Ask The Expert - Luke Gromen - January 2021

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Craig: Welcome back to the Sprott Money News at sprottmoney.com "Ask the Expert" series. It is January 2021, and it's time for your first "Ask The Expert" interview of the brand new year and joining us is a special guest this month, a returning guest, Luke Gromen.

Luke, many of you are familiar with him. He runs the great newsletter, Forest for the Trees. He's a big presence on Twitter. You'll find him being interviewed in many different media spaces as an expert on the financial markets and it's a real treat to have him join us again here at Sprott Money News. Luke, thank you so much for spending some time with me.

Luke: Absolutely. Thanks for having me on, Craig. Always love being here.

Craig: And before we get started, just a reminder, these are brought to you by sprottmoney.com, a leader in online precious metal sales, and then, of course, precious metal storage. Now, of course, it's always a good time to invest in precious metals. And although inventory is still a little tight, you want to be sure to check out our recently added products at sprottmoney.com. You can order them from us directly through the website. But if you want to talk to a real person, just pick up the phone and give us a call, 888-861-0775 and one of our representatives will be happy to help you out and explain how the whole process works.

Luke, before we get started, why don't you take a second and explain how your whole process works. Tell everybody about Forest for the Trees.

Luke: Absolutely. So we are a macroeconomic research firm and we aggregate a large amount of publicly available information from a whole disparate array of resources, and we aggregate it in a pretty unique manner, trying to identify developing economic bottlenecks, because it's been my experience over 25 years in the investments business and in finance, that excess returns accrue to those positioned to benefit from developing economic bottlenecks.

And so we're really just trying to tie the big picture to different sectors and macroeconomic themes for our clients. We publish both institutional and retail investment research products, and you can find out a lot more about us at our website at fftt-llc.com.

Craig: We'll make sure we put that web address right here on the opening page so that people will be sure to go there. And if I might just add, Luke, at my site, TF Metals Report, I know we've got quite a few people that also subscribe to your site, and I never hear anything but raves about how valuable your service is.

Luke: Thank you.

Craig: And if I might just plug it for a second. I mean, what's great, Luke, is you don't try to make it some exclusive thing for hedge fund people or something like that. It's 10 bucks a month, right?

Luke: Yeah, it's almost 15, 20 bucks a month, it's for the retail product, that's 198 bucks a year. It's very, very competitively priced for retail investors.

Craig: I mean, for crying out loud, that's money well spent. And so if I might just give my own thumbs up to it, encourage everybody to check it out. Luke is on top of things. And it's a good thing too because I've got a list of seven questions for you, Luke, that are pretty wide-ranging. Ever since we let people know you're gonna be the guest this month, they've been sending in questions. I've consolidated some because we've gotten so many, but I think these seven are all right in your wheelhouse. I suppose we might as well dive right in if that's okay.

Luke: Absolutely. Let's go.

Craig: Well, my friend, we're on the edge of a crazy time here with this new Biden administration. And, you know, we've just installed a former Fed official, Fed Chairwoman, at the head of the Treasury Department. So there's kind of a little marriage, looks to me at least, being joined between Treasury and the Fed almost, you know, right, overt now.

So along those lines, are we headed down this modern monetary theory path? The question specifically was why is there a need for entitlement reform? Why is there a need even to pay taxes if the Fed is just simply going to be monetizing all the debt going forward?

Luke: I think it really comes down to the international trade value of the dollar, is really the answer to that question. Which is to say, there's mathematically, theoretically, mechanically no reason that the Fed couldn't just print all the money needed to fund all of the U.S. government's operations, etc., and that taxes are banished.

The thing that would happen or the release valve, in that case, would be the international trade value of the dollar. So the dollar would fall sharply, inflation would rise since we import as much as we do. And so I think it really comes down to that desire to balance economic growth against the international trade value of the dollar is really the why for taxes, which is effectively, I think a key tenet of the modern monetary theory worldview.

And so that's why I think it ultimately comes down to the dollar.

Craig: And you know I'm gonna follow up my own question, Luke, because I've been thinking about this recently. What if all the central banks went down the same path together since they're all valued against each other in things like the dollar index? What if the ECB in the Bank of Japan, the Bank of England, what if they all went down the modern monetary theory path at the same time. Relatively speaking, maybe they'd all devalue at the same rate, and you wouldn't have a change?

Luke: That's true, you would expect that the relative valuations between fiat currencies wouldn't change much. Where I think you would see that happen or where the relief valve in that case would be, you would see a run out of fiat currency in total into more finite assets. So you would expect to see...and out of global bond markets as well, in theory.

So you'd expect to see stock markets rise and rise relative to bond markets, you'd expect to see homes rise, you'd expect to see farmland rise, you would expect to see gold prices rise, you'd expect to see Bitcoin rise. And so you'd have basically what people might otherwise call an everything bubble would actually be the outcome of all central banks doing some version of that, where they effectively financed their governments.

Craig: And let's move on to the second question. This gets back to central banks as well. I've been writing a lot about the Fed's history of trying to manage the accumulated debt through a yield curve control. That's what they did coming out of World War Two, it's the last time they used that policy when we had debt to GDP ratios like this in the U.S.

And so that gets to this term that the questioner sent in, inflate away the debt. This person just wants to know, what does that mean? How do you inflate away the debt? Can you put that in English for folks?

Luke: Sure. So I think the best way to think about that is to refer back to a BlackRock white paper put out by three former senior central bank officials. Then this was published in August 2019. And the officials in question were former Fed Vice Chair Stan Fischer, former Swiss National Bank President Phillip Hildebrand, and former Bank of Canada Governor, Jean Boivin.

And they very clearly, you know, the way they phrase it is, is going direct. And so they said in the next downturn, central banks are going to have to go direct, and basically partner with the fiscal authority. So the government. And so the way you inflate away the debt, as they described is you get the fiscal authorities to stimulate or spend a bunch of money. And then the central banks act in government bond markets to cap yields to ensure that the ensuing rise in bond yields, as they respond to the rise in inflation due to the increase in government spending, significant increase in government spending, to ensure that the rise in bond yields does not offset the economic stimulative impact of the stimulus.

And so basically, you have government go into their economies, spend a bunch of money to drive GDP higher, and then central banks prevent interest rates from responding to that increase in GDP. And what you end up with are negative real interest rates and potentially significantly so. And so to the extent that GDP grows, 4% or 5%, 6%, 8%, 10% or more nominally, depending on the level of stimulus, while interest rates are not allowed to rise above say 2%, or 1.5%. Every year that goes by, the debt to GDP ratio falls by the gap in GDP relative growth nominally relative to the interest rate paid. And so in theory, you earn your way out of that over time. That's the theory of it. It's dependent on the monetary authority's ability to stimulate enough.

The relief valve, in that case, goes from being interest rates to being the size of the central bank's balance sheet, and that effectively amounts to central banks financing governments.

Craig: It's interesting you mentioned that paper. I have to look that one up because when you say partner with fiscal authorities, that's exactly what Chairman Powell has been talking about. Then you think about this marriage that I was mentioning earlier, you know, installing a former Fed headed Treasury.

Luke: Yeah, it was a very eye-opening paper. I mean, it was before the COVID crisis and it laid out, here's what we're gonna do in the next crisis. And it's what they started doing and it proved very instructive as you moved into 2020, in terms of just understanding what the playbook likely was, and positioning assets accordingly.

Craig: Yeah. All right. Moving on to question three, hey, another central bank question. Some have suggested that the central banks now desire a higher gold price. Do you agree with that?

Luke: I actually do. It ties back to this point about having negative real interest rates as a way of earning their way out of the debt position over time. And so the connection to gold is that if you look at gold's price, over time it is very tightly correlated to inverse real rates. So in other words, the lower real rates go, which are just nominal rate minus inflation, the lower real rates go, the higher gold goes.

And so through that long-standing relationship, paradoxically, central banks are now in a position where if gold prices fall, the implied message is that real rates are rising. And if real rates rise with, for example, United States debt to GDP at 130% and rising, global sovereign debt to GDP high pretty much around the world, that is signaling that...or will quickly signal it will quickly lead to sovereign debt crises around the world. Debt is becoming less payable if real rates rise on debt loads that are bigger than GDP, particularly for those economies that are very interest-rate sensitive as the United States is.

And so paradoxically, by virtue of how the system has evolved, the central banks now need negative real rates, increasingly negative real rates to make these extraordinarily high debt levels, economic to continue to service without causing a crisis. And so if they need increasingly negative real rates, they paradoxically need a higher gold price to communicate that real rates are getting increasingly negative.

And as gold is falling, it's actually communicating the opposite. It's communicating historically, falling gold price meant that the U.S. and the governments were becoming more solvent, and a falling gold price now because the debt levels are so high through that connection to the real interest rate is or that correlation to the real interest rate, falling gold price now tells you that governments will soon be less solvent, not more solvent. So I do actually think they need a higher gold price. So when will they realize that? We'll see. I suspect they know it on some level but I actually do agree with that statement.

Craig: Before we get to question four, I just want to urge anybody who considers themselves a long term precious metals investor, or even mining share investor, go back and listen to that answer again. Just kind of hit rewind, about two minutes. Listen to that answer again. I think it's very enlightening, Luke. Thank you.

Luke: Thank you.

Craig: Number four, then is to focus on silver this time. A lot of folks think we are in an early stages of a new commodity bull market. You can see that on some of the charts. Would you expect silver to now outperform gold if that's the case?

Luke: Historically, that's been a hallmark, I guess, of a new secular bull market or a bull market to commodities is that you see silver rise relative to gold, you see that gold to silver ratio fall. And so to me, the key question is, are we in a new commodity bull market or not? I think we probably are just given where things stand and some of the things we've talked about before in terms of the needs of governments to stimulate, spend on infrastructure, etc.

So I think the answer if I had a gun to my head, I'd probably say yes, I think that makes sense. I do think we'll probably get some fits and starts here in the short-run relative to that but that ultimately, that's probably I think silver probably is set to do really well over the next several years just given what we're seeing on the monetary side, but then even what we're seeing sort of secularly in terms of increasing interest or mandates to move towards electrified vehicles.

And I think silver has a big role to play there, as well as in some of the other... When you start talking about some of the possibility of green new deals and global resets around climate change, it seems to me that silver has a role to play there and certainly other commodities have a role to play there and some of the metals and what have you.

So to me, I think you'd have both a monetary and a fundamental case as you look out over the next cycle that that silver's probably pretty well positioned.

Craig: All right, my friend. We've hit the quarter pole and we are turning into the home stretch with three questions to go. This one might be kind of a tough one to give a quick answer on but we'll just have you just tell us what you think. Home prices obviously continue to rise, and in some cities, just getting crazy again. A lot of first-time buyers are being priced out. I know, I see apartment buildings going up every place, right?

How does this problem get addressed in the years ahead, especially in this kind of hyperinflation, modern monetary theory world that we seem to be headed toward?

Luke: It's a tough question. You can say, okay, you break the question down. So home prices are getting too high, how do we get home prices lower? In the market ways, you just raise rates and blow up the housing market but the problem is you blow up the economy too. And so it's unclear to me whether that increases affordability or not on a net basis.

I mean, nominally, it would because home prices would fall, but home price is not cheaper if you lose your job. Even if the home price gets cut in half, if you have no income, it's not cheaper. So that's the factors, you know, to balance off on sort of a market perspective.

I think some of the other, I'll say, problem of it is, when you look at the distribution of who owns the wealth in this country, it's very different than it was, say, 40 years ago where and I don't know the exact numbers, but the gist of it is that the first time homebuyers share of global wealth share of us wealth is far lower than their predecessors when they were that age.

And in contrast, at the same on the other side of the same coin, the baby boomers, the older generation, their share of wealth is far higher than their predecessors' share. And so you have this, you know, a big share of the wealth is with people with a low marginal propensity to consume, and not enough wealth is with the people with a high marginal propensity to consume. So there are things you in theory could do from a policy standpoint in terms of wealth taxes, which I'm not a big fan of. That's a political question so I'm not going to veer too much further into that, but hypothetically, something like that.

I think if you gave some sort of incentive for baby boomers to gift to their kids' generation, or their kids, some sort of, if the baby boomer wants to buy a house, they can title that over to the kid and without it being taxable if they have excess wealth they want to spend. But if there too you get into the people with the wealth, they're going to build up the houses for, you know, if your parents don't have the wealth. That's, again, a political question.

To me, maybe the easiest way to sort of jumpstart that in terms of the affordability, I guess, are really two things. Number one, you could put policies in place to increase supplies of housing, which is probably the best way to do it because it's actually economically positive, and it drives real GDP growth. And so that's step one. So that's a policy. That's something in policy.

The other policy step you could, in theory, do would be to get rid of student loans, right? Have Biden do an executive order where student loans are forgiven up to $50,000. And maybe you mandate it, you know, you'll do more or you'll do 50 if you immediately use the money at a down payment for a house. But getting rid of student loans, which, again, is a political question, but it's a very easy solution because most of the student debt is owed to the federal government anyway. So it literally is just a wave of the pen, you know, type of hit a couple of keystrokes and have it done. And immediately you would be putting hundreds of thousands of dollars more into the pockets to be spent of the generation with a very high marginal propensity to consume.

So there are no easy answers. It's a political question, but there are ways you can do it. It ultimately comes down to sort of what do people want?

Craig: All right, just two questions to go. This is kind of an interesting one, you know, the Basel III requirements were first put out, geez, what, five, six years ago? I've lost track because they keep getting postponed. And they've been pushed back again for many of the banks all the way into what 2023 even. We had this net stable funding requirement on unallocated gold in London that we thought was going to kick in at the end of June, now that's being pushed back as well. Do you think any of this stuff Luke, will ever actually be implemented? Or is it just always gonna be kicked down the road and extended, you know, and giving the banks more time?

Luke: I had not seen that had been delayed. Last I heard that the June one was that it hadn't been delayed. But if it's been delayed, that's...

Craig: Luke, it's hard to track. I can't get any information on myself. And then I saw something just this morning, as we speak that somebody said, yeah, they've kicked it to January 2022. I haven't confirmed that but it's really hard to track down the right information but please, go ahead.

Luke: Yeah, no interesting because as it relates to gold, it seems as if the unallocated gold books of the London banks would be treated differently than the allocated gold books with effectively the allocated gold books not having a capital cost and the unallocated gold looks having a big capital cost.

And so the London banks, the LBMA, were squawking fairly loudly that this is a problem in terms of putting it in terms of higher costs and less liquidity. And, you know, the users of gold around the world will be harmed by this because the costs will rise, which is a little disingenuous in my view. It's not like you could raise the price of gold to $20,000 an ounce, and it's because it's used in so little. It's not like CPI is going to go up to 10%, because the price of gold goes to $20,000 now. There's no direct connection there.

So say, hey, people who consume gold are going to be harmed by this is a little disingenuous, in my view. But it to the extent that ever gets passed, it seems like it could have a serious implications for the gold market in terms of actually beginning to shift the price discovery in the gold market to being more driven by physical supply and demand rather than physical supply and demand minus the expansion of paper derivatives because those paper derivatives will become more expensive to hold on the balance sheet than the actual physical.

So we'll see where it goes. I mean, we've been through several iterations of this going back a period of time and it's never mattered since then. So for me, I'm optimistic someday it'll happen because I think it's important over time when you handicap the price of gold, you're handicapping price discovery, and basically all other markets over time. So I think it's important if you believe in free markets and the importance to society and academies and sustainability of free markets and economies, but I'm not holding my breath.

I don't want to put too much stock in it, because like you said, it just keeps getting delayed, but it is interesting, these net stable funding ratios the way they're worded. The fact that the U.S. Fed was meeting with the LBMA in 2017 about them, when sort of consensus is that everybody knows the Fed doesn't care at all about gold yet they are meeting with the LBMA about these net stable funding ratio is around gold, that would seem to have significant implications for the difference between allocated and unallocated gold.

That to me is always one of those watch what they do, not what they say. So we'll see. I know it's not really a definitive answer. I just don't think there's a definitive answer to be had at the moment, unfortunately.

Craig: Yep. Luke, you've been very generous with your time I'll just sneak in one last question that has to do with Bitcoin because I know you follow it. And a lot of folks own some Bitcoin with all their physical metal. What is your long-term forecast? Can it become a part of the monetary system and what happens once all of the Bitcoin is finally mined? There's still an extensive cost, you know, of electricity to maintain the system so is it a viable thing in the end, do you think?

Luke: I think it's so Bitcoin is really interesting to me because it in a lot of ways does what gold does, at least as good as gold does it in terms of the finite supply versus low supply. And there's a few things where I think gold does things better than Bitcoin. One of these is exactly what you refer to which is what I would call an energy debt owed to it right you own a physical gold coin or physical gold bar. That is final settlement. There is no liability attached to it.

Bitcoin is also a bearer asset in a lot of ways with the exception of, to your point, you still need the network needs to exist for that bearer asset to be viable. So it's part of the network and the network needs electricity and electricity has a cost and at the moment the miners are being compensated based on the ability to mine Bitcoin that they can then sell. And at some point when it's all mined, then in theory, the energy cost by that time of keeping the network going will be even bigger. And so to me it speaks to the need that you would probably have to have fees rise significantly at that point to the miners.

Now it's as long as the price rises that I think can make sense. And so that's something that will I think someday be a bigger deal but I don't think it matters for the next 5, 10, 15, 20 years in terms of what we're talking about for Bitcoin now.

And in terms of a price target, some of the people I watched and talked to that I have been the most accurate, they've been very much following the stock to flow model and a range of sort of standard deviations on either side of the main stock to flow model and they are pretty consistently calling for $100,000 by later this year early next year and over time you know then maybe a pullback if it follows the patterns of the last several happenings and then moves higher from there.

So I'm very interested to see if it continues to follow that stock to flow model given the lack of derivatives, the successful expansion of lack of successful expansion of paper derivatives on Bitcoin.

To me right now my gut says that that that stock to flow model is probably still valid so I'm watching for successful paper derivatives and especially unallocated Bitcoin derivatives to build up to change that and thus far they just haven't been successful.

And a big part of that is because it's easier to buy physical Bitcoin than it is paper Bitcoin which is not true for gold where it's future sell Bitcoin off sharply, you know, a billion people with smartphones can jump on their phone and buy some chunk of a Bitcoin and that's much harder to do in terms of getting the physical gold out of the vault from somebody when you see it happen with gold. There's a lot of people that do do that but that's a bit of a difference. So that's how I thought about Bitcoin at least where I stand now.

Craig: Luke, I sure like talking to you. I can ask you about any question on any subject and you give a wise, reasoned response intelligent response. Just great.

Luke: Thank you.

Craig: It's always great having you in for these Ask the Expert segments. Tell everybody again where all your thoughts are summarized, they can find you and subscribe.

Luke: Absolutely. Thank you. Now fftt-llc.com. You can find out what we're up to our different product categories and how you can order them. And if you're interested in following more daily thoughts, etc., like you said, I have a fairly active Twitter feed. It's @LukeGromen, L-U-K-E-G-R-O-M-E-N. All one word.

Craig: And one last request from us at Sprott Money. Obviously, another great interview here. If you enjoy these "Ask the Expert" segments, if you enjoy the "Weekly Wrap Up Podcast," please give us a like, maybe a subscribe, and maybe even a share on whichever channel you're listening to. It will help us to expand the audience. Again, we've been speaking with Luke Gromen for this month's "Ask the Expert" segment Luke, thank you so much for your time. It's just been fantastic.

Luke: Thanks for hearing me out. It was great talking to you, Craig. I always enjoy it.

Craig: And from all of us, it's Sprott Money News at sprottmoney.com. Thank you for listening. We'll talk to you again next month.