children, but they have also created a political dynamic that has grown weary of the Constitution and its attendant political norms.

So how did we get here?

In a ‘reasonable’ world, (assuming a closed-economy) you would expect a group’s GDP to increase in line with the wealth of its people.

As a people, you can’t be a lot richer than your economy grows without stealing that wealth from someone else.

How’d we steal?

We did this by ‘stealing’ wealth both externally through trade in favor of the developed nation, and internally from future people in our own country through artificially low interest rates, monetized debt-driven stimulus, and an increasingly levered financial system supporting investments into industries that don’t necessarily drive productivity. And while the US has been doing this for some time now, I wanted to focus on the accelerating separation between net worth and GDP that has been occurring since 2008.

In 2008 the world faced its largest financial crisis since the great depression leading to the introduction of quantitative easing (QE) to provide liquidity for banks in a time of crisis. While the introduction of QE was justified, for me the real issue that stemmed from this was that QE never really stopped, and just like a drug you begin building a tolerance and asking for more.

We continuously transform emergency government intervention policy into permanent government policy. 

1. Interest Rates

2. Balance Sheet Control

3. Central Bank Communication aka Faith

These are the three main ‘tools’ which the US central bank has been using to play its game since 2008. The third being perhaps the most underrated tool and least mentioned because of its simplicity. The reason we still trudge along as resemblance of a society, Faith, which the central bank has provided exactly just that with its verbal promises in press releases and meetings, always giving the public the benefit of time ahead of its decision to maintain its “extraordinary accommodation” far into the future.

So we went along for another decade with the three ‘tools’.

Then came COVID-19.

Then came low interest rates.

Then came more QE.

Then came stimulus checks and PPP loans.

Now, we are looking at the widest ever gap between individual wealth and GDP.

Even with all the news of recession and inflation, is that it is no longer possible to inflate wealth without sparking inflation in the real economy.

So the lines must converge, and if they do, it would be a wealth destruction bigger than 2008. I hate saying this, but I believe the alternative is worse. The politicians that run our government recognize this problem, but the result of parties’ inability to cooperate towards common ideals is the continuation of public policy that patches cracks rather than fixing the material, such as the latest student loan forgiveness package that seeks to relieve college graduates from debt, but does so by handing out money rather than addressing the systemic drivers of increasing tuition costs to students. As I mentioned earlier, it is difficult to put the genie back in the bottle. Once new measures are taken for emergency purposes, in the hopes of gaining political favor, the government is then able to leverage these measures for non-emergencies when they do not restore economies to equilibrium, but instead exacerbate long-term drivers of poor economic health. The long-term implications of these short-sighted choices do not prevent the politicians that made these choices from being re-elected, so the dynamic is unlikely to change.

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“I said that we needed to shift the focus to improving the quality and returns of economic growth, to promoting sustained and healthy economic development, and to pursuing genuine, rather than inflated, GDP growth and achieving high-quality, efficient, and sustainable development”- Xi Jinping, President of the People’s Republic of China.

While China has excelled over the past decades, many economists are now predicting that several headwinds will affect the country’s overall growth rate. The most prominent indicator is a large amount of debt invested in non-productive assets like infrastructure and real estate. This article aims to explore the reasons behind China’s explosion in growth, how it has been pushed to a level that is difficult to maintain, and how the country needs to transition and deleverage to produce real growth.

Building the Rocket

Before the late 1970s, China was worn down from several conflicts, such as the second Sino-Japanese war and its civil war. More so, the nature of Mao Zedong’s leadership required most enterprises to be nationalized. While this provided stable pay and suitable living conditions, it offered little incentive for workers to innovate and grow the economy. Additionally, China was isolated before the 1970s, allowing for a minuscule amount of knowledge, technology, or investment from the outside world. Due to these reasons, the country was considered very poor during the time (Figure 1).

Figure 1: China’s Historical GDP Per Capita

The spark for change came when Mao Zedong passed in 1976, and two years later, Deng Xiaoping won leadership. He immediately recognized the need for reform and installed several open-door policies to achieve a socialist market economy. Michael Pettis, a finance professor at the Guanghua school of management at Peking University specializing in Chinese financial markets, summarizes the strategy quite well. He states that the act of enforcing liberalizing reforms allowed for the creation of social capital. It is important to spend some time on this term. The World Bank defines social capital as:

“Social capital refers to the institutions, relationships, and norms that shape the quality and quantity of a society's social interactions. Increasing evidence shows that social cohesion is critical for societies to prosper economically and for development to be sustainable. Social capital is not just the sum of the institutions which underpin a society – it is the glue that holds them together”.

Pettis explains the term in a broader sense; for instance, he discusses the model of social capital and how it states there is an appropriate level of capital stock (investments) per worker that is contingent upon the worker and businesses’ ability to absorb the additional capital stock. While this is slightly confusing, it is simplified to say that an economy’s framework must encourage the ability for it to absorb more productive investments. The higher social capital is, the more prosperous a country can become from natural growth. Ultimately, it comes down to having the right institutions and leaders to implement this structure. Pettis explains that the framework of social capital should accomplish three things:

1. Create incentives and rewards for innovation that is defendable through legal action.

2. Encourage the creation of business ventures and phase out older, less efficient operations.

3. Maximize participation in the economy by the whole population while minimizing variability in that participation.

Looking at this list, one can derive that the first two imperatives enforce the third. Suppose this framework of social capital is accomplished. In that case, there is an incentive to innovate and be competitive, which leads to new business ventures, and therefore, a higher participation rate in the economy. To Pettis, social capital is not just the social norms but the entire legal, institutional, and economic system along with the relationship between them that allows the economy to absorb more capital investments and drive productivity growth.

Returning to the topic of China, it can be argued that Deng’s reforms in 1978 built the social capital needed to help the country advance. They relieved the constraints and opened the door for China to improve its trade and learn from the outside world. The country boosted productivity by incentivizing the creation of businesses, which created abundant wealth for the population. For instance, during this time, citizens could produce and sell products by themselves without state-controlled interference. However, it wasn’t long before this growth began to push on the walls of what the economy was capable of.

China quickly realized the lack of capital investment disallowed physical capital to catch up with the already established social capital (as discussed earlier). To increase its infrastructure and capacity to grow, Deng instituted what many believe to be an economic development model that was founded by an economist named Alexander Gerschenkron. The Gerschenkron model was developed to describe the growth seen in Europe throughout the 1930s and in the Soviet Union post the second world war. It discusses how countries poised to grow through industrialization start as relatively backward and in need of investment. The backwardness of the economy refers to lacking the necessary resources to develop and industrialize. These items can consist of: insufficient capital, labor, technology, and political stability for the country to organize and expand. One of the essential items on the list for China was the need for physical capital. While investments to develop these assets can be obtained from multiple sources, for instance, foreign investors, the Gerschenkron model recognized that that path was risky and left the country vulnerable to large capital outflows and economic changes in the investor’s homeland. The safer route, which the government of China proceeded with, is to raise savings rates for corporations and elite individuals who would then invest in the economy. More specifically, the government realized that household income growth led to higher consumption and lower savings rates, diminishing domestic investment. By constraining household income, consumption fell, and savings rose. The government then saw that the private sector was skeptical about investing in the needed productive ventures as the country was still relatively undeveloped and risky to fund. In turn, central authorities allocated savings by identifying productive investments and projects, which was relatively easy due to the considerable lack of physical, advantageous assets. This led to the household and corporations’ savings rates to increase during the early 1990s and 2000s, which they then used to invest and grow, as shown in Figure 2.

Figure 2: China’s National Savings Rate (as a Percent of GDP)

While instituting the Gerschenkron model helped China achieve physical capital equivalent to their social capital, there is still an essential part of the growth story that needs to be addressed: demographics.

Adding Fuel

China’s people play a crucial role in its ability to grow. As mentioned at the beginning of the article, before the 1970s, China had several conflicts that hurt its population base. In 1949 Mao Zedong encouraged the citizens to reproduce to restore manpower. This sparked a baby boom where the population grew massively. It became so large that the government began to stress over the number of children and if the people would be able to care for them. A mismatch developed where the number of children added to the growing population; however, they were not working or producing anything, only consuming and draining the country, which put the food supply at risk. For instance, from 1959 to 1961, the Great Chinese Famine killed an estimated 15 to 30 million people, leading to the government’s action to curb population growth. Central authorities began to push for fewer births which worked as the population slowed from 1970 to 1976. However, it leveled off with no movements until the government instituted the famous one-child policy in 1979, which limited couples’ ability to reproduce more than once. Figure 3 displays the effect the policies had on China’s birth rate.

Figure 3: China’s Birth Rate

While slowing the birth rate will most likely hurt China’s growth in the future (discussed later), the fact of the matter was that the population had still grown to be massive. More so, it was full of youth that would age into the working population precisely when Deng took over, instituted reforms, and adopted the Gerschenkron model to grow social and physical capital (as discussed earlier). This led to a perfect storm where China’s working population grew in line with positive structural changes. Figures 4 and 5 display its peak throughout the 1990s and 2000s.

Figure 4: China’s Population by Age Group

Figure 5: China’s Working Population

Take Off!

The combination of reforms, central authorities investing in productive assets, and the labor force coming to age set off an explosion of economic growth within China. The country accelerated its prosperity through the model of transferring savings to investments. It should be noted that the distribution of this newfound wealth was skewed toward the rich and businesses due to the model’s structure of constraining household income growth for workers. However, income grew at such a rate that all Chinese citizens benefited from the expansion, as shown in Figure 6.

Figure 6: China’s Gross National Income

One of the most important events during China’s ascension was its admission into the World Trade Organization (WTO) in 2001. Central authorities saw the trade group as an opportunity to continue to drive change within the country. To meet WTO requirements, further reforms took place that improved both legislative and regulatory requirements. More so, China refined its laws surrounding copyrights, patents, and trademarks while overhauling national economic institutions. Many of the reforms lead back to Pettis’s social capital discussion and how the creation of these organizations allowed for further incentivization of innovation and investment.

WTO also allowed China to join an organization built to provide more structure and regulations in the global trade industry. That, combined with the advancement of transport logistics, communications technology, and the emergence of global value chains, allowed for an environment where China’s export business would thrive. By 2010 China was already the world leader in exports surpassing the U.S. and Germany, as shown in Figure 7.

Figure 7: Share of Global Exports

China continued to grow from 2000 to 2010, pushed by its structural and genuine growth factors. However, as China’s physical capital converged with its ability to absorb it (social capital), the room and opportunity for real wealth and productive investments peaked, which left the country to turn to more cyclical solutions to keep growth rising.

Going Too Far

By 2010, signs of China’s demographics were already showing signs of stagnating. For instance, if one glances at Figure 5 again, it can be seen that the working population peaks at around 70 percent and then begins to fall rapidly. It displayed a significant signal that the fuel that pushed the machine started running out. More so, in comparing China’s population by age to other countries like the Euro Area and the U.S., it can be seen that China is forecasted to be at a considerable disadvantage regarding demographics and the working population. This is most likely due to the implementation of the one-child policy. Please compare Figure 4 with Figures 8 and 9 to see the analysis.

Figure 8: Euro Area’s Population by Age Group:

Figure 9: U.S. Population by Age Group:

While Europe is expected to have a working population that slowly decreases over the next 80 years, the rate at which it is declining is nowhere near as steep as in China. On the other hand, the U.S. is scheduled to steadily increase its working population over time, leaving China the worst out of the group.

China’s productivity was stagnating as well. Figure 10 displays China’s total factor productivity, a measure of an economy's changes over time regarding inputs such as capital and labor. While the country had a massive spike between 2003 and 2011 (over 22 percent), one can observe it slowing as 2010 passed.

Figure 10: China’s Total Factor Productivity

With demographics and productivity leveling, China realized it had to act to keep the growth train running. To do so, a massive amount of cyclical credit expansion was used over the last decade. Figure 11 compares China’s non-financial sector debt as a percent of GDP to the U.S. and Europe. It took China only ten years to lever the economy, whereas Europe and the U.S. took about 30 to 40 years to accomplish the same expansion.

Figure 11: Non-Financial Sector Debt as a Percent of GDP

It should be noted that debt is not necessarily bad as long as it contributes to productive investments that will create real growth higher than the cost. It can be thought of like this: the effective use of debt is an increase in the economy’s debt-servicing capacity (GDP can be used as a proxy) that is larger than the increase in the debt servicing costs. This was the situation within China till the mid-2000s. However, even though real investments began to dry up, China’s central authorities kept using their ability to create and direct credit to whichever area of their choosing through what is called: credit window guidance. This allows a central bank to impose a bank credit growth quota for commercial banks. That forced debt creation to flow into corporates and households (Figure 12) that levered up during the credit expansion and ultimately contributed to investing in non-productive assets that gave the illusion of natural growth. To return the use of debt, in this situation, it should be thought of like this: non-productive assets increase the economy’s debt servicing capacity (still using GDP as a proxy); however, it is now smaller than the increase in the debt servicing costs as these investments turn out to be worth less than initially thought.

Figure 12: China’s Debt Split by Sector (as a Percent of GDP)

Most of the non-productive investments were focused on areas such as real estate and infrastructure. The piling on of credit led to high investment rates and asset price bubbles within these sectors. For instance, in 2018, real estate investment reached eight percent of China’s GDP, as shown in Figure 13.

Figure 13: China’s Real Estate Investment (In USD and as a Percent of GDP)

Popularity in real estate has also boosted the construction industry, which benefited from the increase in building; by 2016, real estate and construction combined for around 29% of China’s GDP. This growth quickly attracted the financial sector as bank lending is the primary source of real estate funding; by the fourth quarter of 2018, real estate loans accounted for about 28% of all outstanding loans and 40% of the new loans being issued. All this funding caused the real estate market to appreciate immensely and attracted higher valuations due to initial capital gains and extrapolations that the asset prices could only go up. The housing market quickly became a way to invest money with the expectation of ample returns - so much so that housing accounts for 78 percent of all assets in China (including stocks, bonds, etc.) compared to 35 percent in the U.S (Figure 14). These investments have caused Chinese households to lever up quickly (Figure 15).

Figure 14: Different Asset Class Valuations in 2017

Figure 15: Household Leverage Ratio by Country

The high leverage in housing and corporations, along with unprecedented asset price appreciation in real estate (and other sectors), has put China at risk and makes for what many economists call an unsustainable growth model. China's central authorities have recognized the threats of high leverage and have vowed to reform and crack down on the reliance on debt for growth. For instance, regulators implemented what became known as “the three red lines” for property developers. These consist of stringent limits on a company’s debt-to-asset, debt-to-equity, and cash-to-short-term debt ratios. These red lines have already affected the real estate market and large developer companies like Evergrande by making it harder for them to access credit, forcing them to pay down debt, liquidate assets, and, in some cases, default.

Returning Safely to Earth

While China has stated its attempts to reverse its course from using the pro-cyclical, debt-heavy model for growth, it still has a lot of change to implement. Pettis argues that growth can only be achieved through investment, consumption, or trade surplus. He breaks each of these options down with different paths China can take (more on that here). To simplify, China has already invested heavily in its economy, and it is what is causing most of the issues. If it were to attempt to reallocate funds into more productive investments, say in the technology sector, it might find that area of the economy unable to accommodate the large inflows. For instance, China currently invests 40 to 45 percent of GDP annually, with around 60 percent split evenly between infrastructure and real estate investment. On the other hand, the technology sector only makes up 10 percent of GDP, making it very difficult to absorb the transfer. More so, there is already plenty of capital chasing high-flying technology ventures, and inflow may cause another bubble and result in more non-productive investments.

As for China’s trade surplus, it is already at around four to five percent and makes up nearly one percent of the rest of the world. For it to increase further seems unlikely for a country of its size as the world most likely could not support the demand needed to sustain this path. That leaves consumption as the only option, which may be the right one when only looking at the numbers. For instance, China’s household consumption only makes up about 38 percent of GDP and is historically low compared to other countries, as shown in Figure 16.

Figure 16: China’s Household Income (as a Percent of GDP)

The reason household consumption is so low is due to household income being strangled from the current model of high savings being invested by elites and corporations. If China reallocates and increases income, the economy could switch its development model from investment-driven to being powered by domestic consumption. However, for this to happen, households must achieve a higher income by keeping more of what they produce. This means a higher share of GDP will have to be allocated away from either business or the government. As companies in China obtain roughly the same percentage of GDP as other countries and would be less willing to transfer it to households, it will most likely have to come from local governments.

The challenge is getting local governments to step away from the high savings and investment model and transition to giving more to households to increase demand. This issue will likely be heavily debated between the central authorities and the local governments in the coming years. For instance, in 2007, then-Premier Wen Jiabao stated that rebalancing domestic demand toward consumption was a top priority for China’s economy. If one glances back at Figure 16, it can be seen that it has been a challenging goal.

The overall issue again comes back to Pettis’s discussion of social capital. China’s current model is built around institutions, laws, and regulations that enforce and benefit governments, corporations, and elites who adhere to high savings and investments. New social capital must be implemented for China to switch to another model based on demand driven by consumption. This is where the issue begins to raise its head. First, it is incredibly difficult to create new social capital and institutions that support a new structure. Second, the groups profiting from the current model have amassed a large amount of political power, which means they may look to block change as the cost of adjusting will most likely fall on them. While the demand-driven path makes sense in numbers, the political consequences could make it challenging to execute.

If China cannot replace these non-productive investments and the artificial growth they create, it is most likely that a contraction will be seen. There are usually two ways that this event can happen. One is a significant drawdown, such as the U.S. in the early 1930s, which is harmful in the short-term but tends to be more beneficial for the economy in the long-term (permitting political or social conflicts does not make things worse) as debts are restructured, and reform is forced into place. Another option is smaller drawdowns that result in stagnant, low growth rates, such as Japan after the 1990s. Pettis argues that if the country cannot pivot, the most likely occurrence would be similar to Japan with a period of ten to 20 years of low growth. This is due to China’s financial system being largely closed off with the ability of financial authorities to control and restructure systemic liabilities before a significant drawdown can occur.

Perhaps the more optimistic and important thing to note is that China’s central authorities, especially the President, Xi Jinping, have recognized the need for change. In a recent speech on understanding China’s new development stage, linked here, he states:

“I noted that our economy was now in a slowing growth phase, a painful structural adjustment phase, and a phase of absorbing the adverse effects of previous stimulus policies. I emphasized that, at the same time, the world economy was also in a period of profound adjustment, which made for an extremely complex economic development environment. This required us to gain a proper understanding of the characteristics of the current stage of Chinese economic development and to undertake practical reforms and adjustments”.

It is a positive signal that Xi Jinping realized that economic growth could not be sustained at current levels nor via current methods. Even though growth will most likely come down from past highs, it can still be achieved through a different driver, such as demand instead of supply. It is also vital to recognize that the President does not face a political cycle making it a more streamlined process for him to implement painful but necessary reforms. However, the political situation will make it difficult and perhaps too constraining for China’s central authorities to implement change, forcing a vicious, self-reinforcing cycle of slow growth. It will most likely depend on Xi Jinping’s ability to implement structural reforms in a timely manner to avoid debts surging to unmanageable levels.

Conclusion

While China’s immense growth seen throughout the past few decades is certainly impressive, there is no denying that the country has developed some structural and cyclical headwinds. To create and sustain real growth in the long-term, China’s central authorities, especially the country’s President, have recognized the situation and are working to implement change. However, it will still be challenging due to the political and structural issues of implementing reform.

Note from Author:

Hi everyone, I apologize for the article’s length; there is just a lot to unpack regarding China’s economy. As always, I hope you enjoyed reading as I enjoyed writing! If you want to learn more, there is an excellent interview with Michael Pettis (whom I mention several times throughout the article), where he speaks on many of the things I discuss. I have included it here:

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The US Central Bank conducted the biggest interest raise since 1994 last week, which has undoubtedly spooked investors as evidenced by the headlines running with this narrative.

But rightfully so; paying more than $5 a gallon for gas may have been the norm in California for some time, but even in places with less aggressive oil regulation we have seen the average gas price rise like a rollercoaster with no dip. Inflation is being felt everywhere.

All this is happening as the Central Bank’s credibility teeters, with public trust actually having been at peril for sometime (53% of Americans say they don't trust the central bank, and this was in 2021).

This is not a playbook for what central banks should do next, but more so an exploration of what demographics show us regarding the transfer of wealth, which has not been looking so good recently.

Even with the market sell-off in recent weeks, wealth is abundant, but what happens to wealth over time?

The Population Boom

After the end of two world wars we were treated to a sizeable increase in population growth from the generation we have dubbed the Baby Boomers.

As this generation nears retirement, its important to understand the implications this brings forward.

Prior to the Baby Boomer generation, the population slope had never experienced quite the upheaval it has now seen for the last 70 or so years. You would think that being born into a cohort with more people would lead to more competition for jobs, housing, social programs, spots in good schools, and on a macro level, more competition for things as basic as natural resources. So how did this generation of people from the largest population explosion ever, end up in aggregate, very wealthy?

Interestingly enough, David Willets wrote the book “The Pinch: How the Baby Boomers Took Their Children's Future - And Why They Should Give It Back”. In his book, David alludes to the idea that in a democratic system being part of a larger cohort is actually  preferable because it gives that group more voting power on generational issues and more sway in marketplaces. When the Baby Boomers were young, they voted for policies that benefited them, such as low cost or free higher education, family support systems, and strong social welfare. When the Baby Boomers got to the peaks of their careers, their voting patterns changed again.

Just take a look at the divide between the age of voters in the UK in the last decade alone.

This leads us to where we are today, with a projected $70 trillion in assets expected to be handed down over the next two decades.

The Transfer

Properly addressing and managing the transfer of a generation’s wealth could be the  make or break for an economy. If it is not handled correctly, we could genuinely see assets and businesses go without the stewardship they relied on with their previous owners. Regardless, all of this money changing hands is bound to give a boost to the wallets of a younger generation which has famously been saddled with economic headwinds like student loan debts, stagnant wages, and turbulent job markets.

You might be forgiven for thinking “this is great, it is going to finally give my generation the healthy financial boost they need to unsaddle themselves from debt, or  even just become bigger spenders/investors.” While there are definitely going to be some good things that come from this transfer, it may not be all good news.

Starting with savings, the graph below shows the U.S. Personal Savings rate since the index began. Other than a couple of spikes in December of 1992 and December of 2012, we have not seen this metric rise above 10%: an ode to spending pressures and good marketing that capitalism has produced. Of course you are probably thinking: “What about 2020?” Well, we all know it shot up due to unique market conditions rather than long-term, sustained macro trends. If I had to guess, the pre-existing downward trend only continues into the future.

To add insult to injury, smaller inheritances are more likely to be squandered.

Obviously it is easier to spend less money than it is to spend up more money, but it more has to do with where this money goes.

If I received an inheritance of $50,000, it wouldn’t mean I could quit my job, or even purchase a home with straight cash at this point… (I say this from the perspective of someone living in the US).

Of course, $50,000 would be a fat deposit for a house pretty much anywhere in the world, but it would still be up to the recipient of the inheritance to qualify for financing for the remainder of the purchase price.

An asset-based inheritance may give someone an injection of cash, but it doesn’t increase their incomes or polish up their credit score, so more often than one would think, it is difficult to deploy this capital effectively.

Also, despite the GameStop and r/investing craze from the pandemic, only 58% of Americans have funds invested in the stock market (89% with a household income greater than $100,000). Additionally, only 35% said in 2019, that they had anything invested outside 401(k)s. Another important point to note is that while the median inheritance size is $69,000 dollars, the average inheritance size is over $700,000.

What this means is that a large majority of this wealth transfer is coming from, and going to wealthy households. A lot of this wealth is tied up in small businesses and respective owners/trustee recipients.

How many examples are there of businesses out there that have been successfully run by a CEO after they were promoted into that role from their previous position as son of the CEO?

Of course, successful handovers do happen but reputations exist for a reason.

A US Census Bureau study found that 66% of family businesses do not survive the transition from the first generation to the second, of those that do survive, only 50% then make it on to the third generation. But like I said earlier, the real bulk of inheritance that will likely be of global impact rests in the form of trusts and the dubbed ‘trust-fund babies’ receiving the above-average inheritances.

Most developed nations in the world today have some form of estate tax that is levied on the passing down of assets. This includes the US, where there is a federal tax of 40% charged for estates over 11 million dollars in value. Of course, given this high value, the charges don’t apply to 99.9% of inheritances but for those that it does apply for, those charges are pretty steep. So, naturally when Uncle Sam comes knocking at the door looking for his ‘fair’ share of the estate, the great American has improvised and developed a whole industry around this to shield themselves, where firms like insurance companies will offer life insurance policies to cover the estate tax burden.

Beyond this, it must be recognized that the actual valuations given to family companies can be pretty fluid and more often than not these institutions are valued lower than they probably should be for reporting purposes.

Even more to the point, an 11 million dollar family business would likely have some kind of succession plan in place with pre-existing employees in executive positions. The argument for an estate tax is that while it might cause some turbulence in large institutions during a transition phase, that can be planned for, even if it means taking on a loan, selling some shares in the business, or sitting down with an estate lawyer and jumping through some loopholes.

This tax provides strong revenue from people that can afford to take the loss while also reducing the tax burden on smaller businesses or regular folks that might only get few thousand dollars in their trust fund. So, it will continue coming down to the government primarily to redistribute this wealth over the next two decades. The bigger question is where? Student Loan Forgiveness? Public Infrastructure? The Agriculture Industry?

If anything is to be taken away, it’s the fact that around the globe, wealth will be transferred abundantly over these next decades, and it will be messy, sketchy, ugly, and all of the above. But what will the government do? More importantly what will we do? Are we to make policy decisions that favor us in the moment or will we think longer-term?

"Planning for the future without a sense of history is like planting cut flowers." -Daniel J. Boorstin

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“Millions of people will die because these ports are blocked”- David Beasley, Head of UN World Food Program.

While Russia’s invasion of Ukraine has brought the energy market to the forefront, it has also extrapolated other issues. A significant topic not getting as much media attention is the jeopardization of food security within both emerging and developed markets. Due to the war stress-testing several inputs that go into feeding the population, the world could be pushed into a global food crisis. This article will discuss the war's effects along with some suggested short and long-term solutions to today’s growing food insecurity.

Major Producers At War

Food security has always been an issue, even before the war in Ukraine. Problems such as growing demand, combined supply chain disruptions, currency devaluations, climate change impacts, and a rise in fragility and conflict affect farmers’ abilities to yield crops and feed countries worldwide. Unfortunately, the war has plunged the issue into the deep end by sparking several more disruptions. A considerable number of commodities that go into feeding the world are now being jeopardized as both Russia and Ukraine are major exporters of agricultural products, including wheat, barley, corn, rapeseed, and sunflower oil. Figure 1 shows the major wheat exporters, with Russia and Ukraine being number one and five, respectively.

Figure 1: World’s Largest Wheat Exporters

Together, Russia and Ukraine produce 30 percent of the world’s wheat exports and 60 percent of its sunflower oil. More so, at least 26 countries rely on Russia and/or Ukraine for more than half of their grains. Due to the war, Ukraine’s farmers cannot tend the fields and yield crops. The UN Food and Agriculture Organization (FAO) has estimated that the war will leave 20 to 30 percent of Ukraine’s farmland unplanted or unharvested for the 2022 season. There is also the issue of already harvested and stored grain sitting in ports blocked by the Russian Navy. Figure 2 displays a map of Russian forces within Ukraine controlling any travel out of the Sea of Azov and the Black Sea. As a result, Ukrainian grain exports have been halted.

Figure 2: Map of Russian Forces Within Ukraine

Export Bans Multiply the Pressure

While Ukraine cannot get its exports out to the world, Russia is still free to supply the necessary inputs to produce crops. However, due to the war, Russia has decided to use food as a quiet weapon by banning exports of wheat, meslin, rye, barley, and maize to the countries within the Eurasian Economic Union (EAEU), except Belarus. Russia did not stop with grain products as they swiftly moved to halt exports of fertilizer that countries import to grow their crops. China performed a similar ban on fertilizer exports last summer due to rising global and domestic prices. To control and ensure the fertilizer industry within China would remain stable, the National Development and Reform Commission (NDRC) ordered major fertilizer companies to stop exporting. The desired effect was achieved as the price of fertilizer within the country began to fall; however, the global price was pushed farther up as the supply from China dwindled, as shown in Figure 3.

Figure 3: China’s Ban on Fertilizer Exports

With Russia and China banning fertilizer exports, prices have only risen. With fertilizer becoming more expensive, the effect does not bode well for countries that rely on importing to grow crops. For instance, Brazil, the world's largest fertilizer importer, is already having trouble getting enough nutrients for its produce. Moreover, the South American nation leads in global exports of soybeans, coffee, and sugar, which could be reduced in availability due to the higher prices. Examples of decreasing harvests are already being seen in France, where the agriculture ministry has announced it will cut corn plantings by six percent due to expensive fertilizers. As shown in Figure 4, France plans to sow the smallest land area in the last four years.

Figure 4: France Corn Plantings Shrink

With growing prices and export bans by major agricultural producers, other nations are beginning to fear they will not have enough supply to feed their domestic population. As a result, counterproductive protectionist measures have started to develop in countries banning food commodity exports. By the end of March, 53 new food trade interventions were imposed. Out of the 53, 31 were restrictive to exports, and nine involved curbs on wheat exports. Figure 5 shows the progression of restrictive and liberalizing exports/imports from when COVID-19 began. The pace at which restrictive export curbs are rising reiterates the protectionist culture countries are adapting.

Figure 5: Restrictive Food Export Curbs Rising

More specific examples are shown in Figure 6, a summarized list of countries that banned food exports in the months following the beginning of the war. It is derived from the International Food Policy Research Institute. The complete list that includes other countries that have banned other items such as beef, butter, fruits, and vegetables can be found here. As governments continue to ban crucial exports, the global food supply shrinks, putting tremendous upward pressure on the price of food and food inputs, as discussed in the next section.

Figure 6: Countries with Food Export Bans

The Price of a Meal is Increasing

As the war rages on and countries worry about feeding their domestic population, the global food market continues to be stressed. The war has had a significant effect on the prices of agricultural commodities. For instance, in examining wheat, the price rise is nothing short of astounding and is amplified by the export bans, as seen in Figure 7.

Figure 7: Wheat Prices Rise Substantially

While wheat is a crucial input that goes into feeding the world, it is not the only one. In order to look at rising food prices from a 10,000-foot perspective, one can examine the FAO’s food price index. The index comprises an average of five commodity groups: meat, dairy, cereals, vegetable oils, and sugar. Figure 8 shows the index’s historical price along with the cereal and oil groups. To clarify, the cereal index comprises an average of groups of wheat, maize, barley, sorghum, and rice price indices. The oil index contains an average of ten different oil price indices. Meat, dairy, and sugar are similar in the fact that they are well diversified and show a fair overview of their commodity markets. For the complete description of each index, visit here.

Figure 8: Historical Price of Food Index

All three indices have increased substantially since the start of the war. The most recent report released at the beginning of June indicated that the food price index decreased slightly but is still severely elevated from a year-over-year perspective. This is most likely due to the rising prices in the cereal index, which is led by the surge in wheat, which has increased for the fourth consecutive month. Fertilizer followed the same pattern, rising nearly 20 percent from January to March.

The rate at which the price of food and food inputs are rising is affecting the world in both emerging and developed countries. The effects are felt more in countries with low to middle-income levels. As a typical, low-income family spends two-thirds of its income on food, it is becoming increasingly more difficult for them to afford to eat. The World Bank estimates that ten million people are thrown into extreme poverty for each one percentage point increase in food prices. If food prices stay elevated for the rest of the year, global poverty could go up by more than 100 million.

Emerging-market governments are feeling pressure from rising food prices. Food insecurity has morphed into a source of social unrest. There have already been protests in Sri Lanka, Tunisia, and Peru as governments cannot subsidize enough to keep up with rising energy and food costs. Developed markets are feeling the effects as well. Nearly ten million Britons cut down on food consumption or missed meals in April, and France plans to issue food vouchers to the poorest households. Figure 9 displays a world map with countries that are low, medium, or highly dependent on importing food to feed their domestic population. These countries will continue to feel the effects of the shrinking global food supply and rising prices. The following sections will discuss short and long-term solutions.

Figure 9: Countries’ Net Food Imports as a Percentage of Domestic Food Supply

Short-Term Solutions

Several entities have stepped up to try and relieve growing food insecurity. The World Bank stated that it is launching a financial package to provide support. It will give financial aid to countries, including Ukraine, that are hosting refugees, and developing economies suffering collateral economic shocks. It will begin with $50 billion in the current quarter (quarter one of 2022) and will reach about $170 billion in the 15 months following (in June 2023). The World Bank also stated that for price pressures to dissipate, both developed and emerging markets must reduce their export and import restrictions, which are artificially creating price hikes. The World Bank plans to encourage food production, enable market access and private sector investment, and protect the most vulnerable populations through well-targeted and cost-effective cash transfers. The bank also plans to mobilize two programs. The first is the Global Agriculture and Food Security Program (GAFSP), which G20 set up in response to the 2008 food crisis. The second is a multi-donor trust fund called Food Systems 2030, which can help countries strengthen their food systems to meet short and long-term goals.

Other governments have stepped up to provide funding and expertise in the fight. The U.S. Treasury met in April with multilateral institutions to discuss how to tackle food insecurity. The U.S. then decided to allocate funding to a new global food emergency package, bringing the total amount of assistance given for the issue to nearly $2.6 billion since February. More so, the U.S. plans to relieve the global fertilizer shortage with a $500 million program via the U.S. Department of Agriculture. Looking at other organizations, the Asian Development Bank stated that it, along with the FAO and World Food Program (WFP), will support efforts to feed Afghanistan and Sri Lanka. The African Development Bank will use $1.5 billion to help supply fertilizer and seed to 20 million African farmers.

In terms of the war, an estimated 20 million tons of agricultural products are stuck inside Ukraine. Before the war, the country could export grain and oilseed via ship at a rate of up to six million tons per month. However, about 80 percent of the world’s merchant ships are now stuck in Ukrainian ports, while the other ten percent have been attacked or hit by Russian assaults. More so, Russia now has four submarines in the Black Sea guarding any attempt to export any grain out. The EU is setting up a plan for Ukraine to export the commodities via rail. The union feels they can transport the 20 million tons over the next three months. However, there are severe bottlenecks at the borders as neighbors use different rail gauges. More so, if trucks were to be used, they could be hampered by drivers, fuel, and customs officials. Overall, the plan to exit by land will be much slower and could be dragged down by several bottlenecks.

Long-Term Solutions

Perhaps the shortest long-term solution would be for the ports within Ukraine, for instance, the port of Odesa, to be opened back up, which would immediately alleviate some of the price pressure in the global market. However, with Russia using food as a weapon, this seems unlikely until the war ends. With no knowledge of when this will happen or the outcome, it may be fair to say that it could be some time before Ukraine and Russia return to exporting food. Suppose the ports were to open without the war ending. In that case, it may take some extreme increases in food insecurity that would ultimately force Russia’s hand to make a peace agreement to let the ports operate without any interference from the surrounding battle.

The war will eventually end (hopefully), but the world will still be left with growing food insecurity and will need solutions to tackle it. Most long-term solutions focus on reducing food waste, attacking climate change, and improving infrastructure programs and trade policies. While food insecurity poses a threat, every issue is an opportunity, and this is no different. New ideas must be invented to create a more efficient system for feeding the world. However, funding, whether it is from private ventures, NGOs, or government entities, will be required to fulfill these solutions. The world must recognize that these innovations are needed and continue showing support for them.

Conclusion

Russia’s invasion of Ukraine has pushed fears surrounding the ability of the global population to be fed. The ability to find efficient and timely solutions to growing food insecurity has never been more relevant than now. Governments and organizations must continue to search for the best possible ways to relieve the rising prices and shrinking supply. In the meantime, it is best to hope that the ports within Ukraine can open or that the war ends soon.

I hope you enjoyed reading as I enjoyed writing! If you want to learn more, the Financial Times has a great podcast: The Rachman Review, which recently had an episode discussing the crisis. I have included it here:

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The two: 1) Britain’s Classical Economics and the evolution into 2) Keynesian Economics

Yet, we are rarely exposed to other systems of thought.

It is ironic that in the ‘Land of the Free, Home of the Brave’ we are not taught more ideas on how free-market economics and its branches of thought can operate. After all, is economics not a social science? Is it not a collection of production and consumption processes all culminating in an attempt to solve the central economic problem of how we utilize finite goods with an infinite appetite for consumption?

This is the foundation of economics: every study, paper, theory, economic policy, or experiment is ultimately an attempt to find a solution to a problem, that by its very nature, has no single best solution.

So let this be a call to continue diversifying thought and open up exposure to other ideas on how to approach this central allocation problem that unifies all economic theories.

Now, the first thing to know about all of these schools of thought is that they all agree with one another on most issues. For example, the concept of opportunity costs: the forgone benefits that would have been derived from an option not chosen. But economists can differ on the concept of taxation of businesses and how to approach taxation. Going back to the idea of economics as a social science, there is a certain element of philosophy and morality that influences every economic decision, no matter how much economists attempt to wash it away with mathematics.

To make matters even tougher, the only real way to apply a new theory come is to study the results, which means phasing out current policy and bringing in a proposed untested new policy. This is difficult to implement because the stakes are so high; should a policy shift go unexpectedly wrong, it would have an impact on thousands if not millions of lives.

Furthermore, I have a gut feeling that most economists deep down have questioned the very models they use today for their forecasting ability (ahem, U.S. Federal Reserve). So I do believe there are plenty of economists that agree with some of the principles of one school of thought and then disagree wildly on some other areas. This is actually a good thing.

To make sense of things I want to look at the two school’s of thought I presented at the start, and a third one: 3) Austrian Economics.

1) Britain’s Classical Economics

This is the big boy, the elephant in the room that will probably never go away, and it shouldn’t. For all the flaws that Adam Smith brought forward with his monumental book, “The Wealth of Nations," released in 1776, his adamant support for further Division of Labor among manufacturing lines, compounded by Immanuel Kant’s own book, “The Groundwork and Metaphysics of Morals,” in 1785 have since led us to realize advancements in productivity that for some seemed unfathomable. Kant stated:

“All crafts, trades and arts have profited from the division of labour; for when each worker sticks to one particular kind of work that needs to be handled differently from all the others, he can do it better and more easily than when one person does everything. Where work is not thus differentiated and divided, where everyone is a jack-of-all-trades, the crafts remain at an utterly primitive level.”

As suggestions of how to build a better world, these were the prescriptions of these early economists when economists weren’t even a thing.

Markets should be free because the more that people are allowed to trade freely with one another, the more they can specialize and count on others to specialize to deliver all of the goods that they need.

Nations have also done the same thing; they stopped trying to hoard gold as would be suggested by mercantilist philosophies and instead realized who does what well. Once this is known, trade amongst other nations increased wealth and allowed countries too, to specialize.

Government intervention in free markets should be limited exclusively to making sure that contracts are upheld and fraud is not allowed to take place. This gave us an economic incentive to have a government and create laws and next thing you know, you have a society that through classical economics, is assumed that everybody buying, selling, and working is perfectly rational and will always make the most logical decision possible to forward their own selfish interests.

More or less, classical economics argues that we can all work together to make the world a better place by being selfish. It certainly helped accelerate us into this high-tech world.

2) Keynesian Economics

Prior to Mark Zuckerberg making a dating app on a college campus, and before the forewarnings of Nero and the Matrix, came along John Maynard Keynes. He would advocate for stronger government intervention through further regulation of central banks. So putting Bretton Woods aside, what did Keynes bring forward?

If a regular person has heard of any economists, it would be Keynes. He is touted as the most influential economist of the 20th century and he defined the way that almost all governments around the world manage their economic affairs as the rollout of new technologies bolstered by global wars changed the economic landscape.

Factories, markets, advanced financial systems, consumer debt, and public corporations were all commonplace during Keynes’ time, and the ebbs and flows of national prosperity were no longer determined by the harvest but rather by the business cycle. Around this time, economies started experiencing ups and downs that could not be explained exclusively by outside forces, but rather by the sentiment of the people within the nation. Since consumers were the center of modern economies, their changing preferences, expectations, and feelings of optimism, fear, or doubt impacted the economy. This led to the widely-accepted realization of business cycles and boy did Keynes have a solution for us.

The solution was to try and smooth out this business cycle by artificially influencing the spending of consumers. And who better to do this than our own governments? Nations would do this through fiscal policy, which called for taxing people more and spending less government money during economic booms, and then taxing less and spending more during an economic downturn. It would also be influenced by monetary policy set by a nation’s central bank, which really is just a doorway for political and financial entities to comingle, kind of like Paul and Nancy Pelosi.

As it sounds, Keynesian Economics advocated for more intervention from regulators of power, which is why I have a deep suspicion Austrian Economics was never to really take off across these major groups of power.

3) Austrian Economics

The Austrian school hated the idea of Keynesian Economics because it was tampering with the free market, which would limit efficiency and cause a whole host of other, unintended problems.

It was dubbed Austrian Economics because of its birthplace in Vienna (although founded by a Polish man).

The Austrian school shares a lot of similarities with classical economics and most of the economists that have now gone on to define this field didn’t even know that they were creating an academic discipline of economics, in the same way that Adam Smith didn’t know he was creating economics as we know it. What this school of thought did was refocus the power and interests on the consumer, the individual.

With this, these scholars started adding in more allowances for how individuals acted, and specifically how they valued things. Carl Menger was the father of the Austrian School of Economics and is credited with contributing to the theory of Marginal Utility alongside his student Friedrich von Vieser. The theory of marginal utility was an extremely important contribution to economics as a whole. It argued that goods provide a utility, but their utility is decreased for every extra unit of that good there is.

This ran contrary to the classical school of economics which simply advocated for making as much stuff as possible and then letting the free market decide what went where. Now again this might sounds obvious to us now, but you have to remember some important things.

This was the first inkling of economic theory adapting to a world of genuine sustained growth. Before the 1800’s, the idea that anybody could have too much of something was pretty bizarre, but with factories all across Europe working day and night to produce all manner of everything, the decisions everybody were making were starting to shift from, “can I afford this?” to “would I rather have this or that?” This deeper understanding in a world that was becoming more and more plentiful eventually culminated in the Subjective Theory of Value.

This theory argues that an item is not worth the sum of the materials and labor that go into making it, but rather it is worth a function of how important it is. For example, this would explain why diamonds are worth more than water if the latter is needed to survive and the former is not.

However today, Austrian economics is today seen by most conventional economists as a very fringe ideology for its reliance on conjecture rather than rigorous mathematics and statistics.

This makes a lot of their theories non-falsifiable, which in plain English means they are impossible to prove wrong, which sounds great, but in reality it just means that because there are no rigorous models drawn or prescriptions set, it’s very hard to contradict the theories. And like I said earlier, economics is not usually the place you want to ‘test’ your ideas out, given the risks of a major economic collapse.

My point is there is no ‘right’ framework for an economy to operate in; it will always be messy somehow and maybe that is the beauty of it all along. But that also does not mean that we try to fix a problem with solutions that continue to put Blu Tack on the cracks of the Hoover dam. We need greater diversity of thought and to solve 21st century problems, we require 21st century solutions.

So, maybe we all just need to stop and look around.

“Life moves pretty fast. If you don't stop and look around once in a while, you could miss it.” - Ferris Bueller

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If you have checked your day trading account, retirement account, or listened to the news, you may have noticed that the stock market has hit a bit of a rough patch in the past month and 2022 as a whole. Earlier last week, the S&P 500 was down 20% from its highs set in December, placing it in bear market territory (Figure 1).

Figure 1: S&P Drawdowns Since 1900

The main perpetrator of this sell-off has been the lofty valuation multiples (P/E, EV/EBITDA, etc.) that equities received after two years of stimulus. In the low interest rate environment that took place in reaction to the pandemic, risk asset values soared. Investors were “pushed” into riskier assets, such as high beta stocks, to get higher returns than near-zero yielding safe government bonds. This pushed multiples higher. However, as interest rates have rapidly risen in 2022, these valuations have come back down to Earth (Figure 2).

Figure 2: S&P 500 Price to Earnings and the U.S. 10 Year

This type of multiple compression was seen at a more drastic scale for tech stocks during the popping of the Dotcom Bubble (Figure 3). Like the Dotcom Bubble, we see multiples compress before earnings fall. With markets being forward-looking entities, are growth stock multiples fully priced to reflect a decrease in earnings, or will there be further pain as earnings decrease? If they aren’t fully priced in, how will the markets react when earnings actually get bad like those seen during previous recessions?

Figure 3: U.S. Tech Stocks’ Price and Earnings Now Compared to Dotcom Bubble

Despite the drastic compression in multiples seen in the past couple of weeks, there may still be some room on the downside. During the hangover of the Dotcom Bubble, the P/E for S&P companies fell to ~-7x below the historic 5-year moving average (Figure 4). While the S&P 500 is already -2x below its 5-year moving average, there may still be room for further compression. It is unlikely to see compression to the same degree as the Dotcom Bubble, but still enough for the S&P 500 to further decline on a multiple basis.

Figure 4: S&P 500 P/E Minus 5-Year Moving Average

The other main driver that determines the S&P’s value is earnings. Earnings are still expected to increase by around 10% next year because of this lagged effect of interest rates (Figure 5). However, margins have started to show signs of compressing due to higher inflation and exceptionally high readings of the PPI as companies’ input costs rise faster than the price of the goods they sell. Even though companies may be beating earnings estimates, margins become more critical in inflationary environments.

Figure 5: Earnings Set to Increase as Margins Get Squeezed

Retail sales can be seen as an example of inflation’s effect on earnings (Figure 6). On paper, what is reported in earnings filings, retail sales have increased heavily in 2022. However, using 2019 price levels, real retail sales appeared to have peaked in the first half of 2021.

Figure 6: Inflation-Adjusted Retail Sales

These inflationary pressures have started to eat into traditional retailers like Walmart (Figure 7). Consumer staple (CS) stocks, including Walmart, are thought to be safe places to hide out during equity sell-offs. Before May, CS stocks were able to fend off the sell-off that plagued the rest of the S&P 500. However, several value retailers like Walmart and Target reported disappointing Q1 earnings, citing inflation driven by higher transportation costs from fuel and employment costs (CNBC).

Figure 7: Walmart Getting Beaten By Inflation

Overall, this has been the worst return of the S&P 500 during an earnings season by a wide margin in the past decade (Figure 8). While there have been many other macro factors at play, saying it is occurring amid a -20% S&P drawdown, this is a sign of investors starting to price in worsening future earnings likely due to rising recession risks.

Figure 8: Average Weekly S&P 500 Return In Earnings Seasons

Growth stocks have been one of the worst areas hit by this equity sell-off. The last time growth stocks were this overvalued compared to value stocks was during the Dotcom Bubble. The growth to value ratio has significantly decreased from its peak but still has a way to return to the historical mean.

Figure 9: Growth to Value Stock Ratio

This overvaluation of growth stocks compared to value stocks was a symptom of a low interest rate environment. This relationship between the growth to value stock rotation and interest rates can also be seen through the high to low beta (essentially the same thing as growth stocks, which have a higher beta due to their increased risk) and the 2-year change in the 10 year advanced by 18 months (Figure 10). The effects of interest rates historically appear to be strong on the high to low beta ratio. The rapid increase in the 10 year in 2022 shows that high beta stocks are in for a rough couple of months.

Figure 10: High vs. Low Beta Stocks with the 2-Year Change in the 10 Year Advanced by 18 Months

Speculation levels in the options market have also settled. Put option open interest, which is used to hedge falling security prices, has outpaced call option open interest, which pays off when a security’s value rises above the strike price. Many day-traders used call options as a speculative tool in the past two years to leverage their positions. However, the wind has sharply shifted as investors use more put options to hedge against falling equity values.

Figure 11: Put to Call Option Ratio Means Portfolios are Bracing for Choppy Waters

Finally, this was stolen from another substack; even though the carnage in the equity market has been brutal there is still room to fall. Looking at equity risk premium, which is calculated by subtracting real yields from equity earning yields, equities still haven’t reached the historically cheap level (Figure 12). With the Fed put a non-existent option for the equity market, the idea that the Fed will step in to save markets as they have in the past two decades seems to be far-fetched in an inflationary environment. The Fed is focused on controlling inflation, especially being able to produce results before the midterm elections in November.

Figure 12: Equity Risk Premium is Saying Equities Still Have Room to Fall

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Roughly 13,000 years ago during the Pleistocene ice age, humans were able to traverse across the Bering Sea from Asia into North America. Today, we are beginning to see another opportunity forming near the Arctic, this time due to the melting of the polar ice caps.

The image above shows the declining size of the ice caps, and while this will have negative consequences to coastal cities, ecosystems, and humans, it also opens the door for new traveling routes across the Arctic ocean. This article focuses on what nations are planning to do in the region and particularly focuses on Russia’s objectives.

“Increased ice melt in the Arctic will open up shorter transit routes to Asia, provide easier access to proven substantial reserves of unexploited natural resources, and see a continued increase in tourism and visitor numbers. While offering economic benefits to the region, there will be a greater risk of accidents and environmental disasters such as oil spills, which will require close cooperation with all Arctic states and Arctic communities to ensure safety at sea.” - The UK’s Defence Contribution in the High North

As much as we would all love to see the ice caps preserved, governments have been prepping and bolstering their capabilities for greater travel and movement across the region for some time now, as can be seen in the infographic below.

Why? Well, like the quote from earlier said, there are “proven substantial reserves of unexploited natural resources,” and a lot more resources than most would think.

The United States Geological Survey (USGS) released the very first assessment of Arctic oil and gas resources in 2008, revealing that the Arctic holds 13% of the world’s undiscovered oil reserves and 30% of the world’s undiscovered natural gas reserves, of which Russia holds more than half. While many argue that Russia cannot keep up with the financial costs of war in Ukraine, it is no secret that Putin views the Arctic as a pile of untapped cash. Commodity prices are high and the Arctic represents a vast treasure trove of commodities.

Another point mentioned was the “shorter transit routes to Asia.”

Typically, shipping to Japan from Rotterdam would use the Suez Canal and take about 30 days, whereas a route from New York would use the Panama Canal and take about 25 days. But if the Europe-Asia trip used the Northern Sea Route along the northern coast of Russia, the trip would last 18 days and the distance would shrink from around 11,500 nautical miles to 6,900 nautical miles. For the U.S.-Asia trip through the Northwest Passage, it would take 21 days, rather than 25.

Controlling these routes brings significant advantages to countries and corporations looking for a competitive edge.

Going back to Russia, we saw the build-up of Russian troops around the Ukraine-Russia border as early as March and April of 2021, almost an entire year prior to the actual invasion.

We see a similar scenario unfolding in front of our very own eyes in Finland as it considers NATO membership, begins lessening its energy reliance off of Russia, and ultimately signal its decision to side with the ‘Western’ members of the Arctic Council.

With Russian troops gathering around the borders of Finland, we see people in Finland moving farming equipment near the Russian border and banning all Russian overland freight transport with trucks carrying Russian license plates.

We see Prince Haakon of Norway visiting Kirkenes, the town that borders Russia, trying to calm relations between the two sides while the Norwegian authorities quietly arrest Russian spies within Norway.

At this year’s Arctic Council meetings in March, all member nations (everyone but Russia) boycotted the meetings in response to the Russian invasion. In response, Russia's ambassador-at-large to the Arctic Council unconvincingly stated that “Russia firmly believes that there is no potential for conflict in the Arctic.”

In stark contrast, Klaus Dodds, a geopolitician at Britain's Royal Holloway University who studies Arctic relations, stated that “the Arctic is facing its biggest crisis in 35 years,” while Russia prepares for its final year (2023) holding chairmanship of the Arctic Council.

As can be seen, the Arctic is getting very noisy. It could be that Russia’s strategy all along has been to use Ukraine as a distraction and to create a situation that effectively prohibits the U.S. and NATO from responding to Russia’s land grabs and military build-ups in the North. The focus on Ukraine and the fear of a direct confrontation allows Russia to take many steps in other locations without any response.

Welcome to a divided world…

"A house divided against itself cannot stand" - Abraham Lincoln

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― Japanese Proverb

Those who follow the market have probably heard about the drastic devaluation of the Japanese Yen (JPY) in the past month (Figure 1). For those who don’t follow the foreign exchange market a rising USD/JPY is a weakening yen as it takes more yen to match the value of $1 USD. Since COVID, there have been multiple significant headlines regarding large devaluations of nations’ currencies from the Turkish Lira, Russian Ruble, and the Sri Lankan Rupee more recently. Currency devaluation is not a rare phenomenon within emerging market countries like the ones previously mentioned, but what’s different about the yen is its historical reputation as a safe haven asset. For those who don’t know, safe-haven assets have stable demand, liquid markets, strong relevance within the market, and will retain value in times of market turbulence. These can range from metals such as gold, U.S. Treasuries, and currencies like the Swiss Franc (CHF), Japanese Yen, and the U.S. Dollar (USD).

Figure 1: USD/JPY Sell-Off

In the past year or so, the dollar has been on a tear. Despite 40-year high inflation in the U.S., the dollar has been sustained by three main macro drivers. First is the safe haven aspect previously mentioned, as rising geopolitical risk and market uncertainty cause investors to seek quality assets, and what’s a better store of value than cold hard cash (well, all commodities and any asset that hasn’t lost 8.5% of their value in the past year). The second is the globalized nature of inflation. It stems from inefficacies within the global supply chain to meet strong demand from wealthy consuming countries and has since spilled over into most countries. Yes, the 8.5% CPI YoY headline is bad, but it’s not an isolated incident. Think about it in the old analogy of getting chased by a bear, or in this case inflation. You, the U.S., don’t need to outrun the bear to survive. All you need to do is to outrun your friend next to you, other countries. The final and most important driver is what the Fed has been doing to combat inflation, raising interest rates (Figure 2).

Figure 2: Rising Yields Are Driving The Dollar

Given that currencies are evaluated on a relative basis, usually to the dollar, this has caused devaluations of many currencies unless you are a commodity exporter, which Japan is not. What sets the yen apart from other currencies is not only the drastic nature of the sell-off for such a safe currency. It is a symptom of a disease that has been plaguing the Japanese economy for the past two decades: Japanification.

Brief History Lesson

I won’t dive too deep into the idea of Japanification, but to understand why the yen is depreciating, one has to understand the unique state of the Japanese economy. In the 1980’s, Japan became a manufacturing and exporting juggernaut as the world moved towards globalization. At the same time, the U.S. was coming off the gold standard, letting the dollar float. The dollar soon became the preferred payment method for oil exporters, ushering us into the petrodollar stage. High demand and floating nature gave the dollar, and therefore the American consumer, significant purchasing power, letting them buy higher volumes of goods for cheaper from countries with weaker currencies like, you guessed it, Japan. This sparked a wave of Japanese imports, the effects of which can still be seen today, as Toyota was the top-selling car manufacturer in the U.S. in 2021.

Figure 3: Effect Of American Purchasing Power On Japanese Stocks

As the dollar appreciated, U.S. exporters struggled to find demand for their products. To bolster U.S. exports, the U.S. agreed with other major countries at the Plaza Accord to devalue the U.S. Dollar (Figure 3). This did not go over well for Japanese exporters as they found a drastic decrease in their primary customer’s purchasing power. At the same time, Japanese equities and real estate markets that were heavily overvalued were about to burst. Long story short, Japan faced a severe economic slowdown just as its population growth leveled off (Figure 4).

Figure 4: Japan YoY Population Growth

This lack of population growth caused the median age of Japan to rise. In 2022 the median age in Japan is 47.3 years compared to the global median of 30.9 years. This population aging has had a deflationary effect on the economy since. According to a Bank For International Settlements study, adults between 30 and 60 tend to have a deflationary impact. They produce more than they consume, given that they are deeper into the workforce than a recent college grad who just took out massive student loans. This age range is more focused on saving than borrowing, which means they benefit more from deflation increasing their savings rather than inflation reducing their debt. This is bad for a central bank trying to jump-start a struggling economy as expansionary monetary policy and modern economies depend on credit to succeed. It just so happens that Japan’s median age of 47.3 years sits at the trough of this relationship, shown in Figure 5.

Figure 5: How Does Age Affect Inflation?

How To Unsuccessfully Deal With Deflation

This has left the Bank of Japan (BOJ) in a tricky spot as they have had to find new monetary policy methods or aggressively push old ones to force Japan out of its deflationary spiral. Do you think the size of the Fed’s balance sheet is bad after over a decade of quantitative easing? The BOJ was one of the earliest adopters of QE and holds a similar-sized balance sheet to the Fed, but when adjusted for the size of the two economies, the BOJ’s QE vastly outpaces the Fed’s (Figure 6).

Figure 6: BOJ Was Printing Bank Reserves Before It Was Cool

The extreme dovish attitude of the BOJ is the not-so-secret answer to the problem of a devaluing yen. While everyone is rushing to hike rates to combat inflation, the BOJ maintains its dovishness. This is because Japan is still a percent below the BOJ’s inflation target of 2%. While everyone is worrying about inflation increasing, the BOJ sees signs of inflation moving to its long-term target (Figure 7).

Figure 7: Japan Headline CPI YoY%

This push to 2% has made the BOJ maintain expansionary monetary policy measures. The most important right now is the idea of yield curve control (YCC) (Figure 8). YCC is the idea for a central bank to set a longer-dated interest rate and then buy or sell bonds to get to the target rate. This is different from the Fed’s QE as the market prices in rates that are based on the set amount of bonds being bought by the Fed (among other things). Here, the BOJ buys and sells bonds (Japanese Government Bonds “JGBs”) based on what the market is setting as the equilibrium interest rate to meet their target of 0.25% on the 10-year JGB.

Figure 8: Japan Yield Curve V.S. U.S. Yield Curve

The YCC policy has led to a vast yield difference between Japan and other developed nations like the U.S., and this difference in interest rates is the primary reason why the yen has been selling off (Figure 9). Despite the yen’s rapid devaluation, the BOJ continues to buy bonds to suppress yields.

Figure 9: The U.S. Is Leaving Japan In The Dust When It Comes To Hiking Rates

Implications Of A Weak Yen

At this point, you might be thinking, “wait, isn’t a weak yen what drove Japan’s expansion in the ’80s?” You wouldn’t be wrong. Typically, a weakening yen has resulted in a strengthening Japanese economy or at least an appreciation in Japanese equities. However, in recent months this relationship has harshly diverged (Figure 10)

Figure 10: Yen And Nikkei Separate

Yes, Japan is the 4th largest exporter and is a net exporter, but it is important to look at the goods they are importing and exporting. As a manufacturing country, Japan typically exports electronics, cars, and refined commodities. More important, are Japan’s imports. Japan happens to be the 5th largest importer of crude oil and imports many raw commodities, which they then turn into finished goods. Now, a weakening yen may be increasing demand for exporters within the country, but the rapid rise in oil prices and other raw material inputs have outpaced the price of the finished goods (Figure 11). A weakening yen also means it’s now more expensive for Japan to purchase inputs, causing margins to get crushed. To summarize, the price of goods Japan is importing is rising faster than the price of goods that Japan exports.

Figure 11: Weak Yen And High Commodity Prices Are Dangerous For Japan

Margin pressures can be directly seen when comparing Japan’s CPI and PPI. Margins for Japanese companies are getting squeezed to the lowest levels since the early 1980’s as producers fail to raise prices to keep up with higher input costs (Figure 12).

Figure 12: Japanese Margins Are Shrinking

The question then becomes, will the BOJ step in to save the yen by opening the yield curve flood gates and letting interest rates float? The answer is probably no. Looking at Figure 13, historically, when the BOJ intervenes in the currency yen, volatility tends to be much higher at a mean of 20.7% but was only 9.6% a week ago.

Figure 13: When Does The BOJ Step In?

This is a lose-lose situation for Japan as if they let the yen further depreciate, margins for Japanese companies will contract further and the buying power of the Japanese citizen will rapidly decrease, spelling economic doom. However, if they let yields rise, they abandon their 2% inflation target, and go back to deflation, reducing the incentives to borrow that fuel economic growth.

Why Should You Care?

So why should you care what the central bank of a country thousands of miles away does with its monetary policy? It just so happens that Japan is the second-largest holder of U.S. debt right after the Fed (Figure 14).

Figure 14: Who Owns U.S. Debt?

After the BOJ’s extreme expansionary monetary policy, interest rates in Japan were left near zero or negative. Japanese investors and institutions had to turn to the U.S. for positive yields on safe government bonds, which led to Japan being the primary foreign holder of U.S. debt and has continued to increase their holdings (Figure 15).

Figure 15: Amount Of U.S. Debt Owned By Major Foreign Holders In The Past Two Decades

So what happens if the BOJ chooses to save its currency by letting the rate rise? Well, then yields in Japan will have positive returns again. All those Japanese holders of U.S. debt seeking positive yields overseas could start to pull back their foreign investments and place them in domestic securities. This spells trouble for the U.S. Treasury market, with run-off beginning in the coming months. There is a potential that the two largest buyers of Treasuries, the Fed and Japan, will be exiting (by exiting I really mean fewer inflows from Japan, not a complete exit) the market at the same time. If these two exit, or reduce their buying simultaneously, then a massive void will form in the Treasury market. If no one steps up to fill the void, demand won’t match supply, causing interest rates to move higher.

Conclusion

On the surface, the yen’s devaluation appears to be attributed to the strength of the dollar. However, like an iceberg, below water level is a complex system with potential global repercussions. The yen crashing is a symptom of a more significant systematic problem Japan has been facing for the past four decades. It has left the BOJ with a difficult dilemma to save the yen, with the BOJ having options either resulting in deflation or the yen crashing, drastically increasing import costs and reducing profitability. Both of these situations have the potential to spell doom for the Japanese economy, resulting in a “pick your poison” type situation for the BOJ.

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Here is a graph from Tim Urban’s Wait But Why post explaining the political structure and what terminologies such as “totalitarian” signify.

I want us to focus on the area in red, but also the area in white. The reason being is that every nation falls within these two quadrants (realistically speaking, you need some law and order). For example, I think it would be fair to say that China would fall in the red and the U.S. in the white, presenting us with the graph below:

Honestly, putting cultural norms aside, I believe the y-axis (Government Control) is the biggest factor driving the surge in global multipolarity which we have seen unfold since the pandemic began. But alas, I will save that discussion for another time.

Now, returning to the narrative and China, the totalitarian status still holds with its one-party system and a leader in charge for life. However, the misconception I was referring to earlier falls under centrally planned economies.

Professor Chenggang Xu explains this misconception beautifully well in this video interview where he describes China’s economic system as a “regionally decentralized totalitarian system.”

You can picture this through a hierarchical lens whereby the Chinese Communist Party (CCP) sets objectives for the nation which are contingent on the performance of individual provinces, and these provinces do the same for their respective cities.

Listed below is a graph showcasing the different Provincial GDP targets set by the CCP. You can also see how major cities such as Beijing and Shanghai fall as independent provinces with the same directive control.

And in conjunction, here is the breakdown of provincial GDP contribution as a percentage of China’s total GDP with Bloomberg providing color-coded risk assessments related to lockdown measures stemming from COVID-19.

Having lived in China, Hong Kong (pre-China taking it over), and Singapore, I’m not surprised how the ‘East’ has been able to organize itself to the point of setting growth objectives at regional levels. The U.S. has an undeniably greater sense of individualism vs collectivism as compared to the ‘East.’ And that is another factor influencing China’s response to the pandemic, collectivism. I view collectivism stemming from Confucian thought and his view of the family as a model for the state (I’m no expert in Chinese philosophy, so please correct me if I’m wrong). The term xiào, 孝, which refers to Filial Piety is made up of two characters, 耂 (“an old man with long hair, bent over”) and 子 (“a child”).

“and surely proper behavior towards parents and elder brothers is the trunk of goodness?”- Confucius

So now we have a regionally decentralized totalitarian system with a focus on collectivism.

And as China’s history has told us, ‘collective’ responses have brought the country closer together, but have also driven support for the opposition.

As you might have heard, China has been experiencing waves of COVID-19 outbreaks across major GDP hubs such as Beijing, Hong Kong, Shanghai, and Shenzhen over 2022. This has led to a collective response like no other, and lockdown measures are being reinstated in Shanghai and Shenzhen which contributed over 7% of national GDP in 2020. Shanghai in particular began its lockdown on March 28, which was just three days after the latest Purchasing Managers' Index (PMI) levels were released, providing us a backdrop for further deteriorating conditions in April.

Shanghai is an ‘economic beast.’ Not only is it China’s financial and international trade center, but it is also the transport and logistics center of the Yangtze River Delta. With strict lockdowns being imposed (I say ‘strict,’ some say barbaric), other nearby provinces have set up roadblocks, enforced strict PCR testing requirements, and even imposed quarantines on truckers. Air traffic across China has also continued to take a severe hit, illustrating an even more pessimistic outlook than the beginning of the pandemic in early 2020.

The impact on shipping paints a similar picture, with lockdowns preventing the labor force’s ability to work. This is concerning to see happening in Shanghai which is responsible for 7% of Chinese exports. The graph below comes from a Freight Waves article and displays the average dwell time in days at the Port of Shanghai.

This all suggests the possibility of a contraction in China’s GDP growth at the beginning of Q2 with self-imposed lockdowns being a key driver as a consequence.

And who do you think gets the short end of the stick? The CCP or the provinces? The hierarchical lens tell all. Clearly the provinces get the short end, which is why I am not surprised we are hearing stories that provincial governments are bypassing State Council orders in an attempt to curb infection rates and follow through with the CCP’s “COVID Zero” objective at any costs, to avoid criticism from a lackluster COVID defense.

How long will this last? The lockdowns? The view of COVID-19 as a pandemic as opposed to an endemic? How far will the CCP push its “COVID Zero” narrative?

It’s hard to have an informed perspective when speaking of a foreign place where you are not physically present to see and experience, but I welcome any feedback and opinions on the matter.

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― Lao Tzu

I included this quote because I thought it was a good representation of the current business cycle (at least from the start of COVID to now). Unprecedented stimulus and the uniqueness of the Pandemic have resulted in one of the quickest business cycles, of which we are currently experiencing what Milton Friedman referred to as the “Inflation Hangover.” I know I’m late to the game talking about an inverted yield curve and the effects of rate hikes, and you are probably tired of hearing about the two, but bear with me.

Is The Curve Still Steep?

With the extreme tightening of the 2-10 year U.S. Treasury spread in the past six months (eventually inverted in the first week of April but has since bounced back), the flattening of the yield curve has been a center point in financial media. However, what is the predictive power of the sole 2-10 year spread, and why does it look relatively steep when looking at the whole curve?

Fig. 1: U.S. Yield Curve As Of 4/7/22 And 1M Earlier

One spread can’t tell the whole story, but it can be an indicator and lead the rest of the curve. Despite the headlines of inversions indicating recession risk, only 27% of the curve is inverted as of a week ago. This is above the long-run average and is seemingly increasing but still a ways off from the historical choke point of 75%, as shown in Figure 2.

Figure 2: How Much Curve Inversion Is Too Much Inversion?

While most yield curve spreads have seemingly been flattening, the 3 month - 10 year spread has decided to go its own way. In the past, the 3 month - 10 year spread has had the stronger recession predictive power. This has become increasingly important in this lower yield that we have experienced in the past two decades. Due to supply and demand factors, it has been increasingly easier to invert the curve, as massive purchases from quantitative easing (QE) and foreign investors craving risk-free treasuries to park their dollars in have artificially suppressed long-end yields. Looking back at Figure 1, the curve seems to have steepened when considering T-bills (Treasuries with less than 1 year to maturity). Opposers of the inverted curve have increasingly pointed out that since the 3 month - 10 year spread has been increasing, the inversion of the curve doesn’t spell recession. The derivative market is telling a different story however. Forwards are derivative contracts of a certain security for a specified tenor or period in time when the contract expires. In this case, a 1y3m forward would equal the yield on the 3 month U.S. Treasury 1 year out from now. Through forwards, we can see what the market is predicting the 3 month Treasury to be yielding in one year’s time. If one were to look at the spread between the 1 year forward of the 3 month and the 1 year forward of the 10 year (Figure 3), they would see the market pricing in a deep inversion one year out. The reason for this lag is pretty simple: T-Bills like the 3 month are nearsighted and hug the Fed Funds Rate tighter than longer duration Treasuries. Since the Fed has only hiked once, they have lagged the rest of the curve in the mass sell-off.

Figure 3: Two Roads Diverge In A Yellow Wood

Looking at Figure 4, we can see that this is the largest divergence between the 3 month - 10 year and its 1 year forward counterpart in the past two decades as markets price in aggressive rate hikes.

Figure 4: Spread Between 3m-10yr And 1y3m-1y10y

The 3 month Treasury has lagged the rest of the curve but has still sold off. So that leaves only one party to blame for the abrupt bear steepening of the 3 month - 10 year spread, the U.S. 10 year Treasury. The hawkish nature of the Fed, including the plan released in the March Minutes on Wednesday for quantitative tightening (QT) runoff amounting to $60 billion a month starting in May, has resulted in the selling of long-end yields. This can be shown in Figure 5 as the yield on the 10 year has peaked above the two-year two standard deviations trend barrier for the first time since 1999.

Figure 5: U.S. 10yr And Its Two-Year Simple Moving Average +/- Two Standard Deviations

This can be seen in the dramatic increase of the MOVE Index, which measures interest rate volatility. The MOVE Index initially increased due to the Fed’s hawkish shift early this year, then spiked even more from drastic swings in interest rates as investors looked to price in higher rates one day while also driving down yields in a flight to quality the next. After settling for a brief period, investors have reverted to causing a bloodbath of sell-offs in the Treasury and interest rate market as a whole. What’s strange is this increase in bond volatility hasn’t been realized by stocks as the VIX (real-time market index representing the market's expectations for volatility over the coming 30 days) remains relatively calm. With March CPI being released on Tuesday, which is likely to surprise on the upside due to the realized inflation stemming from the impacts of the war in Ukraine, will equities get a shock of reality?

Figure 6: Will VIX Close The Gap With MOVE?

First Domino To Fall

Figure 7: “Star Wars: A New HOPE”

I thought the graphic and acronym above puts an easy visual on the timeliness of the effects of rate hikes. The “H” in HOPE, housing, is starting to show signs of classic behavior from previous hiking cycles. The yield on a 30 year fixed-rate mortgage has sharply surged year-to-date to levels last seen at the peak of the last hiking cycle and even those after the 2008 Global Financial Crisis (GFC). Fortunately, a tiny percentage, ~6%, of homeowners have ARMs (adjustable rate mortgages) compared to levels seen before the GFC, which topped out at 35%. This means that most homeowners aren’t exposed to their mortgage payments rapidly rising from higher interest rates. This is further proof against a housing bubble, or at least to the size seen during the GFC. Not to mention the vast differences: actual incomes that can support monthly payments (“actual” is a loose term as this measure can be partially attributed to more stimulus and record-low borrowing costs), lower speculation in the housing market (ignore companies like Zillow and BlackRock), a lack of lust from banks to package loans, and the genuine undersupply of housing currently. That list could go on and on, but that’s a story for another time.

Figure 8: The 30yr Mortgage Rate Doing Its Best GameStop Impression

Due to the suddenness of the Fed’s pivot, the housing market (much like the Fed) is behind the historical curve. We are starting to see a rollover in home sales in response to the rapid increase in rates, as shown in Figure 9. We are also seeing that the supply of new homes has been steadily increasing while still lagging behind demand. In addition to this, despite the downtrend in the past decade, we are entering into the cyclical period of the year where there is an increase in existing homes entering the market. This minuscule increase in supply and the higher borrowing cost dampening demand may slightly relieve the housing market. Then again, we’ll see, real yields are still relatively low, and the construction of homes severely diminished post-GFC (also, you can’t make more land unless you’re the Netherlands).

Figure 9: Housing Rolling Over

Higher mortgage rates have not been more evident than in the refinancing market. Homeowners took advantage of low-interest rates and a historically accommodative credit environment by refinancing their mortgages at the lowest mortgage rates ever seen. This has taken a sharp reversal as refinancing moves inversely with mortgage rates.

Figure 10: No more Refinancing

With this rapid increase in rates, mortgage values have declined significantly, with the Bloomberg Mortgage Index crashing to a two-decade low of $95. Not surprisingly, most mortgages in this index are trading well below par, as shown by the green segment in Figure 11.

Figure 11: Mortgages Trading Well Below Par

For a quick, more in-depth look into the housing market, here is the weekly capital markets outlook by Merrill Lynch that highlights the problem in the housing industry and gives a decent outlook.

Conclusion

While this rate cycle is genuinely unique in many aspects, history still rhymes. After two years of credit binging, the U.S. economy is experiencing what Friedman described as an “inflation hangover.” The signs of a classic tightening cycle (spoiler, they usually don’t end well) are starting to show with the wobbling of the first domino, housing. This cycle has had a faster pace and more complexity than previous ones when considering COVID-19 and the war in Ukraine. The question becomes: can Powell and the FOMC slam on the breaks without crashing the car to achieve the ever rare “soft-landing,” or will he roll the car into the wall leaving us in a stagflation environment?

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"Malo periculosam, libertatem quam quietam servitutem." - Thomas Jefferson

“What do you want out of life?”

Chances are you’re looking at the above question in confusion. It is a very broad question; you could take your interpretation in multiple directions.

How about I reframe it for you?

How about: “Who do you want to dictate what you want out of life?”

When framed in this way, your answer probably changes dramatically. Maybe its your parents, your government, or yourself.

Regardless, I target this piece as a wake-up call for all the dreamers, techno-utopians, luddites, atheists, the religious, people who keep up with the Kardashians, and more.

Over the last decade, we have seen the phenomenal rise of phone usage with Americans now spending nearly a month and a half (44 days) on their phones throughout the year. I’m not here to tell you to stop using your phones. The importance of a phone has become crucial for anybody navigating the 21st century. What I am here to tell you is that your smartphone data is a component of the larger AI picture which improves algorithms and in theory, should result in a more user friendly experience for the consumer of the smartphone.

When you break it down, it looks like a beautiful never-ending cycle of continuous improvement - very Kaizen.

However, the gathering of data is also a double-edged sword driving the ethical debate of invasion of privacy versus guarantees of safety. This leads me to my focal point. With better technology comes less freedom, whether we like it or not, and we have already sacrificed more freedom than we realize in the pursuit of maximized utility.

Before you call me a hypocrite for clicking “yes” on allowing cookies, trust me, I’m in the same boat. I agree to give up a certain amount of my freedom (personal information) in exchange for better technology. Developments in blockchain allow for anonymity across transactions, but most people operate their blockchain wallets using an ‘established’ (i.e. backed by PE and VC from developed markets) trading application like Coinbase, Robinhood, or even Venmo.

But the thing about these ‘established’ trading firms is that they follow the tradeoff above by continuing to track and use data the same way traditional tech companies do. In doing so, they continue to grow this fallacy of technological growth as a democratizing tool. Just take a look at Ben Hunt’s article: “In Praise of Bitcoin.”

In my dystopian vision, Bitcoin isn’t banned or criminalized. Pfft. That’s a rookie, weak State move. No, I see a future where everyone buys Bitcoin. Where you are encouraged to buy Bitcoin. Where Bitcoin is sold to you morning, noon and night. Where normie economists get on conference calls late at night because they’re Bitcoin price-curious.

Except it’s not really Bitcoin.

Instead, it’s Bitcoin! TM — a cartoon version of the OG Bitcoin, either a Wall Street-abstracted representation of the price of Bitcoin or a government-painted version of Bitcoin in Dayglo orange. Either way — abstracted or painted — your Bitcoin! TM is trackable and traceable, fully KYC and AML and FBAR and SWIFT and every other US Treasury acronym-compliant. Either way, your Bitcoin! TM has all the revolutionary potential of a bumper sticker and all the identity signaling power of a small tattoo on your upper arm.

Bitcoin! TM doesn’t stick it to the Man … Bitcoin! TM IS the Man.

It has been fascinating witnessing the rapid developments of digital currency over these last couple of years, including the bombardment of Mark Wahlberg and Lebron James Crypto.com ads coming across the TV screen.

Bitcoin rapidly rose in correlation with the S&P500 over the month of January:

Nearly a third of Bitcoin’s value is held in the top 0.01% of accounts:

And just as how gold was commoditized by Wall Street through ETFs promising ‘casino chips’ for the price of gold, we see history rhyming once again.

So if we live by the expectations of Moore’s Law where the number of transistors in a dense integrated circuit doubles about every two years, then we should also expect the rate at which technology encroaches on our freedom to follow this same pattern.

Of course, ‘freedom’ has such a subjective interpretation and we often do not realize the boundaries that it entails. So while I’m not counting down as pessimistically as the annual doomsday clock, I’m not expecting the utopian society from Brave New World either.

What we can point to as something increasing at an accelerating rate just like Moore’s Law is the amount of fiscal spending occurring over this upcoming decade as presented by the Clocktower Group.

Throughout the past several centuries, the human race has dominated its reach for natural resources through geographic expansion buoyed by industrial revolutions throughout history. However, these new green investments will stress their focus on efficiency, representing a shift that focuses more on customized production and critical resources while maintaining the image of a ‘net-zero’ product in-hand. And to further add fire, these investments are largely being conducted with the backdrop of an increasingly polarized world where political parties across the spectrum call for deglobalization through improvements in domestic supply chains.

Bringing this all together, once you begin to see the importance and ‘need’ of such improvements in technology as pushed by those in power, then you begin to see the direction in relation to the double-edged sword. Ultimately it will come down to who, what, and how people treat those that control the technology, just as it always has been from the wheel to the machine learning algorithms we deploy.

“But it was alright, everything was alright, the struggle was finished. He had won the victory over himself. He loved Big Brother.” - George Orwell

So where will technology bring us? And does the future really need us?

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