MI271: The Long Term Debt Cycle & De-Dollarization “Fairytale” Explained w/ Alfonso Peccatiello

26:29Why? To make sure that the next borrower could borrow even more than the previous one. And therefore, that cycle could continue and we could create some sort of cyclical growth that would offset structural growth that was declining. There is a game stopper there though. And when you cannot lower real interest rates further, when you reach points where basically borrowing rates are as low as they can be, it becomes tricky to engineer this process because the next guy, the next marginal borrower, can't borrow more unless interest rates are lower. Kenny. That's what Japan found out in the late 90s.

27:08The real estate bubble in Japan had basically led through the same process of being able to lever up at lower and lower interest rates had led to a real estate bubble in Japan. When the bubble burst, Japan tried exactly this mechanism and they said, well, you know, guys, I'll give you interest rates that are as low as they can be. Go and lever up. And the private sector was like, no, the rates are already 0%. You can't make them lower. I don't have a higher capacity to generate structural cash flows. I'm not going to borrow more. So basically, Japan has been stagnating effectively for the last 20 years because they reached the point where you cannot lower real interest rates anymore.

27:47And the private sector is not willing to lever up more. So where do we stand in that long-term cycle is if I look at where real interest rates were before the pandemic, well, in the US they were negative. In Europe they were more negative. In the UK they were even more negative than that. So basically you were flirting with the boundaries of how low borrowing rates can be. And if you can't push it any lower, you can't run the system for a lot more. The risk is that you keep stretching the system until, like in Japan in the 90s, you end up creating too much leverage. And at some point, the bubble bursts.

28:25So either via bursting the credit bubble or via effectively not being able to lower interest rates further, you reach the latest stages of the debt cycle. I think we went really close to that before the pandemic. And now the problem is as interest rates are much higher than before, people are staying away from levering up. mortgage applications are down. So what you're doing is you're freezing credit in all these sectors and you're risking that there's going to be some deleveraging. Okay, that was going to be my next question for you. Do you think that we could see a period of deleveraging as happened in 2008 and 1929 in the US as that is typically the last stage of this long-term debt cycle?

29:09Or do you think that we're not going to get there this time? I think policymakers will fight this as hard as they can, Rebecca, because leveraging a fiat system is the way you grow a fiat system if you don't have the structural capacity to grow it through demographics and productivity. If you don't have that, then you need to lever up the system. That's the only way to grow it at socially acceptable, politically acceptable growth rates. So policymakers are not going to volunteer to deleverage the system. Why? They're not going to be reelected. Nobody is going to be reelected if under his or her watch, you're deleveraging the system.

29:50Deleveraging means basically you're doing the inverse process of what we did over the last 40 years. Now, try to think of what happened to asset prices over the last 40 years. The stock market went up about 10 % a year. House prices, same thing. So everybody felt richer. It's the wealth effect that you can generate through this process. Now, try to undo that and tell me which politicians is going to volunteer for it. The issue is that in Japan, also policymakers in the 90s didn't want this massive deleveraging. But when it starts and it starts hitting consumers, it is very, very hard to stop and especially very hard to ask the private system to re-leverage after the deleveraging, which is what happened in Japan.

30:31People got burnt. They don't want to accumulate more debt. I think policymakers are not going to volunteer for it, Rebecca, but the chances that it happens are not negligible. And then I think largely markets and everyone is expecting a recession, but how does a recessionary scenario differ from a period of deleveraging? Well, it's a good question. Sometimes they coincide. So during the great financial crisis, you had the recession and you had the deleveraging. I mean, the housing market was deleveraging really aggressively during the great financial crisis. People were forced basically to liquidate their houses too.

31:07And foreclosures went up, et cetera, et cetera. So that's a deleveraging of the housing market. Sometimes though, you have a recession without any meaningful deleveraging. So that happens when basically the recession hits particularly the labor market, industrial profits, rather than creating some credit stress somewhere. So the key is how does this recession play out? Does it hit a very leveraged sector? Does it hit the credit market like it did with the housing market in 2008? If it's directly one of these very leveraged credit sectors, then deleveraging is the obvious thing that happens next.

31:45If instead, it's a domestically driven, consumption-driven recession where the labor market weakens, where people spend less, but not necessarily the household sector in the US is the most in-depth out there. It's not necessarily so. So it could be that it is just a more orderly consumption, on labor market-driven recession, in that case, you don't have necessarily a deleveraging episode as well. So recessions can take different paths at the end of the day, and it's not a guarantee that you always get a deleveraging with one. When I was reading on Ray Dalio's long-term debt cycle, I believe I read that he said a period of deleveraging can occur when interest rate tools are no longer an option.

32:27But since central banks do have the option now, at least in the US, they are high enough to go down, as you mentioned, even to the lower zero bound. Is that a way that we could potentially avoid this episode then? Yes, in principle, that could be the case. Although the reasons why the private sector levers up is not only that interest rates are very low, but also that there is a stable economic environment around and especially they haven't suffered a deleveraging episode first. So to make an example. In Japan in the 90s, the Bank of Japan cut interest rates from basically 5 % all the way to zero, and it kept interest rates there, Rebecca, forever, ever since.

33:12The Japanese private sector has refused to lever up, even if interest rates dropped so aggressively. Why? Because the deleveraging of the 90s was so painful for them that there was no interest rate cheap enough that could convince them to take on additional debt. So it is the process here that matters. If the US can get inflation down to 2%, maybe with a recession, but without a massive deleveraging episode first, then yes, lowering interest rates at 0 % will prevent this late cycle deleveraging episode happening at all. Because people will suffer, but they will not be burned by a deleveraging episode first.

33:53So if you lower interest rates, you can encourage them to lever up again later in the cycle. But if the US can't get this orderly move down and you get a deleveraging episode first, when people get burned directly, then you cut interest rates at 0%. It won't do much, at least for a couple of years before you can convince people, then getting that back on their balance sheet is something they can afford. So it's the sequence that matters really. Let's take a quick break and hear from today's sponsors. Hey, it's Sean O'Malley, just popping in with a quick message. If you like this podcast, well, I've got great news for you.

34:28We've got a handful of other shows for you to explore, from learning about Bitcoin to embracing a richer, wiser, happier lifestyle. Just go into your podcast app and type in We Study Billionaires to find our collection of shows. We Study Billionaires is our flagship podcast, and we've made a name for ourselves over the years by interviewing the best investors in the world, including Ray Dalio, Howard Marks, Joel Greenblatt, and many, many more. My colleagues Stig Brodersen, Clay Fink, Kyle Greve, Preston Pysh, and William Green each hosts their own We Study Billionaires episodes and bring their own unique perspectives.

35:03A whole new world of insights awaits you. Just go ahead and type in We Study Billionaires into your podcast app and see what you've been missing out on. Seriously, go ahead. I promise you'll like what you find. Bonus points if you show your support for our work by clicking follow. If something piques your interest, just start listening. No hard feelings. I'll be waiting for you back here. Just like everybody else, there was a time when I was a beginner investor, and I have to say, investing is particularly filled with jargon that can just make it so difficult for new investors to understand what is going on.

35:33But it's never too late to get smarter about stock investing from the ground up. At The Investor's Podcast Network, we've made a habit of studying the world's best investors, and now I'm distilling those learnings into a simple course for you or for anyone in your life who you might want to share the gift of knowledge with. With my How to Get Started with Stocks course, you can master the principles of excellent lifelong investing with valuable insights for both beginners and pros. The course covers 10 different sections, beginning with the basics of what a stock actually is and how the stock markets work, to strategies to optimize your retirement savings, how to pick great companies for the long term, what to look for in ETFs, and how to monitor your investments, plus so much more.

36:11To begin getting smarter about investing, just visit theinvestorspodcast.com slash get started with stocks. That's theinvestorspodcast.com slash get started with stocks. And for a limited time, you can use code STOCKS15 for a 15 % discount at checkout. Not to be cliche, but building a market-beating portfolio really doesn't have to be a mystery, at least with the right tools. If you've listened to our podcast for a while, then you know we spend a lot of time learning from savvy investors. So why not use the same tools we do? With TIP Finance, you can. Screening for great companies, calculating intrinsic value, keeping up with legendary investors' portfolios, and more are all not just possible, but easy to do.

36:58TIP Finance was created by investors for investors. It's quite literally the tools we wanted to use ourselves when researching investments in a simple to use interface. You can get started by creating an account for free. Who knows, maybe TIP Finance will help you find your next 100 to 1 investment. Between the screener and Legend Investment Portfolios to reference, I've gotten a ton of ideas from TIP Finance. What are you waiting for? Take the next step in your investment journey today with the right tools at your fingertips. Grab your device and type into your browser, theinvestorspodcast.com slash tip-finance to get started.

37:36That's theinvestorspodcast.com slash tip-finance. All right, back to the show. Okay, that was a very helpful explanation. I do want to move on to de-dollarization now because I still have a lot I want to get through with you. I think this is such an interesting topic. We've been seeing a lot of this being talked about lately. There's been talks between China reaching a deal with Brazil to trade their domestic currencies and closing LNG deals in yuan. And there's talks of the BRICS countries wanting to trade oil in gold instead of USD. And so I'm just wondering, a lot of these events have led some to believe, is the US dollar world over?

38:21And if so, what are the potential alternatives that could take this over. Yeah, that's something I covered as well in the macro education series. I think it's a super important topic. Before we answer this question, I think we need to try and explain a bit how the system works. It is a bit overlooked, I think. People take it for granted, but it's something I would like to refresh for a second for our listeners. So what we have basically created is a system where if you are a country outside the US and want to transact with anyone else, and you want to maybe sell your goods or services or commodities, whatever you want to sell with another player in the world, you can do that in a streamlined system where you use one denominator of your transactions.

39:07Everybody uses the same, basically. About 70 % to 80 % of global payments, trade invoices, settlements are done in the same currency. That currency is the US dollar. That facilitates quite a lot of things. I mean, counters can transact against each other. They don't need to worry about domestic currency. They don't need to worry about settlement. It's all standardized in one currency. Okay. That's how the system works. Now let's make an example to understand that being the dollar is actually quite a privilege, but it's not easy at all either. And that will be the first step to answer your question.

39:39What is the alternative basically? What's the next system going to look like? Let's say I'm a Brazilian corporate and I sell soybeans or any other commodity that is very popular in Brazil. When I sell soybeans to China, the trade will today happen in dollars. So I'm Brazil. I have this hard earned dollars now on my balance sheet because I sold my commodities that I can create as added value and China has bought them. So I have dollars. Okay. So what do I do with these dollars? Those dollars will sit on the asset side of a corporate in Brazil, right? They have sold soybeans, they now have dollars.

40:15These dollars will enter the banking system because the corporate will deposit these dollars to a Brazilian bank, right? That's the only way you can keep your money in our fiat system, you deposit it at a bank. That means that dollars have entered the Brazilian banking system. They need to be invested or kept safe somewhere, right? So the way we do that today is via investing in treasuries. All these foreign players in the world that sell any goods or any services in dollars will get these dollars in and they will recycle them, keeping them safe in US treasuries. In order to find a market that welcomes this gigantic amount of money circulating in the world and coming from global trades and global transactions, you need a huge deep market out there.

41:00It needs to be liquid. It needs to be transactable. It needs to be deep. It needs to have a repo market underlying. That's a lot of ifs. And it is not very easy to find one because it also needs to be relatively risk-free. You just need to have a parking, a liquid parking place for your dollars. The treasury market is pretty good at that, I have to say. The thing to consider here is that the US needs to supply the world with an additional amount of these treasuries every year to guarantee that the new dollars generated from trades, trade growth goes up every year in the world. We grow, we trade more with each other, which means there will be more dollars that are looking for a home at the end of the process, which means you need to expand the supply of dollars.

41:45You need to expand the supply of an item where people can recycle the dollars. You need to issue treasuries. You need to give people the ability to have a deep and expanding treasury market. And the US does that via basically running permanent deficits. Running fiscal deficits is a feature if you want to be the global reserve currency in the world. And it is not easy to be the dollar. You need to have a deep liquid repo market, treasury market that you want to expand every year. And now answering the first part of your question, what are the alternatives? Today, the currency that takes the most share after the dollar is the euro.

42:22And that's the most likely candidate because together with the deep and liquid repo market and treasury market, you need to have the rule of law. People don't want to allocate their hard earned dollars from transactions into a country, the treasury market of a country, like it could be Russia or China, where it is debatable whether you will ever be able to get your money back because of lack of rule of law or capital controls. So you don't want that, right? You want a democracy, you want the rule of law, you want the liquid market. The euro might have something like that, but it doesn't have a deep enough bond market.

42:56Highly rated AAA government bonds in Europe as percentage of GDP are a fraction of treasury bonds in the US as percentage of GDP. So even Europe doesn't qualify for that role. It is hard to be the dollar. It's a great privilege, but it isn't easy either because you need to fulfill a lot of roles. And as per today, there are not many valid alternatives. Actually, there is no valid alternative. Okay. And then just quickly tying this back to the discussion on deleveraging. In a global credit system that is so tied to the US dollars and leverage to US dollars, in the event of an economic downturn and deleveraging scenario, what would the impacts be on the US dollar and this US-based system?

43:46And perhaps does this tie into why it's so hard for countries to switch? Yeah, so right. Because the other side of the coin we need to look at is that because the system that we have created not only needs an asset where to recycle these dollars, but because this dollar-based, a lot of countries that are sitting outside the US have chosen to lever up in dollars. So they issue dollar denominated debt, Rebecca, to fund their businesses. I mean, think you're a Brazilian corporate, you sell soybeans. If you want to lever up your business, you have to issue bonds or debt to borrow money. You will be forced to borrow money in dollars because you sell your commodities in dollars in the first place.

44:30So you issue dollar denominated bonds, despite not having any organic access to the very dollars you need to service this debt unless for trade growth. If trade is going fine, if you're selling more soybeans, if more dollars are coming in, you're good. You can have dollar debt because dollars are coming in. So you can pay your coupons, you can service your debt freely. We have issued$12 trillion of dollar-denominated debt from entities that don't have access to the Fed. They don't have liquidity access to these dollars when they need them. The only way to get dollars is via trade growth. That explains a lot of the link between deleveraging and dollar strength that you were referring to before.

45:12So if trade growth is slowing down, if Brazil cannot get their hands on enough dollars because the world is slowing down, and so there is a recession, and they can't sell enough soybeans to China anymore, they don't get a lot of dollars coming in, right? The flow, fresh dollar slows down. But you still need to service the other side of your balance sheet, which is debt. And you have dollar debt you need to service. But where are these dollars, Rebecca? I don't see these dollars anymore. So the system is built so that if there is a deleveraging, people scramble to the dollars because they need them to pay their debt.

45:47So what happens is the dollar goes up. Everybody wants fresh cash dollars and they bid them up because they need them to pay back their debt. Paying back their debt means deleveraging. So when you deleverage a system that is so entrenched and based on the dollar, the dollar appreciates. And this is why if China and Brazil decide to trade against each other in another currency, or any other block of countries would decide to do that, all of these countries have dollar denominated debt on their balance sheet, all of them, because they're so ingrained in the system, they have issued dollar debt. China has issued dollar debt.

46:24Brazil has issued dollar debt. If they decide to trade against each other in one, then Brazil, all of a sudden, will have less dollars at hand, right? They're selling their commodities. Instead of getting dollars in, they're getting one. But their debt is still sitting there and it's denominated in dollars. So the reason why I'm saying that is if you walk away from this organic fresh flow of dollars that you need and want to have to service your liabilities, how are you going to get your dollars? How are you going to service your liabilities? The only way to get away from this system, the way we have built it, is a property leveraging episode.

46:59We say, let's default on the dollars. Let's forget about it. I don't want to repay my dollar debt. So you're basically defaulting on trillions and trillions and trillions of dollar debt out there. That is not an orderly event. You can choose to do that, Rebecca, but the reason why I chose to write that piece is that people talk to me of a de-dollarization like if it can be an organized, orchestrated, fairly orderly event. It cannot be by the way the system is organized. Okay. That was extremely helpful to hear that explanation because my next question was going to be, is there a certain amount of global trade that would happen between countries saying, we are switching our global trade, we're going to buy commodities and things in gold, yuan, bitcoin, anything else, would there be a certain nominal amount that would then cause implications for the dollar?

47:51But what you just mentioned is that they still have to service that liability side. So as long as that is there, it doesn't matter how much global trade they do in dollars, they'll still have to eventually convert those other foreign currencies or assets to dollars eventually. And that's why the system keeps going. Look, the thing is, Rebecca, they can choose to, they can decide to do that. But what will happen is that by doing that, either they choose to default on dollars, which means they will basically lose the trust of any other country in the world that still transacts in the dollar in the first place.

48:24So they can choose to do that, but it's a very tectonic shift. It's a hard decision for them, right? Them as in a block of country deciding to try and walk away. If they do default on dollar debt, you're defaulting on global obligations, which means who else is going to trust you, right? In this fiat debt-based system, nobody can trust you if you freely want to default on your global obligations. The other way to do that, it's the more painful way, which is to deleverage the system first in a relatively orderly fashion, which means you pay back all your debt, all your dollar debt. You have to pay it back.

48:58There is 12 trillion year after year, instead of levering up further in dollars, if you're Brazil, you pay down your dollar debt. But that means that by paying down your dollar debt, you need quite a lot of dollars coming in year after year, and you will be trying to pay down this huge$12 trillion of debt out there. How many dollars do you need to pay down all this debt? So this system basically is quite interesting because one way or another, it needs to some non-orderly, non-linear events to morph into something else. An orderly de-dollarization is nothing more than a fairy tale. It doesn't exist.

49:35And if you look at history, every time you have moved from one global reserve currency system to another reserve currency or to another system whatsoever, a gold-backed system, a Bitcoin-backed system, any other system, any of these transitions has been quite rough, and it has involved almost always proper geopolitical conflicts. An orderly de-dollarization doesn't exist. And if you get one, it's going to be quite a rough ride and most likely involving even some worse. That's what I want to come across with. Explain how the system works to make people understand why you keep hearing about the dedolarization, but it never happens.

50:14It is very, very difficult to engineer one and most likely it requires quite a rough path ahead. Okay. And I guess one way that we could monitor this going forward as investors is looking to the countries and seeing if their US liability sides are in fact decreasing substantially over time rather than increasing as you would perhaps expect. Yes, that's a good thing to do. So look at the so-called Eurodollar system. So how many dollar debt and liabilities are getting issued from entities sitting outside the US. There is a database that you can use to track that. And I also talked about it in the macro education series.

50:59So if people want to try and find the tools to follow this massive macro shift and see if it's really happening, there are public sources to do that. The other thing is, yeah, if Brazil starts issuing Reminbi-denominated bonds, that is interesting, isn't it? Because that means that Brazil is not only choosing to transact with China in one, but also willing to lever up in renminbi in one. So it's not only doing the asset side, but also the liability side. So far, there has been basically no indication of that, because you need Brazil to be willing to transact in one and then get this one back and invest them somewhere as well.

51:38So you need China then to open up their bond market. You see how many pieces need to happen together. And some of them also include political shifts that are massive opening up. So not having capital controls like China has, for example, lowering your amount of corruption in the political system like Brazil has to make sure that you can invite other countries to invest their foreign reserve assets in Brazil or in China. A lot needs to change to make sure that this can become a more credible threat to the dollar. And even if it does, there is still$12 trillion debt that we need to discuss about anyway.

52:13So there's a lot of ifs and there's a lot of data to follow, but all of that can be and should be followed in a holistic way. And that's really what I try to do on the macro compass. I know that it sounds fancy to scream that the dollar is going to zero, but what you need really is a grounded, level-headed approach to these complex macro topics where you can follow the data really and understand what's going on. That's what I try to do with the macro compass. And I absolutely love reading all of your articles on there. The last Last thing I want to ask you before I let you go today is just what is a practical portfolio implication or strategy that investors can take away after listening to this episode here?

52:54Well, there's one, I think, which is more short term and one more long term. So short term, look, if I'm saying that I expect the Federal Reserve to be forced to cut rates to 0 % in 2024, then the obvious assets that benefits from it is bonds. Because bond prices have an inverse relationship to yields. So if yields go down all the way back to zero, if Fed funds go back to zero, then bond prices will benefit from it. So I think that it's something to consider in your portfolio right now to have a bit more bonds in it to protect your portfolio against this potential recession we see ahead. So this will be one of the potential practical short-term implications long-term.

53:36Look, I think the role of the dollar and gold, both of them in portfolios, is relatively underestimated. If you have dollars in your portfolio, every time, Rebecca, you'll have one of these situations where the world is trying to deleverage, where we are trying to scramble to get dollars because there are all these dollar liabilities out there. Having an exposure to the dollar in your portfolio will benefit you from that. So it acts like a diversifier in periods when all the rest gets actually hit pretty bad, including the stock market. So having some dollars in your portfolio, even if you believe in a de-dollarization, might interestingly be something good to have.

54:15And I just explained why the dollar actually needs to basically appreciate in the system before you can bring it all the way down, right? By the way, the system is created. Gold instead would work against the second layer of this process, because once you transition away from the dollar, I discussed how hard it is to actually have one currency that replaces the dollar. It is basically impossible. Nobody fits all the requirements that the dollar has to be the global reserve currency. So I believe that gold will play a very, very important role, like it did last time that we tried to transition away from a fiat system, which means basically before the 70s.

54:52The reason why gold plays that role is that it already sits on the balance sheet of all these institutions. Brazil has gold, China has gold, Russia has gold, Saudi Arabia has gold. All governments in the world, even developed market economies, have quite a lot of gold on their balance sheets. Gold has already served this stabilizer role as basically the hard asset underpinning the global credit system. And I do think that investors might consider that it might play that role again in the future. Yes, we are a much more technological economy than we were in the 50s and in the 60s. That is true.

55:25But I still think that gold can take on that role, or at least investors might consider that it can, leading to an appreciation of gold prices, which can be pretty rapid. I think it's a good hedge. Always to consider to have a relatively decent allocation to gold in your portfolio to hedge against the second leg of the dollarization. Okay. Thank you so much for your time today, Alfonso. That was excellent as always. I never have enough time with you, but can you give a handoff to yourself and where our listeners can go to learn more about you and all of the work that you put out? Thanks, Rebecca.

55:59The best way to follow what I do is on themacrocompass.com. It's the website of my investment research and portfolio strategy firm. All I try to do really is basically what we discussed in this conversation. Macro can be pretty complicated, full of jargon, a lot of pieces to put together. The idea is I try to break them down in plain English, give people the data and the sources to go and do the work themselves too. It's basically one macro learning journey together where people also can get some actionable investment strategy on top of it to steer their portfolio according to which part of the macro cycle we are in.

56:35All of that is on themacrocombust.com. Of course. And I will make sure to link that in the show notes. Thank you so much again today, Alfonso. Thanks, Rebecca Toxin. All right. I hope you enjoyed today's episode. make sure to follow the show on your favorite podcast app so that you never miss a new episode. And if you've been enjoying the podcast, I would really appreciate it if you left a rating or review. This really helps support us and is the best way to help new people discover the show. And if you haven't already, make sure to sign up for our free newsletter, We Study Markets, which goes out daily and will help you understand what's going on in the markets in just a few minutes.

57:17So with that all said, I will see you again next time.

57:53Thank you.