Gresham’s Law

March 17, 2024 – Weekly Comment

The crosscurrents, dislocations and uncertainties in the present situation point up one uncomfortable but inescapable fact: we are dealing with a situation marked by gross imbalances that can neither be sustained indefinitely nor dealt with successfully by monetary policy alone, however it is conducted. 
We are borrowing as a nation far more than we are willing to save internally.
We are buying abroad much more than we are able to sell.
We reconcile borrowing more than we sell by piling up debts abroad in amounts unparalleled in our history.

Seems like a quote from one of today’s financial blogs.  But it’s Paul Volcker from 1985.  The issues never change.  It’s only where we are on the spectrum. 

What it boils down to is confidence.  Trust in national institutions that safeguard justice and monetary integrity.  Integrity with respect to the store of wealth and medium of exchange. 

It relates to Gresham’s Law:  “Bad money drives good money out of circulation.”  In my mind, the rallies in gold and bitcoin are a reflection of this phenomenon. I googled Gresham’s Law and bitcoin as I was thinking about this, and unsurprisingly there was already an article about it, by a person (again unsurprisingly) named “Sheepy” on Linked-In.  “…more established cryptos like Bitcoin or Ethereum might be considered ‘good money’ due to their wider acceptance and relative stability.  In contrast, lesser known or more volatile cryptos might be ‘bad money’… The way gov’ts and financial institutions approach crypto can also affect the perception of good and bad money.”

A real-time example is afforded by El Salvador’s President Nayib Bukele, who is transferring a “big chunk” of its bitcoin assets to an offline physical vault. Hold your good assets out of circulation.

The period before the 1896 Democratic National Convention (which was held in Chicago, as will be the next one on Aug 19-22, which ought to be a doozy) was dominated by attacks on the gold standard by opponents who wanted bimetallism, re-introducing silver as legal tender.  From Wikipedia:

This would inflate the money supply, and, adherents argued, increase the nation’s prosperity. Critics contended that the inflation which would follow the introduction of such a policy would harm workers, whose wages would not rise as fast as prices would, and the operation of Gresham’s law would drive gold from circulation, effectively placing the United States on a silver standard.

Sound familiar?  The huge Covid increase in fiscal transfers and M2 sparked inflation.  As Powell frequently reminds us, inflation hurts the lower income end of the population most as wages lag.
The 1896 convention was famous due to William Jennings Bryan’s Cross of Gold speech. I include this excerpt as it strikes me in its relevance for today:

There are two ideas of government. There are those who believe that, if you will only legislate to make the well-to-do prosperous, their prosperity will leak through on those below. The Democratic idea, however, has been that if you legislate to make the masses prosperous, their prosperity will find its way up through every class which rests upon them. You come to us and tell us that the great cities are in favor of the gold standard; we reply that the great cities rest upon our broad and fertile prairies. Burn down your cities and leave our farms, and your cities will spring up again as if by magic; but destroy our farms and the grass will grow in the streets of every city in the country.

In my mind, the “farms” of the 1800’s can be equated to domestic productive capacity and enterprise.  Capital deployed to enhance productivity raises the nation’s standard of living; it benefits the “masses”.  Anyone can see the decay of big cities.

In the Roman Empire it was Diocletian in 301 A.D. who fixed prices because of debilitating inflation, caused by debasement of the currency.  A Mises Institute article notes that in the time between Nero and Diocletian, “the denarius (standard silver coin) had been reduced to one-tenth of its former value.”  The vast ’Price Setting Edict’ failed of course and was repealed in 307.  Nixon echoed the strategy in 1970. 

The Fed is trying to get us back to where the purchasing power of the currency is officially devalued by just 2% a year.  However, the Fed’s efforts are being thwarted by Fed’l Gov’t spending.  One quarter of last year’s job growth was government.  A recent tweet by EJ Antoni notes that “Over 52% of fed’l gov’t spending in Feb was financed by debt.”  The White House press release announcing Biden’s 2025 Budget blares that it “Advances Gender Equity and Equality”.   A budget blog notes, “…the level of borrowing under the President’s budget would be unprecedented outside a war or national emergency.”  Is gender equity a crisis?  The blog continues, “…spending would rise from 22.7% of GDP in FY 2023 to 24.6% in 2024 and 24.8% in 2025.  …Revenue which fell to 16.5% of GDP in 2023, would rise to 18% of GDP in 2024 and grow to 20.3% of GDP by 2034.”  When Gov’t spending is 25% of GDP, but tax revenue is only 16.4% of GDP (long term average 17%) there’s a problem.  Ken Rogoff noted this weekend that “Washington has a very relaxed attitude toward debt that I think they’re going to be sorry about.”

All of this brings us to the topic of US treasury yields, especially at the long end.  Vol is not screaming.  Credit spreads are tight.  But inflationary signals are tipping slightly higher.  Oil and copper are at new highs for 2024.  Good assets are being accumulated (gold, bitcoin) relative to treasuries. Not that treasuries are ’bad money’ but the architecture underlying their value is obviously being eroded. 

The BOJ and FOMC meetings this week aren’t likely to improve sentiment for longer maturity bonds.  Ten-year JGBs ended the week at a high for 2024 at 77.8 bps.  Last year’s high was just over 95 bps. Wage increases in Japan make it likely the BOJ announces a hike March 19.  Near SOFR contracts are at new lows for the year, having significantly repriced easing over the next year or so.  For example, SFRZ4 settled at a high of 9639.5 in January (3.605%) but was almost exactly 100 bps lower just two months later with Friday’s settle at 9540.5 (4.595%).  That yield is almost exactly 75 bps lower than the current Fed Effective of 5.33%, synching with the last dot plot which indicated three cuts.  There are some that think Fed members may trim back their assessments of appropriate cuts for this year to bring the median to two but I personally don’t see much of a chance of that.  Indeed, there has been heavy trade in SOFR options suggesting increased confidence for 2-3 eases.  SFRZ4 9537.5 straddle settled 68.5 on Friday.  The previous week, the Z4 atm 9562.5^ settled 76.5.  With SFRZ4 settling at 9540.5, the 9500p settled 16.25 with 31 delta.  The 9600c settled 18.0 with a 28d.  SVB failed just one year ago; the market is still sensitive to potential issues that could cause emergency easing. Calls are bid vs puts.

However, what is perhaps more likely than a repeat of last March, is a repeat of the following period.  From last May to October the 10y yield soared from 3.4% to 5%.  That yield increase led many to say that tightening financial conditions were doing the Fed’s job. 

From October to December the 10y yield plunged from 5% to 3.8%.  Since then it has been generally rising, though at a much slower pace than last summer’s increase.  The 50% retrace of Q4’s move is 4.39% and 61.8% is 4.53%.  I can envision a scenario where the Fed remains fairly neutral pre-election, but long end yields adjust higher with a tipping point realization that debt levels are out of control.  A deterioration in employment data might not do anything to stop a rise in longer end yields. Ironically, Fed easing could accentuate negative sentiment toward bonds.  The odds of such a scenario playing out may not be high, but I believe they are increasing.  If so, the attached chart points up an opportunity.

The chart is the 30-year bond yield with 3-month vol on the US contract overlaid.  The ten year looks much the same, but I highlight longer maturities as we go into the 20-year auction on Tuesday.  Vol is back where it was on the SVB unwind, having continually compressed in the aftermath of October’s yield surge. However, yields are moving higher.  OTM puts might be considered relatively cheap. 

UST 2Y448.4472.123.7
UST 5Y406.1432.326.2
UST 10Y408.7430.221.5
UST 30Y426.2442.616.4
GERM 2Y275.9294.618.7
GERM 10Y226.7244.217.5
JPN 20Y149.5154.85.3
CHINA 10Y229.3234.75.4
SOFR M4/M5-125.5-101.524.0
SOFR M5/M6-35.0-36.5-1.5
SOFR M6/M71.0-6.5-7.5
CRUDE (CLK4)77.5080.583.08

Posted on March 17, 2024 at 1:08 pm by alexmanzara · Permalink
In: Eurodollar Options

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