Transcription
Welcome back to another episode of Milkshakes, Markets and Madness. This is a show where we talk about the financial markets, the madness surrounding those markets, and we do it all through the lens of the dollar milkshake theory. And this week we're going to talk about the debasement trade.
The reason we're going to talk about the debasement trade, it's kind of become a popular narrative, one that is kind of an a priori given by most people at this point. And we've got a situation where the Fed has now gone towards not just rate cuts, but they've even started doing not QEQE. And as a result, the narrative has gotten more traction than ever. And it's not that the narrative is wrong, it's just that it can't be accepted as a certainty. And I want to kind of walk through and talk about why that is.
So, let's pull up a couple slides here. And you know, it's actually part of the reason I want to talk about it today is I sent this tweet out a week or so ago and I got so many questions about it that I figured I'd just do an episode here where we talk about it in more detail. And what I said was the biggest problem with the debasement trade as a thesis, even though it may be correct, is that it simplifies everything in a way that indicates that there's an easy solution. And I just don't think that the years ahead are going to be easy.
Now, the easy solution that most people have come up with is you just buy hard assets, whether it's gold or silver or Bitcoin or stocks or real estate or whatever it is, and you wait for the currency to get debased. Now, that's obviously not a horrible idea. Fiat currency does in fact lose value over time. Um, that's kind of what it's designed to do. It's not designed to hold value. So, getting out of fiat currency and getting into assets is a very smart move. That's why we invest.
But I think there is this belief that all of the central banks are completely cornered. There's absolutely nothing they can do and they're just going to open the floodgates, print more money, and that's automatically going to lead to great fortunes for people who are smart enough to buy real assets. And I think it's going to be more difficult than that. And I'm going to tell you why that is.
But essentially, you know, part of the reason that this has gained traction is asset prices have gone very high. And part of the reason asset prices are high is liquidity is full. Um this is a chart from Michael How at Capital Wars. Um you know there's a number of different ways to measure liquidity. This is his measurement of it but it's basically shown it at it's at its high and it looks like it might be starting to roll over a little bit but as of now it's high and a lot of people like to extrapolate recent events and as a result um you know this whole debasement trade has has has gained momentum and gained following. Um and for good reason.
Listen, if we look at a basket of global assets, um risk assets, you know, over the last couple years, a lot of them are up tremendously, whether it's stocks or gold or oil or oil is one of the few things that's down. Actually, energy and bonds are two of the few assets that are down over the last couple years, whereas most indices um and hard assets have risen. Um same thing for silver. Silver has gone through the roof. It's now it closed at its all-time high at $67. Um, same thing if we look at copper. Copper is near its all-time high. Um, you know, if we look at something like Bitcoin, Bitcoin has pulled back, uh, you know, recently, but it's had a heck of a run. Um, and considering how far it's come in the last five or 10 years, it's hard to look at it as a as a failure. Um, and I think in many ways, Bitcoin is a pure play on global liquidity. Um, and then gold. Gold gold is sitting at its all-time high as well.
And listen, I I think it's important that all these assets uh you know can be found in a portfolio. And it's it's this you know criticizing the debasement trade. It's actually not even a criticism. It's just something that you I think you need to think about in a little bit uh deeper manner than just accepting it as as an easy solution by buying um these things. And again, you know, I think everybody should own gold. Uh you know, many of you know that I joined the board of monetary medals recently. I think this is a fantastic for solution for those who already own gold and are looking of ways to still be in gold but perhaps diversify out of just the stack that you have, you know, squirreled away for the day when, you know, fiat currency becomes completely worthless and you want to find different ways to own gold. I think monetary metals is a fantastic way to do it. It's a way to earn yield on your gold and it's kind of a it, you know, it's not as risky uh as buying gold mining shares, but it's not as safe as just holding gold in a vault. Um, so if you believe that, as I do, that there's different ways to own something and different riskreward scenarios that are worth the additional risk, we think this is a fantastic way to do it. It's a way to earn three to four percent on your gold while still owning your gold. And um you know if you add that to a portfolio um you know studies have shown that the overall sharp ratio improves dramatically. Um
But you know, as as it goes with the debasement trade again, it it's not that the debasement trade is wrong, but there are some things you need to think about and one of the biggest things you need to think about is, you know, nothing is certain. And I and I put a chart of oil up here as this is an example. Now, however certain you are that the debasement trade is on right now and is going to work perfectly, I would encourage you to go back to early 2022 when Russia had just invaded um Ukraine and oil was screaming higher and take a look at all the predictions with near certainty of where energy prices were going to be in the years ahead. And then fast forward a year when Biden was selling oil from the strategic petroleum reserve in the high 90s and all the predictions of what that would mean for um the United States and the critical supply of oil uh when we would need it and how stupid a move it was and how nobody was ever going to be able to buy oil below 90 bucks again. Well, here we are three years down the road, almost four years down the road now, and oil's been cut in half, and that went against basically everybody's prediction. And it was the most certain thing in the world three years ago that energy prices were going higher, and now they're back to where they have been for much of the last 10 years. So, I just use this as an example um of a as as certain as something may look, it doesn't necessarily mean it's going to automatically play out in the real world the way we all think it's going to. And I I I just whenever whenever I see people starting to get certain about something, I I always want them to kind of take a step back and reassess.
And part of the reason is because of the type of monetary system we have. You guys have heard me talk about this many many times. These are the mo two most important symbols to remember if you want to understand how the monetary system works. These are the two most important symbols and that is if the current um amount of money in the system is not circulating um well first of all the money in the system needs to circulate for the system to survive. Now, if it's not circulating, then the central banks or the monetary authorities have to come in and plug the hole by adding more quote unquote money to the system. But if you know, as long as the money is is circulating, it's not necessary. And the way money circulates is basically by transactions taking place, people not sitting on it, or new money getting loaned into existence. If if those things fail to happen, that's when the central banks have to come in and plug the hole. And that the plugging the hole is an important concept to understand because if they're plugging a hole with money, but they're not plugging the hole fast enough, even though they're adding new money, the overall system can be contracting. And that is why in a debt-based monetary system, you always have to be ready for a credit contraction and a liquidity uh drop in liquidity. and why something like the debasement trade is not just a perfect given.
But you know, if we think of it this way at the bottom, this is the bank reserves that sit at the Fed or the or the central bank. That money never leaves the banking system. That is collateral off of which new money is loaned into existence. It's the money at the top. So if we've got four trillion in reserves at the bottom, that money stays in the banking system. It does not circulate. What does circulate is the money that's been loaned into existence using those bank reserves as collateral. So that's the the lighter uh color up up in front or up up top. And that money is loaned into existence. It has interest attached to it. And that's important. That's why the money has to circulate because when you loan money into existence, there is never enough money to pay all of of the loans that must be paid and the new interest because new interest is owed every year. So that's why that money needs to circulate. If that money doesn't circulate, then you start to get credit contractions and that's when the Fed comes in and puts new bank reserves in at the bottom in order to encourage the lending.
But the reason I bring this up now is we've gone back to this not QEQE where the Fed is now increasing bank reserves or they're, you know, the they they want to make sure there's plenty of reserves in the system. And the reason they're doing that is they are seeing something in their signals that's telling them they need to be ready for more reserves and they don't want to get into a situation where the hole gets too big too quick and they have to plug it even more. So they're sending a signal that there's going to be ample reserves. And the reason they're sending that signal is they want to encourage the market, which is the money up above, to continue lending more money into existence. But if the if the if the private market doesn't take the signal, it doesn't matter how many reserves the Fed puts down at the bottom. If the private market does not use that to create new money, it's not going to hit the the overall economy. Um, and this is why I say it's very important not to confuse new supply of dollars with more supply of dollars. Again, when they're putting bank reserves into the system, they're trying to plug a hole that is starting to develop. If the hole is growing faster than the new reserves that they're making, then the hole is actually still growing and they're not putting enough in fast enough. So just because they're doing QE or just because they're providing liquidity, it doesn't mean there's going to be it doesn't necessarily mean there's going to be more money in existence. So in other words, don't confuse new money with more money. It certainly can be, but it doesn't have to be. And in that that's why you always have to kind of have one eye on the exit and always be prepared for a credit contraction or some kind of a liquidity shock. If we did not have a debt debt a debt based monetary system, that risk risk would not be nearly as high as it is.
And this is just another one of Michael Howell's charts that shows the liquidity collateral. You know, it's showing the toeer rate. And you can see here where over the last couple months the the the rate has has jumped. And this is probably what led um or one of the things that led the Fed to to go back to increasing the reserves. But one of the reasons I'm I'm gonna go and say one of the reasons that they haven't had to do that until now. And the reason assets are near their highs is a combination of both the yen and the dollar. Now I'm using both the the yen uh futures here. Um because if I if I put the regularly yen chart up when the yen rises that's actually it weakening. So I I used the futures just to show, but this basically shows that since at the since the beginning of the year, the the yen went up initially into April, but since then the yen has fallen 10%. And at the beginning of the year, the dollar fell 10% into April and has gone sideways since then. But the reason this is important is the yen and the dollar are two of the biggest carry trades in the world. And what that means is people borrow in that currency or or enter in some kind of transaction in that currency and then they go and take on some economic project or some investment that they are hoping will pay them a higher rate than the the rate that they're paying on the borrowing or that they're going to make enough money um to uh to cover whatever that currency is either appreciating or to depreciating against. So the fact that both the yen and the dollar are down on the year is part of the reason liquidity has been so ample and it's part of the reason asset prices have been so high and this this comes important later on but uh um the the reason I wanted to focus on this is because you guys have heard me talk about the dollar many many times part of the reason so what I've done here is I've shown the the dollar index overlaid on the VIX and if you go back for the last 25 years. Virtually every time there's been a spike in the VIX, it has corresponded with a higher DXY or a rising DXY. Now, this is not a perfect correlation, but it's very close. And part of the reason again is the dollar has is the underlying currency for the entire global economy. It is the funding currency that that that that almost the whole world uses. And so if the if there starts to be a liquidity crunch that then causes the VIX to spike, it makes sense that the underlying currency would rise as well.
But the what I wanted to show I I don't think that's a big surprise to most people. But what I wanted to show is the yen as well. Now again, this is not perfect, but oftentimes when we get into periods of high volatility, you will see the yen rising as well. And part of the reason is the yen is a funding currency. You've probably heard of this yen carry trade. The yen is a currency that the many you know entities around the world have borrowed in to then go invest elsewhere. And as a result when volatility picks up that volatility often picks up when liquidity is decreasing and when yen liquidity decreases and the yen rises it corresponds with the with a higher VIX. And so this is why I say when the yen and the dollar are falling, you're typically going to get a low VIX, which is what we have right now. But in periods where the VIX is spiking, it's oftentimes seen or correlated with both the yen and the dollar rising. And so the yen and the dollar rising against all other currencies, that's kind of a nightmare for global liquidity. And that's something that you certainly would not want to see if you were heavily uh invested. Um
But the reason I bring this up now is, you know, there's been a lot of talk is the yen carry trade going to blow up again? You know, there's a number of articles uh that have that I mean you you can always find these articles, but in the last month or so they they've started to pick up again. And part of the reason they've started to pick up is because what's going on with monetary policy in Japan. So here here here's just again is what the the carry trade is is you borrow in Japanese yen. You convert that to some other currency. Uh maybe you just sit in that currency that's yielding a higher interest rate than the yen and you pocket that difference or you take that new currency and you go invest in some project and at the end of that project, you know, you you you sell that asset, you convert your that currency back to yen and you go pay off your yen and you made money on the yen carry trade. But when the yen strengthens or goes against you, that whole trade can get blown up.
And so part of the reason the bank of or part of the reason the yen carry trade exists in the first place is because after they had their big economic crash in the late 90s, the Bank of Japan dropped interest rates from high single digits to basically nothing. So you can see this is the this is the chart of short-term interest rates and you can see back in the 90s into the mid 90s it came down and it was basically at zero for 20 years. Now, in the last couple years, you've seen it start to tick up a little bit. And as if if we if we zoom in, you can start to see it a little bit more. Now, on this chart, as the yen as the line is coming down, that's the yen strengthening. And as it starts to go back up, that is the yen losing value. And what I want to point out here is the yen has lost 50% of its value versus the dollar in the last three years. That is an enormous move for a currency, any currency, let alone the third biggest currency in the world. And the reason I point that out is that does not happen without the US. I don't want to say they're blessing, but the idea that the Bank of Japan would do this or would weaken their currency that much and the United States would just not be involved in those discussions or wouldn't say anything unless they kind of gave it its blessing. Uh that's just not the way this works. Um so it's hard. So in other words, this is a way of saying the US has probably um okay with Japan doing this because they see them as an ally and there's a benefit in some ways to the to to the UN to the US when Japan weakens their currency. Um
But you know, as we see here now we zooming in on the interest rates the interest rates in the Japan just raised interest rates again this last week and so they've taken them from negative um just a couple years ago now up to 75 basis points. Now, 75 basis points is clearly not very high, but when you're coming from zero or negative, it starts to add up. And when you are used to borrowing at zero and now you have to borrow at 75 basis points, it starts to have an impact or it starts to make you think. And not only that, if if they raise rates too much, then that could start to strengthen the currency. And so even if the interest rate is not high, if the currency starts to strengthen, then that goes against the the yen carry trade as well because people have to pay back yen with now more expensive yen. And it's not just short-term interest rates. Long-term interest rates have started to rise uh in Japan. The 10-year is now over 2%. Um again, where it was um that's the highest it's been in, you know, 25 years. And if we look at the 30-year uh yield, it's above 3% and that's the highest it's been in 25 years. So, you know, the the cost to borrow for Japan um has gone up tremendously in the last couple years.
Now, what's what's amazing is the is the currency has not started to react to these higher interest rates yet. Part of the reason is because interest rates are still higher in much of the rest of the world. So even though interest rates are starting to rise in Japan, they're not higher than they are elsewhere. So on a relative basis, you know, yields are still relatively low in Japan. But the fact that interest rates are rising, it's starting to scare people that are in this yen carry trade and they're worried that as a result of higher yields, the yen and the fact because the yen has fallen so much in the last couple years that if the yen were to very quickly strengthen that could lead to the yen carry trade blowing up. The yen carry trade blowing up leads to a loss of liquidity. The loss of liquidity leads to the the VIX spiking. And when when the VIX spikes, the dollar typically spikes. And so you can get into you can go from a very liquid and benign environment to a very illlquid and crazy environment very quickly when you have a carry trade that gets unwound. So that's why uh that's why this is getting so much topic talked about now and it's why I think you have to be careful with the debasement trade. Again, it's not that you can't do it. It's not that you can't employ that strategy. It's just how you have to be aware of how it can go against you. Um
I if it does and if if we go back to this is a this is like a 50-year chart on the yen. And you know some people will look at these uh these resistance line and say well these are just ridiculous signs. And listen I tend to agree with you in many ways technical analysis is a little bit silly. But the reason I put this on here is because the yen is at a level now where if it goes through 160, there is zero resistance from a technical basis all the way to 200 and 250. Now, that doesn't mean that that's necessarily where the yen's going. I'm just pointing out that we're at a pretty critical level on the yen. And if it goes much higher, it could start to get interesting pretty quickly. And when I say higher, higher on this chart means that it's weakening. And the fact is is I I think the the Bank of Japan wants it to get weaker. I don't think that they necessarily want the currency to to to strengthen, but they don't want the currency to crash either. And this is where they're in a really tough spot. Um they probably want to keep it weak and even a little bit weaker, but do it in a controlled manner. The problem is when it doesn't go in a controlled manner anymore and it starts to get away from them. Um, and this is just another I just zoomed in here and you can see it's kind of right at this 160 level, which is a pretty pretty pretty critical level. Um
My friend Michael Nicolidos wrote a very good piece on this uh, I don't know, two or three weeks ago. I'll put a link in it in the description of this video here. Um but he basically because this was getting so much uh talked so much airtime and talk about he put out a really good article and his point was Japan is not losing control and I agree with him. I I think what's happening right now is what Japan wants to happen and I'll go through kind of his reasoning of why it is. But I will also say it's a very dangerous game that they're playing. And the fact is is if the currency starts to really fall and then they decide they don't want it to fall and they're not able to get it under control, that's where it could get really interesting really quickly. I'm pretty sure Michael would agree with that. But uh in any case, he's basically saying Japan isn't losing control. And it really the reason that he's saying this is they want a a weaken. A weak yin tends to help them. They're an export economy. Not only that, they're uh you know an ally of the United States. A weekend provides liquidity to the world. The more liquidity in the world, the more investments flow to the United States. Um and that helps uh you know overall volatility stay low. Not only that, but as the yen weakens, it puts more pressure on China because it's a regional competitor. And as the yen weakens, then people will buy more Japanese goods versus buying Chinese goods because they're cheaper. and if people buy less Chinese goods and that puts pressure on China. So there's many reasons why uh Michael thinks that they're doing this on purpose and again I tend to agree with him. Um
And but you know, the it it doesn't mean that it can't go south in a hurry. And again you know, the like like what I just mentioned the winners here you know, the Japanese exporters benefit from lowal from from lower Japanese prices. Um, the Japanese government gets to see some inflation, reducing the real debt burden. And again, here's the thing. Japan has been trying to get inflation for decades. That's why they had interest rates at zero. And now that they're finally starting to get some inflationary effects. Everybody wants them to squash the inflation, but they're finally getting success. Again, the whole reason for these really low interest rates and extraordinary measures and QE and all this stuff is because they wanted inflation. So the idea that now they have inflation that they're just going to turn around and snuff it out, I I think is is is to misunderstand the point of doing it in the first place. Um and then you know, as as as I mentioned earlier with a weaker yen, US capital markets continue to get inflows. Um US Treasury benefits as Japan keeps buying American debt. Um, but the losers here are are China and you know, there's obviously a big war economic war going on with China right now and Japan is a big ally of the United States in in that competition. Um, but China faces more competitive more competitive Japan just as tensions flare. Um and uh you know one of one of the things I wanted to point out is if you look at uh the Chinese yuan now again this as this as the line goes up and to the right that's the yuan weakening and you can see over the last 10 years it's weakened tremendously versus the dollar but in the last you know the last year it has started to strengthen again and China is having many deflationary problems internally and so the yuan strengthening doesn't help that and as a big exporter themselves strengthening yuan actually hurts China's competitiveness. So it kind of puts China in in a tough spot as well. Um and you know, if you guys don't follow Michael follow Michael Pettis on on on Twitter. I would encourage you to do it. He puts out a lot of good analysis on China and um he put one out just a couple days ago talking about how the the economic data coming out of China shows that they continue to struggle. So again, the strengthening yuan is certainly not helping that.
But as we go back to the yen and the DXY again, as as these have both fallen this year, that's provided a lot of liquidity to the market. What could change very quickly is if we get some kind of a credit um contraction in both the yen market and the dollar market. And if these two currencies were to strengthen quickly as a or even you know just start to rise it starts to squeeze liquidity out of global markets. So if you are a global investor the last thing you want to see is the yen and the dollar rising together versus foreign currencies um and and their fiat competitors. Um
But just you know, in summary here, it it's not that the basement trade is wrong. It's just that I don't think it's going to be easy and I think you always have to be ready for a credit contraction in a system like we have. A credit contraction or a deflationary impulse can come out of nowhere and it's always a risk. Even if we are in an inflationary environment, it's always a potential risk. Not to mention the geopolitical factors are going to play a role especially in critical assets. You know, the debasement trade is oftentimes associated with critical assets that are very important from not just an economic perspective, but sometimes a national security perspective. And you know, as as trade tensions and geopolitical tensions rise, um things might not just be left to whether from from an economic perspective of whether they play out or not. And I think governments um will impose whether it's tariffs, whether it's certain level of taxes, whether it's uh you know um windfall profits, but I I I think geopolitical factors are going to play a huge role in many assets that would benefit or or in a that would in a free market benefit um from a debasement trade.
And finally, the one thing I would say is rather than trying to make these grand predictions about what's going to happen based on, you know, one certain um narrative or another, just spend more time trying to understand what these different signals mean and what could happen as opposed to making a certain prediction or or a prediction with a high degree of certainty of what's going to happen. And I think if you kind of keep an open mind and understand what the dynamics mean as opposed to predicting exactly what they're going to cause, I think I think that'll translate into better performance in your portfolio. Um
In at the end of the day, I think the the point here is as you see these headlines about the yen carry trade, I don't think Japan has lost control. U, but they're playing a very dangerous game. And the interesting thing is that if it gets if the regardless of which way the yen goes from here, it can cause problems. If it gets a lot weaker, that can cause a deflationary impulse in China, which can then reverberate to the rest of the world. If the yen strengthens dramatically, that can cause a Japanese yen carry trade unwind, which can cause volatility. So, if the yen kind of stays in this range, perhaps it's pretty benign and it's nothing nothing really to to worry about. And if you know, if it moves a few percent here or there, it doesn't really matter. But if it makes a big move lower or a big move higher, I think that could be the cause of a lot of volatility in 2026. Um
Finally, you know, we wrote a whole page or paper on this um about a year and a half ago. If you go to research.santiago.com, santiago.com. You can find it on our Substack. You can also just go to santiagocapitalap.com and um you know you you can look for it there. I'll put a link also in the description of this video if that's something that you would want to read. Um and finally, you know, if you like this topic, you know, please go to our site, our research. Capitalap.com and sign up. Also, if you like this video, hit the subscribe button, hit the like button. I'm told that that really helps uh with with with our channel and that I need to do a better job of reminding you guys to do that. But in any case, I I hope this was helpful. Um this is uh going out on December 21st. We're probably not going to have an episode next week. So, I want to wish everybody um fantastic Christmas, holiday season, happy new year, all that kind of stuff. And look forward to catching up with you guys again in 2026. Okay, guys. Peace.