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In the title of his latest commentary, Ray Dalio, Founder of Bridgewater Associates, asks “Why in the World Would You Own Dollar Debt?”  He argues that the current dynamic is “typical of the late stage of the long-term debt cycle.”

The world is a) substantially overweighted in bonds (and other financial assets, especially US bonds) at the same time that b) governments (especially the US) are producing enormous amounts more debt and bonds and other debt assets. This is particularly true for US bonds. US bond holdings are over a third of global bond holdings held by central banks, sovereign wealth funds, and international investors with the next largest country/currency bond being euro bonds at only roughly 60% of US bond holdings.  Their overweighted position in US bonds is largely because of the “exorbitant privilege” the US has had being the world’s leading reserve currency, which has allowed the US to overborrow for decades.  The cycle of becoming a reserve currency, overborrowing, and being overindebted threatening the reserve currency status is classic.

Some international investors are shifting a portion of their fixed income allocation from US$ bonds to Chinese bonds, which now account for about 6% of global portfolios.  Given the low interest rates in many countries, investors have also been willing to invest more in common stocks and precious metals.  However, bonds still have a place in portfolios for now, given valuation levels in the stock market that have already priced in a strong recovery.

The recent disclosure of some large bank losses due to business with Bill Hwang’s Archegos Capital raises some questions about derivatives and capital markets.  A record level of margin debt has contributed to higher prices in the stock market, but derivatives have added another source of leverage for speculators.

Bloomberg estimates that derivative contracts with Archegos caused the forced liquidation of more than $20 billion in holdings.  Much of the leverage used by Archegos was provided by Nomura Holdings Inc. and Credit Suisse Group AG via equity swaps and a type of derivative contract called contracts for difference.  Archegos may never actually have owned most of the underlying securities, preferring to bet on the highly levered derivatives contracts instead.  Among the stocks impacted by the forced liquidations was ViacomCBS which has dropped nearly 60% since March 22.  The prime brokerage losses have not been fully disclosed yet, but Credit Suisse has reported a loss of $4.7 billion so far due to their business relationship with Archegos.  Total losses for all banks are likely to exceed $10 billion.

Some of the large banks also have exposure in the precious metals markets with large short positions in silver, platinum, and gold.  Futures contracts for these three metals have a higher level of contractual open interest relative to global production than other commodities.  The short positions are highly concentrated among among eight large bank trading groups.  For example, the eight largest traders are net short silver an amount that would require 180 days of global mine production.  They are also net short platinum by 117 days and gold by 86 days of global mine production.

Investment demand for bullion and coins has picked up considerably from prior years.  Sprott Asset Management compared the total demand for coins and bars at three government mints: the US Mint, Perth (Australia) Mint, and Royal Canadian Mint.  For 2020, sales of gold coins and bars at the three mints was 157% higher than 2019, while the sale of silver coins and bars was 54% higher.  Gold and silver bullion ETFs have increased their inventories of bars.  Buyers of COMEX contracts are also requiring delivery of physical metal at higher levels than they did in past years.  Given government and central bank policies around the world, investment demand for precious metals is likely to continue or rise from current levels.  Higher prices should follow.

If you have any questions or comments, please contact me.

Robert G. Kahl
CFA, CPA, MBA