Prof G Markets: Liquidity and Portfolio Management in an Inflationary Decade — With Lyn Alden

0:28Support for this show comes from Aura Frames. Steel is exclusive to listeners and frames sell out fast, so orders you now to get it in time for the holidays and support the show by mentioning us at checkout. Terms and conditions apply.

0:45Toast the holidays in a new way and raise a glass of rum chata, a delicious creamy blend of horchata with rum. Enjoy it over ice or in your coffee. Rum chata, your holiday cocktails just got sweeter. Tap or click the banner for more. Drink responsibly. Caribbean rum with real dairy cream, natural and artificial flavors. Alcohol 13.75 % by volume, 27.5 proof. Copyright 2025 Agave Loco Brands, Powaukee, Wisconsin. All rights reserved.

1:24Welcome to a special episode of Prop G Markets. The dog is on vacation. That's right. I'm at some kennel in the countryside, rolling around in deer urine. So today we're running a brand new conversation on the state of the markets with Lynn Alden, an independent analyst and full-time investor. I absolutely love Lynn. I find that she's incredibly analytical, sober, smart, thoughtful, measured, all those good things. The kind of person you want to manage your money. So with that, here's our conversation with Lynn Alden. Lynn, where does this podcast find you? I'm in New Jersey still. In New Jersey still.

1:59Still. That's what the New Jersey Chamber of Commerce likes to hear, the term still. Yeah, somehow still here, yeah. You wrote in your newsletter that regulators want banks to be reasonably safe, but not too safe. They want all banks to be leveraged bond funds to a certain degree and won't allow safer ones to exist. Say more? There have been a number of banks that have applied and said, we just want to hold all of our cash deposits at the Fed for customers. And you basically would have a full reserve bank. and those types of applications tend to get denied for various reasons. Some of them are litigated.

2:32I think there's not been enough awareness of technology changes among financial regulators in recent years and decades because when we think of bank runs, we see pictures from like say 1907, people going to the bank, withdrawing their money. Obviously, it's changed over time. And now, some of the bank runs we saw out west recently, these are very kind of tech forward banks and people could, you know, they had software APIs, they could like withdraw their funds, you know, through their own interfaces, things move much faster. Starting this year, FedNow is going to come out, which can further accelerate how fast money can move around between banks.

3:11And so some of the liquidity requirements that we're used to seeing in banks that might have made sense, you know, decades ago, I think don't really make sense here. And so yeah, Basically, I think the regulators are kind of in this weird position where obviously they want safe banks. They want banks to have safe collateral, safe lending practices, to be well capitalized. And yet, on the other hand, you had these banks that want to be super liquid, super safe, and those don't get accepted. Couldn't you make the argument that a certain number of ring-fenced bank failures is probably a signal of a healthy economy?

3:48If we never had a bank failure, wouldn't that say that we aren't being promiscuous or aggressive enough with the leverage to grow the economy? Well, I think that, yeah, it's normal to have bank failures. I think there's different types of credit, though. I mean, basically, there's very healthy types of credit, you know, short term financing, basically, you're making it so that small businesses, large businesses have access to all sorts of liquidity that they need. that doesn't necessarily have to be combined with some of these riskier practices, as well as we don't necessarily need customer deposits to be the ones fueling the majority of those loans.

4:23I mean, that's obviously what maximizes how much of that lending happens, but it also puts a lot of those customer funds at risk. And there's even a thing where obviously there's different types of deposits. There's demand deposits, there's time deposits. And I think there's at least a case to be made to have more rules around demand deposits. Demand deposits are ones that can come out instantly. And banks, they kind of assume that no more than 5 % or 10 % of their deposits are going to pull out at any given time, because otherwise they run into a severe liquidity crisis. And that just seems like a very fragile situation, I think, in the 21st century.

5:00And I think that some of the guardrails make less sense now. They don't really guard against the the problems that arise in this new system. There's so much regulation around avoiding credit problems, like making bad loans or buying bad securities, and there's not enough attention paid to the liquidity. And I think that's kind of the underlying issue. Obviously, credit is still important, but that most people, when they think of a bank, they just want to hold deposits there, they want to have payment services, and they don't want to feel like they're kind of investing. If I understand you correctly, it's that the one side of it is just the requirements for banks to around what they invest in.

5:37And usually what takes down these financial institutions is mismatched durations, investing kind of long and borrowing short. But what you're also saying, and I've been reading a lot about this, is that in an era of online banking, where typically it used to be, oh, I'm a little, I read a story in the newspaper two days later about this bank trying to raise money and perhaps not being as financially sound as it should be. Oh, I should really go to the bank tomorrow and get money out. Now it's, you see it on Twitter, and within three minutes on your app, you can withdraw the funds. So are you saying that given the dispersion, if you will, of the real-time nature or how easy or frictionless it is to take funds out, you can go from a standing start to a run on the bank in no time?

6:20And are you suggesting that we probably need to recognize that and have greater liquidity ratio requirements? Yeah, that's a perfect way to describe it. A lot of financial technology or banking technology over the past century and a half is basically about transactions have increased in speed a lot faster than settlements. But if you go back long enough, you have these gold-backed banks. And of course, the gold's very slow, and you put it into the bank. And then once it's in the bank, you now have these accounts that are linked to each other by telecommunication systems ever since the second half of the 1800s.

6:52And you basically transform the speed with which your money can move. And so banks rely on that speed difference to assume that that bank runs are not going to be very rapid, not very frequent, and not done unless there's very good reasons to do so. But in a world where the settlements have kind of caught up just as quickly as the transactions have, then you add social media, you add software APIs, everything has accelerated so much, having 5 % liquidity available just doesn't really cut it in that type of new environment. And so, yeah, I think as technology has evolved, liquidity needs are going to have to evolve as well.

7:28Let's talk about the Fed. You also wrote in your newsletter that the U.S. Federal Reserve is now operating at a financial loss and is months away from having negative tangible equity for the first time in modern history. Can you explain what you mean by tangible equity at the Fed? Should we be concerned with this? Well, we should be concerned, but not for the same reason. So basically, the funny thing is the Fed isn't the same problem as a lot of these banks are. The difference is that nobody can do a run on the Fed. And so basically what the Federal Reserve did is that they bought a lot of treasuries and mortgage-backed securities, which are long-duration assets.

8:01And those are their assets. Just like any other bank, the Fed has assets and it has liabilities. And its assets are mainly those long-duration treasuries, mortgage-backed securities, things like that. Their liabilities consist of a few different buckets. One of them is banknotes. Anytime you have physical currency, that's a direct liability of the Fed. They pay zero interest, obviously, on physical banknotes. then bank reserves hold their excess cash at the Fed and they do in the current environment get interest on those bank reserves. That's one of the tools that the Federal Reserve uses to set its interest rate policies.

8:33So they kind of have to pay that out. And then there's also reverse repos, which are more complex. But basically it's another side of the Federal Reserve's liabilities and those also do pay interest. And what happened was for the first time in modern history, they raised rates so significantly that their short-term liabilities pay out higher interest than the interest they're earning on their long-duration assets, their treasures and mortgage-backed securities. So the Federal Reserve is operating at a loss. I mean, it has about a trillion dollars in unrealized losses on its treasures and mortgage-backed securities, but it's unlike a normal bank.

9:06It's never forced to sell them. It's entirely its choice whether or not it ever realizes any losses. It's almost certainly not going to. But aside from those unrealized losses, their interest margin is negative. So they're basically every week that they're in operation, they're actually losing money. And the way that works is that normally the Fed, for decades when they've been profitable, they send excess profits to the Treasury. Basically, it goes back to taxpayers. Now that the Fed is unprofitable, that's no longer happening. So one ramification is that the Treasury just lost about$100 billion a year revenue source, which is equal to about four NASAs, more or less.

9:40It seems like small compared to numbers that have been thrown around in recent years, but$100 billion is still significant. And then it also kind of long-term can somewhat damage Fed independence. Part of the reason why the Fed has assets, has liabilities, operates at a profit is because it's almost like a fourth branch of government. It's basically something that's separate from the executive branch. The president can't just call up the Fed and tell them to, say, change rates before an election, for example. In some countries, they can, but in countries where there's some degree of central bank independence, that's kind of their safeguard against that.

10:15Now, what I mean by negative tangible equity is that if you add up their assets and their liabilities, putting aside the unrealized losses, which puts them at deeply negative equity territory, even without those, they have negative equity now. And that's because of these accumulated operating losses. And the way the accounting works is that they actually record those losses as kind of like an asset, which is how they stay solvent on paper. And the way that works is that if they ever become profitable again, they get to pay themselves back before they would ever continue paying the treasury in the future.

10:48So they kind of say, well, we're broke now, but one day we won't be broke. And so out of that future income, we'll pay back this hole. And so that's what I mean by negative tangible equity. And basically, it kind of shows, one, that most banks, their liabilities don't adjust right away. They don't raise deposit rates quickly, whereas the Federal Reserve did, essentially. That's how it sets monetary policy. So it actually kind of showcased this problem in banks before it happened to normal banks. And it happened to the Fed more severely with the big caveat that no one could do a run on them. So they're able to kind of operate perpetually in that kind of zombie state.

11:24So the Fed has to manage this tension between trying to control inflation, and their primary tool is raising interest rates, while not tanking the economy. Where do you think the Fed is in terms of managing that balance? So before recent events with the banking crisis, they were firmly on the side of do everything they can to get inflation down, even if it slows down the economy, even if it increases unemployment. And it's become more challenging in recent times because I think their approach, especially if you look at the Fed chairman when he talks about this, he cites the 1970s. He cited Paul Volcker, for example.

12:04And if you look back in the 70s, the inflation we saw then was primarily lending-driven. Most of the new money in circulation was from bank lending. And we had very low debt to GDP. And so the policy was, okay, how do you tighten it so that banks lend less? If you go back further than that to the 1940s, we had very high inflation, very similar to the 1970s. It was not from bank lending. Banks were barely lending at all. It was obviously from very large monetized fiscal deficits to fight the war, as well as all the domestic parts of doing that. Manufacturing facilities, when soldiers come home, you give them GI bills, and that was inflationary.

12:43And debts were so high that the Federal Reserve just kind of partially lost independence. And in that environment, they didn't even try to raise rates. They actually capped yields, and they just held rates low despite inflation. And I think that The challenge that they face here in the 2020s is that their environment is in many ways more similar to the 1940s. There's very, very high debt to GDP, and there was a war-like fiscal response in recent years to COVID, to lockdowns, things like that. Very large money creation from that fiscal source, not due to excess bank lending, and yet they're trying to treat it as though it's a 1970s-style thing.

13:20So, you know, jack up rates as high as you can, try to tighten bank lending, even though banks, you know, they're just kind of lending at a normal pace at the current time. And so I think that's the challenge the Fed finds themselves in. And historically, this is the single hardest environment for a central bank to operate, because it's almost like you're just choosing between different wrong answers. And so I think until the bank crisis, they were firmly on the side of inflation. And now I think they're kind of forced to take a more balanced approach because it's not just about slowing down the economy.

13:50It's also about financial stability. And so, you know, to the extent that they continue to, say, raise rates or suck liquidity out of the system with quantitative tightening, that's kind of pulling liquidity out of those smaller banks at a time. And as we just discussed, technology's changed. And if anything, banks have higher liquidity requirements and the Fed has been actively withdrawing liquidity from the banking system. Stay with us. We'll be right back.

14:39be big to be meaningful. That quiet endurance, grace, and decency are their own kind of heroism. In a world obsessed with progress, Train Dreams asks us to take pause and reflect on our relationship with loss, nature, and the need to belong. And maybe that's the modern journey, not domination or conquest, but learning how to live with change, grief, and tenderness without losing our sense of purpose. Train Dreams captures the tension between progress and preservation, between the machines that build our world and the nature that still defines it. In a time when we're all searching for purpose, Train Dreams feels timeless because the frontier isn't just a place, it's a state of being.

15:17Train Dreams, now playing only on Netflix.

15:26Support for the show comes from Shopify. If you run a small business, you know there's nothing small about it. As a business owner myself, I get it. Every day there's a new decision to make and even the smallest decisions can feel massive. What can help the most is a platform with all the tools you need to be successful, a platform like Shopify. Shopify is the commerce platform behind millions of businesses around the world and 10 % of all e-commerce in the U.S. From household names, including Mattel and Gymshark, to those brands just getting started. That's why they've developed an array of tools to help make running your small business easier.

15:58Their point-of-sale system is a unified command center for your retail business. It gives your staff the tools they need to close the sale every time. and it lets your customers shop however they want, whether that's online, in-store, or a combination of the two. Shopify's first-party data tools give you insights that you can use to keep your marketing sharp and give your customers personalized experiences. And at the end of the day, that's the goal of any small business owner, keeping your customers happy. Get all the big stuff for your small business ride with Shopify. Sign up for your$1 per month trial and start selling today at shopify.com slash prop g.

16:30Go to shopify.com slash prop g.

16:48The stuff you worry about, if you worry about it long enough, I believe it doesn't come true. Remember all the hand-wringing over Greek sovereign debt like 10, 15 years ago? We were waiting for Greece to fall and then it would be a domino contagion through Europe. You know, stuff you're not worried about that gets you. It feels like a recession has been a month away for 18 months now. And I look at unemployment, which is at historic lows. I look at spending, which I guess there's some evidence it's slowing down, but it still seems robust. And yet people seem to be so worried about a recession.

17:19And I can't find any data supporting this impending recession. What are your thoughts? Where do you think the economy is headed and what evidence do you think supports that direction? So I think it's almost like two economies. So there's interest rate sensitive sectors and then ones that aren't really. So for example, travel and restaurants are not very interest rate sensitive. And obviously there's been pent up demand, no signs of recession there. Whereas if you look at either highly leveraged spaces, like obviously real estate is very interest rate sensitive, that's been firmly slowing down.

17:50And then when you look at unprofitable tech companies, right, because they're reliant on basically having a zero discount rate, constantly issuing new equity, underpricing their products. And as soon as they have a real cost of capital, a lot of that starts kind of eating itself and going in reverse where they have to, you know, they can't issue the equity the way that they were. Therefore, if they're going to keep paying their employees or to keep funding themselves, they have to raise prices of their product. And then that slows down their growth because some of their growth was just not really there to begin with.

18:18It was only there because they were underpricing their products because they were selling more equity. And so those two areas, are the hardest hit areas. And they're generally higher income people on average. So a lot of recessions, you see it kind of start from the bottom up, lower income, people lose their jobs first. Whereas in here, if anything, we've seen the opposite. So I think that I would say the majority of indicators are decelerating while still positive, which is when you look at most these in rate of change terms, you see deceleration before you see negative numbers. And so if you look at, say, the purchasing managers index, for example, that's been decelerating since 2021, which is normal speed.

18:55I mean, these are usually roughly like 18 months down and up cycles. Real estate sector has been decelerating. So there has been a lot of, I think, genuine concern around recession, but it's offset by these other strong areas. And with unemployment in particular, right before recessions, unemployment is usually low. It's kind of a lagging indicator. That's one of the hardest things to go by. But I think to your point, there is a different employment response this time because it's a lot of those, I guess, quote unquote, real world jobs that are still firmly in demand that don't have a lot of people filling them.

19:31And so there's really not a lot of signs of stress there. But I think from the Fed's perspective right now, they're more focused on inflation versus financial stability. Even though their two mandates are basically about employment and price stability, financial stability is kind of their underlying mandate because it's part of maintaining the other two. You mentioned real estate, and I saw that I think for the first month and 13 years, housing prices have come down on average nationally. Isn't that just an overdue correction? Don't housing prices need to come down? It's a challenging market because it's so levered, right?

20:05Even the typical homeowner. I mean, if you talk to most people and say, should you buy things on five times leverage? They would say no, with the exception being real estate. It's normal to say put 20 % down. And so relatively small changes can cause rather big problems, which is where that risk comes from. If you look back at the very long term for real estate, the only two times in history where real estate came down on a nationwide basis at a very large level was the Great Depression and the Great Recession. That's part of why those were two giant disinflationary implosions in the credit sector.

20:41Other times you've had instances where the national home price index would kind of like hit stall speed. It would contract by a couple percentage points on a year-over-year basis or down from the highs. That's kind of what we're in now so far, which I think is healthy after such a vertical ascent in the past few years, such high real estate prices. I think it's going to be different than 2008 in the sense that even though there was a lot of rapid buying, there was a lot less buying on bad credit in the residential sector, at least. And so I do think we're due for corrections. It only gets dangerous when you start going straight down, right?

21:18When you start to have massive contractions in highly levered types of assets. So I think we're probably going to be more likely seeing kind of a stall speed, like just kind of like this period where - This goes flat. Yeah, things go flat. Maybe things go down in inflation adjusted terms, rather than kind of fall vertically in the nominal sense. I would think there'd just be so much equity in these houses and also the loans. I mean, just the credit standards have been tightened so dramatically since the last real estate crash. So I wanna switch to Bitcoin. And you think a lot about this and I wanna put forward a thesis and you tell me where I have this right or wrong.

21:56I'm sort of concerned or disheartened by the fact that there's a run on a bank and Bitcoin accelerates. And my fear around Bitcoin is that now some of the biggest investors in Bitcoin no longer share the same incentives around what's good for America, that a run on a bank that potentially threatens the entire banking system or the U.S. dollar is good for Andreessen Horowitz. And so they might, given some of the things you're talking about with distributed computing and real-time communications, be able to foment or pour fuel on the fire of a bank run, which sends the value of their crypto up. I mean, is that the danger of Bitcoin or am I overstating it?

22:35So, I mean, I think there are individual actors that do that. And the interesting thing you point out, Andreessen Horowitz, I mean, if you focus on the Bitcoin community specifically, they tend to not to have very high opinions on Andreessen Horowitz because they associate that type of activity more with kind of the broad crypto scam type of behaviors. If you look at, say, chain analysis, crypto adoption index, which is basically trying to measure kind of per capita adoption of, say, Bitcoin, stable coins, crypto around the world, 18 out of 20 of the top 20 are developing countries, which makes sense when you zoom out because those are ones with less stable financial systems, less stable currencies, higher percentages of unbanked people.