The reason for investing in the yield curve is due to the interplay between loans and government bonds. When the 30-year Treasury yield changes, it affects the mortgage rate and other forms of fixed-rate loans, including leases. If the Treasury yield drops, mortgage rates become cheaper, but if it rises, mortgage rates become more expensive. This is because banks make money from the interest rate spread, or the difference between the rate at which they borrow and the rate at which they lend. However, when government bonds have yields below zero, banks must pay to lend, instead of making money from the interest spread. This has been a problem for European banks for years.

The rise in rates across all markets has led to an increase in yields, including those not typically thought of, such as commercial mortgage-backed securities (CMBS). Hence, value of CMBS has dropped significantly and reached an all-time low in just 7 months, faster than other bonds such as LQD or HYG. Exchange-traded funds (ETFs) give exposure to the price of underlying assets. For example, the PSLV ETF has silver as its underlying asset, so its price moves with the price of silver. On the other hand, HYG and LQD ETFs hold investment grade and junk bonds, respectively, so if the price of LQD goes down, it means that investment grade bonds are decreasing in value. This applies to all ETFs, regardless of their size or liquidity. CMBS ETF tracks the prices of bonds in the corporate mortgage-backed security markets. Although it has a smaller asset under management and less liquidity compared to other ETFs, it still reflects the current state of the bond market. It’s expected that if quantitative easing (QE) doesn't pick up, the Federal Reserve's secondary and primary market facilities may intervene.

The recent increase in the interest rate on the 30-year bond is having a significant impact on various markets, particularly the US housing market. The 30-year Treasury bond is considered the benchmark for determining the cost of a 30-year fixed mortgage and thus affects the profit margins of banks who loan money at a higher rate than what they earn through their Treasury bonds. The rise in interest rates due to general inflation makes it more expensive for people to afford mortgages, leading to a decrease in housing demand and making housing bonds less attractive. When the interest rate on a mortgage increase, the monthly payments become more expensive, making it difficult for many people to afford to buy a house. This, in turn, results in a decrease in housing demand, making housing bonds less attractive and worthless, especially for those with fixed-rate mortgages. Banks no longer hold the mortgages they issue, instead selling them to Fannie Mae and Freddie Mac. They then slice the mortgages and repackage in bulk as mortgage-backed securities (MBS), which are then sold on as bonds to different investors. They provide guarantees to the investors, meaning that if the loans default, they are on the hook for it. The health of these bonds can be monitored through housing bond ETFs, which follow the prices of the underlying housing bonds. As yields and prices are inversely related, a drop in the bond price results in an increase in yield. This could lead to a decrease in the value of the bond if inflation rises to a level higher than the fixed interest rate on the bond. The rise in interest rates will result in higher monthly payments, making it difficult for many people to afford to buy a house. This, in turn, will lead to a decrease in housing demand, making housing bonds less attractive.

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Yield Curve Control (YCC) and Quantitative Easing (QE)

2 monetary policies used by central banks to manipulate the money supply and interest rates in an economy. YCC involves the central bank directly controlling long-term interest rates by buying government bonds. The aim is to flatten the yield curve and lower long-term rates, boosting economic activity by buying bonds generally slower than in QE. Meanwhile, QE involves the central bank creating new money to buy financial assets, such as government bonds, from banks, increasing the money supply and lowering interest rates to stimulate the economy. YCC targets the shape of the yield curve ie. Concered with the prices of the bonds, while QE targets the overall money supply i.e quantities of bonds. Both policies can reduce borrowing costs and increase spending, but YCC is a more targeted approach with a predictable impact, while QE is an indirect approach that may lead to inflationary pressure.

The choice not to implement yield curve control means that either the bond market will die or the currency will. In this scenario, the dollar is expected to spike, but the bonds will die. By choosing not to implement YCC, the Federal Reserve is signalling that either the bond market or the currency will suffer as a result. The death of the bond market could mean that bond prices fall, which would lead to higher interest rates and a decrease in demand for bonds. This, in turn, could have negative consequences for the economy, as it would increase borrowing costs for businesses and consumers. On the other hand, the death of the currency could mean that the value of the dollar decreases, leading to inflation. In this scenario, the dollar is expected to spike in the short-term, but its long-term value will decline. This would mean that the purchasing power of the dollar would decrease, making it more expensive to buy goods and services. Inflation can also lead to a decrease in the demand for bonds, as investors may seek other investments that offer protection from inflation.

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Pandemic buying and rates going haywire

In 2020, the Fed started buying bonds from big companies like Apple, which sparked controversy as to why these companies needed extra money. The focus was on these big names (FANGs and Berkshire Hathaways) as a sign of market confidence, as long as their bonds were rising, people felt that the market wasn't going to collapse due to the pandemic. However, the Fed may soon have to buy bonds from "zombie companies," those that can no longer service their debt with their earnings and have to borrow more. These companies, making up ~20% of the US market, are in a precarious situation, as they would go bankrupt if they can't borrow anymore, a lot of these with a negative book value per share, meaning that even if you sell the entire company, you would still lose money. These companies are vulnerable to higher interest rates and an upward-sloping yield curve, which puts additional pressure on their solvency.

The recent spike in interest rates and crash of the corporate mortgage-backed security (CMBS) assets can be explained by the government's borrowing and printing of bonds. The CMBS leases are essentially loans that have an interest rate attached to it, which is based on government bonds. As the government continues to borrow and print more bonds, the Federal Reserve has to purchase these bonds, creating hidden inflation. However, the Fed has recently mentioned the possibility of quantitative tightening, selling the bonds from its balance sheet back into the open market, which has caused a slide in bonds and the entire yield curve. This has happened because the market is already oversupplied with bonds due to the US government running a large deficit and trying to pass a new spending bill with a deficit of $1.4T. Although the currency is technically deflationary, it is being spent on social programs, putting it back into the market. This creates a cycle of currency going back and forth, while the bonds and national debt continue to increase.

The Federal Reserve's intervention in the credit markets during the global pandemic of 2020 helped bail out junk debt, but the bonds that received the bailout may not have been AAA rated, leading to potential trouble for these bonds and the ETFs invested in them. The Fed's announcement of faster and more aggressive quantitative tightening starting in 2023 has caused concern in the market, as the Fed's selling of mortgage-backed securities could negatively impact their price. This potential policy error is being indicated by the behavior of bonds in the market, specifically the US three-month bond, which saw an increase after the Fed's announcement. The Fed's policy could have a significant impact on the market, as the MBB ETF has a market cap of 25.6 billion and total assets of 10 billion.

Investing in Exchange Traded Funds (ETFs) carries with it the assumption that the underlying assets within the fund are of a certain quality or rating. However, recent events suggest that this may not always be the case. In particular, the presence of non-AAA rated bonds in a fund labeled as a AAA rated ETF raises questions about the integrity of the rating system and the potential for mismanagement of funds. The issue came to light in the aftermath of the last mortgage crisis, where it was discovered that a number of FICO scores below 660 and below 700 were included in a AAA rated ETF. Fed acting as a forced buyer of last resort has enabled this kind of behaviour to continue unchecked.

Since March 2020, the Federal Reserve has been engaged in a program of quantitative easing, with a monthly spend of at least $40 billion in mortgage-backed securities. This needs an army of real estate agents tasked with checking the properties underlying these securities, but the sheer volume of the market makes this a humanly impossible task. This is a situation reminiscent of the 2008 financial crisis, when the failure to adequately check the quality of mortgage-backed securities led to the eventual collapse of the market. The current situation is different from the 2008 crisis, however, as the problem now lies with fixed-rate mortgages. The higher interest rates go, the harder it is to refinance mortgages, and the likelihood of a 2008-style collapse of the housing market grows. It’s becoming a matter of national security to audit the balance sheet of the Fed. If there are still good assets on the balance sheet, these should be sold into the market to help mitigate the effects of a potential housing market collapse. If it’s filled with bad assets, the Fed has the ability to print money to keep the market from collapsing.

As of now, the US taxpayer is on the hook since both Fannie Mae and Freddie Mac are still in conservatorship. Over the past decade, Fannie Mae has reduced its mortgage portfolio balance from nearly 800 billion to below 100 billion and has also reduced its debt from almost 800 billion to 180 billion dollars in debt. Despite the reduction of their own mortgage portfolio and debt, the actual guarantee business of Fannie Mae has grown by 800 billion. In contrast, the number of guaranteed mortgage-backed securities by both Fannie Mae and Freddie Mac has doubled since 2013. Furthermore, since July 2019, there has been a concerning development regarding the relationship between Fannie Mae and Freddie Mac. It has been discovered that there is cross-collateral contamination worth at least 337 billion dollars between them, meaning that if a loan is re-securitized by Fannie Mae and defaults, it will also default on Freddie Mac's balance sheet, puting both at risk of defaulting on their balance sheets.

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Currency valuations

Is influenced by the value of bonds and the amount of currency in circulation. The current monetary system is fractional reserve, where value of the currency is directly related to value of bonds. If the value of bonds decreases, so does the value of the currency. To prevent this problem, the US government must stop spending and selling bonds, keeping the amount of bonds in the market stable. This will prevent the decrease in value of the currency. The US government cannot print its own money, but the central bank can print money and loan it out to the government. However, all the money created through this process must eventually go back to the central bank. The central bank must make up the difference in cases of liquidity crisis, as all interest on loans creates new money that must come from somewhere. This has been a repeating cycle since the US dropped the gold standard in the 1970s due to printing too much currency and not collecting enough gold.

On the other hand, Russia is currently implementing a commodity-based economy, where the value of the currency, the ruble, is tied to the value of commodities like gold, instead of fiat-debt. The value of the ruble will increase as gas is sold for rubles, but the increased supply of rubles will eventually devalue the currency. The Suez Crisis of 1956 was a significant event in the history of global power dynamics. Egypt and England attempted to take control of the Suez Canal, a key waterway connecting the Red Sea and the Mediterranean. However, this effort was opposed by Israel, France, and the US. In response, the US leveraged its financial power of dollar, to force England to cede control of the canal. This marked a turning point in the world's recognition of the dollar as the new global reserve currency, overtaking the pound. Today we see Russia is trying to challenge US dominance by utilizing its commodity power and low national debt. This could lead to a similar shift in the balance of global power. Alasdair McCloud’s sources claim that Russia's real gold reserve stands at approximately 12,000 tons, 4,000 tons more than what has been publicly disclosed. This, if true, has significant implications for the Russian economy. Dividing Russia's M2 money supply by 12,000 tons of gold, we get a ruble-to-gold ratio of 5.55 rubles per gram. This ratio has led some economists to predict a ceiling in rubles per gram, followed by a floor, rather than a hard peg as is currently in place. This soft peg would allow the central bank to buy gold at 5,000 rubles per gram and sell at 5,500, creating a floating currency that could absorb shocks and protection against currency manipulation and ensure the stability of the Russian economy. The Russian central bank could simply change the lower bound of the peg in response to such actions, effectively jawboning the market and preventing a run on the ruble. This would also have the effect of reducing the amount of rubles that would be sold in the market, as the lower bound would decrease with each revaluation of the ruble. It should be noted that while this strategy may be seen as a form of currency manipulation, it is a defensive measure against potential manipulation by external actors. The soft peg would also have the added benefit of ensuring that the ruble remains a stable currency, thereby promoting economic growth and stability.

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The way ahead?

Shares of gold and silver miners can provide a way for people to protect themselves from inflation. When there is a massive rotation out of non-inflation protective assets to inflation protective assets, gold miners' shares can increase in value. Gold miners benefit from rising demand for gold and the price they receive for the gold they produce and the impact of inflation will just get added on top of that. The supply chains work on the auction process, and if there is an outsized demand for it, the miner will ask for a higher price, which will eventually be returned to the shareholders. Low debt, rising revenues, and exposure to both the gold and silver price make these miners a good investment. They also have a solid dividend plan, with a cash buffer to pay dividends even during a market drop. The majority of gains from investing in these miners come from the last leg of the bull run, even when hyperinflation happens. During that time, profits will be good, but towards the end, when the curve becomes exponential, that is where most of the gains come from.

Central Bank Digital Currencies (CBDCs) as digital dollars, will be on the liability side of the Federal Reserve's balance sheet, making it a loan. This means that we can expect the eventual phasing out of cash which will also mean that the physical limitations on how much currency can be created will no longer apply and thus remove limit of how much the currency can depreciate. In the past, hyperinflations were only stopped when a government could no longer afford to import paper to print money. However, with CBDCs, there will be no such limit, and this raises questions about the stability of our currency.

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Sources:

https://youtu.be/qQ4NOUAi98I

https://youtu.be/Z7pqgjAB63I

https://youtu.be/vgPuRDmmTN8

https://youtu.be/aCp4nDCkNLU

https://youtu.be/hKP8AyHtlSo

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