The Fruits Of The State: How The World’s Most Trusted Asset Becomes Toxic And Poisons The Market – OpEd


The problems in the financial system are growing, and no one can remain on the sidelines. Assets that we thought were risk-free and “basic” thanks to easy money policies and constant stimulation of consumption through increased government spending have turned into a toxic poison that is beginning to spread through the financial system.  

Rising inflation depreciates yields primarily on the short “left” edge of the government debt yield curve, because nominal yields on the short edge are smaller. The inevitable monetary tightening makes the difference between the cost of credit and the yield on all debts minimal. Because of these two factors, a sell-off begins in the debt market – the price falls, the yield rises. This is exacerbated by the braking of QE – the redemption of government bonds by the FED – and the beginning of QT, that is, the sale of bonds from the balance sheet of the FED, which means an increased supply of bonds in the market – they become cheaper.

The depreciation of assets and the clearing of the FED balance sheet are two drivers of the sell-off in the debt market and rising yields. At the same time, the demand for cache – the dollar – is growing, becoming the most sought-after asset, especially given the need for third countries to contain their currencies and maintain export earnings through an increase in the dollar supply.

As a result of increased inflationary pressures and monetary tightening, bear flattening then negative steepening, or inversion, occurs: the yield on short debt exceeds the yield on long debt: the yield spread becomes zero or negative, and the yield curve flattens or flips to the right side down. Riskier and longer assets become less profitable than shorter and less risky assets.

Why is this happening? Let me remind you.

First, because the assets whose profitability is low and most susceptible to inflationary erosion, including the impact of rising credit rates, are sold off: the cost of credit more quickly equals the lower profitability of short debts than the higher profitability of longer and riskier debts.

Second, the least profitable and most liquid debt is sold first: short debt is more liquid than long debt.

Simultaneously with the sale of debt and the faster sale of the short edge of its yield, which causes the curve to invert, stocks are sold off as assets whose cash flows are also discounted by inflation and the credit rate, which reduces intrinsic value, and hence the stock price.

However, some stocks, such as those of companies with a large cachet, may feel better than the market and be more resilient. Also, in companies in some industries where cash flows are stable and resilient, the discount rate does not affect the valuation of these companies as much, unlike companies where the entire valuation is very sensitive to the discount rate and cash flows are promised in the long run.

We can assume that the equity market is entering a period of spread investment attractiveness when the overall correlation of all sectors and companies, characteristic of cycles of low rates and pervasive all-encompassing growth, is reduced.

In a situation where monetary tightening is underway to collapse consumer, investment, and manufacturing activity, value volatility increases because of heightened sensitivity to everything from regulatory pronouncements to anecdotal news. This increasing sensitivity to risk stems from the fact that both bonds, whose yields have been eaten up by expensive credit and inflation, and company stocks, whose cash flow values have fallen for the same reasons, are pledged assets and part of own investments in banks, filling pension funds and insurance companies.

The depreciation of assets will cause systemic failures, followed by a chain effect. Declining yields and collateral values could lead to margin calls, which could go unfulfilled because of the high cost of lending and declining corporate earnings. This, in turn, is fraught with bankruptcies, especially for those companies that were earning little, were inefficient, and had high levels of leverage.

Further, the depreciation of return on assets and their value causes distortions in the solvency of banks, insurance companies and pension funds, as their ability to make payments on customer claims is reduced by the decline in the returns on their investments or, even worse, by the depreciation of these investments, which causes risks of inability to meet obligations.

When large-scale systemic collapses occur, governments and regulators are forced to cure these collapses in order to avoid a chain reaction. To do this, they dramatically reduce the cost of credit for certain institutions in a targeted way or in general, providing liquidity to financial companies in distress. The recent $300 billion spike in the FED’s balance sheet is just the beginning. Of course, all of this comes with the inevitable loss of value of these companies, as some liabilities have to be zeroed out and defaulted on, for example, to certain creditors or shareholders.

The provision of liquidity, the need for which can expand to enormous proportions as asset depreciation problems escalate, is extremely detrimental to efforts to combat inflation, because at a time when all these asset value problems are gaining momentum, inflation is still at high levels, the labor market is tight, and manufacturing activity and business expectations are in decline.

But there are even more depressing consequences. Virtually all of the major U.S. federal banks are now one big national government bank, since the government actually guarantees a “bailout” and a refund, no matter what happens. This means that the banks no longer think about efficiency and market competition: their whole focus is now on how to get maximum government support. 

This position of the largest federal banks makes them absolute monopolists relative to other participants in the banking system, and their competitive opportunities are non-market and total. The potential consequences of this can be called absolutely catastrophic.

If a bank has an extraordinary privileged position, namely state support, it begins to dictate terms to consumers as a monopolist. This distorts the producer-consumer relationship: the quality of the product and the consumer’s benefits fall, while the producer’s rights and opportunities expand. Management does not strive for market efficiency, but only for compliance with state requirements. Investment efficiency and discipline are not dictated by the motives of survival and competition, but are now conditioned solely by the evaluation or guarantee of the amount of state support.

A situation arises where the “big brother” tells you what to do in exchange for the guarantees provided, and promises to “take care of everything,” but in the end he drives you “to the brink” and at the last moment lends a helping hand, after which you fall into even greater dependence. This is very similar to the logic of processes in subsocial communities like the Italian Cosa Nostra or feudal society. In either case, this is the degradation of market competition, or rather its deliberate murder.

This also includes the consequences of consumer behavior with regard to banking services. It is obvious that potential consumers of banking services will be put before the fork: either to carry money in these very same quasi-state banks with all their charms – low rates, poor service and other monopolistic outrages, or choose other instruments to save their money from inflation, which, by the way, is generated by the same state and turned it into another tax.   

In addition, the guarantee of return of funds in any amount from the state totally distorts the investment behavior and decision-making of potential investors: you no longer have to worry about thinking about the benefits-costs, assess and assume the risks, think about the decision and its consequences. Now you can just carry any money to the “big banks” – the state will pay for everything, no matter what happens. Nothing else but a reincarnation of Soviet socialism can be called.

As I have already noted, all economic agents have become very sensitive to any news, and this means that the next monetary, way and target, easing will trigger the following fears: on the one hand, expanding liquidity in an environment of high inflation is very dangerous, on the other hand, the beginning of systemic failures in banks leaves the government no choice but to “save the situation” and flood the relevant financial companies with money.

It must be said that the obvious reasons for the current situation should not raise any doubts: it is the result of the easy money policy that the sprawling Big State has been pursuing for several decades. Cheap money has caused disequilibrium growth in the value of markets, which inevitably collapses when there is a critical disequilibrium in consumption and production. The easy money was created, among other things, by the expansion of government debt and the collateral schemes of the FED, which lent to banks against the very government debt they were constantly redeeming.

As a result, when the value of assets evaporates due to inflation and the forced appreciation of money, government debt becomes just as worthless and toxic an asset as high-risk stocks of “paper” start-ups. The case of SVB (NASDAQ:SIVB), which did everything “by the book” but got caught in a stalemate created by those who created the book.

Now imagine the number of such assets on the balance sheets of pension funds, insurers and banks in general. It is hard to imagine, because that is practically all they have and where they can invest their clients’ money to meet their liability obligations. And that means that there is no other option for the government but to start a new cycle of leverage expansion.

Otherwise, if one imagines that the government decides to “clean up,” one could safely speak of a total and unprecedented civilizational breakdown, compared to which the current geopolitical tensions and global economic erosions would seem like a child’s play in a sandbox.

In the investment sense, we have clearly entered an era in which Howard Marx’s phrase “the main thing is to buy well, not to buy well” becomes a guideline in investment philosophy. Spreads, arbitrage, factor investing and macro-momentum are now apparently pushing out the value approach and microeconomic analysis for some longer or less time.

Exposures to individual companies become riskier as the inverse to the previous cycle of unrestrained growth emerges: all assets are now bad and risky, just as they were previously all promising and growing. 

As we remember, adaptability is the main competitive advantage of any living unit.

Investors are no exception

Paul Tolmachev

Paul Tolmachev is an Investment Manager, Economist and Political Analyst. He is Certified Professional in Philosophy, Politics and Economics (PPE Program), Duke University. Paul is serving as a Portfolio Manager for BlackRock running $500 million assets under personal management. He also is a visiting research scholar at The Hoover Institution (Stanford University), where he researches political economy and social behavior, specializing in the analysis of macroeconomics, politics, and social processes. Paul is a columnist and contributor to a number of international think tanks and publications, including, Mises Institute, Eurasia Review, WallStreet Window, The Heritage Foundation,, L'Indro, etc.

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