jwithrow, Author at The Phoenician League

The Great Reorganization – Part 4

Autumn is upon us up here in the mountains of Virginia. The air has cooled… the humidity has evaporated… and the leaves are beginning to make their annual descent back to the Earth.

There’s something magical about this time of year. It’s a reminder that everything is finite. As the book of Ecclesiastes says: There is a time for everything… and a season for every activity under the heavens.

The gravel road pictured above is our driveway. There’s one way in and one way out… like we’re at the end of the world up here. Most days I feel like we are.

We bought this property from the family who owned the old Downer’s Hardware store in the nearby town. They opened the store in 1953 and ran it for just over 50 years.

We were a couple decades into the “cheap money” experiment when Downer’s Hardware closed its doors in 2004… but we hadn’t yet reached the apex.

We talked yesterday about the result of this experiment – cheap money cheapens everything. The case of Downer’s Hardware illustrates this dynamic…

The Great Reorganization – Part 3

We’re talking about America’s Great Reorganization this week.

For those just joining us – the thesis is rather simple. Virtually every aspect of our economy has been “financialized” over the past 50 years. This caused some major distortions that threaten to sink the entire dollar-based financial system.

Most of the mainstream financial analysis I’ve seen largely ignores this dynamic. It takes the position that nothing has broken yet… therefore nothing big is likely to break going forward.

At the same time, much of the alternative financial commentary out there seems to employ single-variable analysis. It looks at the increase of fiscal debt and deficits and presumes that they will continue apace until the system collapses under its own weight.

But what if that variable isn’t fixed? What if it changes?

As we discussed yesterday, the US Congress has shown no desire to cut spending and get its fiscal house in order. But a major sea-change at the heart of the dollar-based financial system could force the issue.

That sea-change stems from the Secured Overnight Financing Rate (SOFR) replacing the London Interbank Offered Rate (LIBOR) as the interest rate benchmark for dollar-denominated loans and derivatives.

SOFR allowed the Federal Reserve (the Fed) to break ranks with the global central bank cartel. It’s what enabled Fed Chair Jerome Powell to raise interest rates at the most aggressive pace in history.

The financial media covered that story daily. They said it was all about combatting inflation. But that was just part of the story – a small part.

The Great Reorganization – Part 2

Yesterday we made a bold claim. The second American revolution is currently underway.

Except this revolution isn’t being fought on the battlefield. It’s financial in nature.

It all centers around something called the Secured Overnight Financing Rate (SOFR). SOFR (pronounced “so-fur”) is now the benchmark interest rate for dollar-denominated loans and derivatives. It was created in 2018. And it replaced the London Interbank Offered Rate (LIBOR) in January 2022.

This is an esoteric corner of the global financial system… but it’s critical to understanding what’s playing out today. Especially on the geopolitical and macroeconomic level.

Simply put, SOFR connects the dots.

When LIBOR was the benchmark rate for dollar-denominated loans, the US economy was tied to the agenda established by the power factions controlling the European Union (EU). That’s because 11 panel banks in Europe could manipulate interest rates through LIBOR, as we discussed yesterday.

With SOFR now in place, those European banks have no influence on dollar-denominated interest rates. SOFR liberated US monetary policy… and paved the way for what I’m calling the Great Reorganization.

The Great Reorganization – Part 1

We spent the past two weeks talking about what a normal economy looks like… and how it’s all been distorted over the last 50 years or so. Even the US Treasury market – the bedrock underpinning the global financial system – is starting to crack.

As we’ve discussed, the current financial trajectory is not sustainable. But that doesn’t mean the American financial system is doomed.

If you’ll permit me, I’d like to venture into an esoteric corner of the global financial system today… and maybe even peak behind some curtains. What I’ll share with you is my analysis – the conclusions I’ve come to after many hours of careful consideration.

The Federal Reserve (the Fed) began publishing something called the Secured Overnight Financing Rate (SOFR) in April 2018 – two months after Jerome Powell became Fed Chairman. We didn’t realize it then, but the second American revolution was underway.

The bedrock is cracking…

We’ve been talking the past week and a half about the economy, interest rates, and normalization.

Today, let’s delve into the cornerstone of global finance—US Treasuries. Treasuries have been the bedrock of the global financial system in a sense… but the foundation is now cracking.

US Treasuries are government debt securities issued by the United States Treasury Department. They’re considered risk-free assets. And they underpin much of the global financial system. Here\’s how they work:

Domestic Role: Treasuries finance the US government’s operations. They’re sold to investors who then receive periodic interest payments at the specified yield for the full duration of the security. Insurance companies, banks, investment funds, and private corporations buy Treasuries to earn a rate of return on their cash reserves.

Global Role: Treasuries have been the world’s reserve currency since the end of World War II. Countries and central banks use them to store value in dollars, settle international transactions, and to manage their own currencies. This allows the US government to borrow money at lower rates and issue financial sanctions with global impact.

Both domestic and foreign institutions have used US Treasuries as a primary reserve asset for over 50 years now. But as we discussed yesterday, every aspect of the economy has been distorted in that time… and the US Treasury market is no different.

How the normal became abnormal

Yesterday we discussed how a normal economy operates. We can summarize it as follows:

Market-based system & sound money –> savings –> investment –> economic growth –> strong division of labor –> standards of living rise –> increased savings –> increased investment –> stock market rises –> increased entrepreneurship –> more startups –> outsized gains for investors –> good companies scale… bad companies go bust –> recessions clean out the system –> resumed economic growth

The problem is, these days we have interventions at every stage in the process described above.

For starters, arbitrary regulations and an arcane tax code distort activity throughout the economy. Paired together, regulations and taxes create a system of incentives and disincentives that influence economic activity.

Certain incentives may make a particular company or project look worthwhile when it otherwise wouldn’t be. And the reverse is also true. Disincentives can make a particular investment look bad when it otherwise would be productive.

When this happens, it throws a wrench in the free-flowing system we outlined above. It doesn’t take long before market signals are muddled. Then malinvestment sprouts up to cover the wheels of commerce like kudzu on a neglected building.

Normal and not normal…

This past Saturday was Fall Fun Day up here in the mountains of Virginia.

Fall Fun Day is an annual festival featuring food, beverages, music, and a variety of outdoor games for adults and children alike. There are sack races… mummy wrap contests… hay rides… and I witnessed a little spontaneous karaoke as well.

Here’s a shot of a small gathering underneath an ancient elm tree:

There’s a long tradition of annual harvest festivals throughout America’s Appalachia region.

The autumn harvest itself may have lost significance since our conquest over food scarcity… but these annual celebrations are still rooted in the region’s agricultural heritage. It’s Thomas Jefferson’s vision for America actualized.

While Fall Fun Day has become a normal occurrence for us each year, there’s nothing normal about what’s happened to our economy over the past 16 years.

What I learned watching the bankers party

Today we’ll wrap up our talk on the Fed, interest rates, and the future…

When we left off yesterday, I mentioned that something telling happened right in my back yard. Michelle Bowman spoke at the 133rd Annual Convention of the Kentucky Bankers Association last week.

Bowman is one of the 12 voting members of the Fed. She occupies a seat representing America’s community banks. That’s why she was invited to speak at the Kentucky Bankers’ event.

The convention took place at the historic Homestead Resort up here in Hot Springs, VA. As fate would have it, my in-laws came to visit us the same weekend… and we put them up in a room at the Homestead. We were there on Sunday as the conference attendees were getting settled in.

I met a few Kentucky bankers at the pool that afternoon. And we could see their opening reception from the balcony of my in-law’s room. It took place out on the lawn.

Here’s a picture I took as they were setting up:

Here we can see the grounds crew setting up tables and chairs for the event. This entire lawn was packed with bankers enjoying food, beverages, and live music a few hours later.

Breaking ranks…

Yesterday we discussed an odd dynamic – US Treasury rates went up after the Federal Reserve (the Fed) cut its target interest rate by 50 basis points two weeks ago.

That being the case… what happens next? Is the Fed going to slash rates aggressively from here?

When we left off yesterday, I mentioned that Fed Chair Jerome Powell said two things in his talk that I found telling. First, he emphasized that he remains focused on “normalization”.

When a Wall Street Journal reporter asked Powell if rate cuts were a signal that the Fed would also start buying Treasury bonds again, the answer was a clear ‘no’.

Powell told him that this isn’t even a point of discussion right now. He added that “you can have the balance sheet shrinking but also be cutting rates”.

Here’s why that’s important…

The Fed purchased over $8 trillion dollars’ worth of Treasury bonds from 2008 to 2022. They created money from nothing to buy those bonds… which pumped liquidity into the financial system and helped drive interest rates down to zero.

When they were Fed Chair, both Ben Bernanke and Janet Yellen made it a habit to buy more Treasury bonds whenever the Fed’s existing bonds matured. That kept the cheap money game going for longer than otherwise would have been possible.

Powell broke ranks and reversed course with his quantitative tightening (QT). This chart tells the story:

The Fed Cuts… Rates Go Up

When we left off yesterday, we were talking about interest rates… and hoping it didn’t put everybody to sleep.

All the talk in the financial world (geopolitics aside) has been the Fed’s 50-point rate cut.

Does it signal that the easy money days are coming back again? Are small-cap stocks finally going to catch a bid? Are 3% mortgages coming back?

Before we project too far, I think it’s important to point out that the Fed can only influence short-term interest rates with its monetary policy decisions. It cannot magically “set rates” throughout the economy.

As evidence – both the 10-year and the 30-year Treasury bond rates went up after the Fed’s 50-point rate cut.

The 10-year Treasury rate was 3.62% on September 16^th – two days before Powell’s announcement. By September 23^rd, the 10-year rate had jumped to 3.75%. It increased 13 basis points.

The 30-year Treasury rate was 3.93% on September 16^th. It spiked to 4.13% in the days after the Fed’s rate cut. That’s a move of 20 basis points.

Meanwhile, shorter duration Treasuries have hardly moved since the Fed’s rate cut.

Source: Bloomberg

This shows us that the Fed’s rate cut was already priced into the market. Short term Treasury rates have not fallen much since the big announcement.

Yet, long-term rates have risen materially. In financial lingo, this is known as the “bear steepener”.