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Rising Instability And Its Impact on Financial Markets

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Rising Instability And Its Impact on Financial Markets

In today’s highly volatile market environment, it is crucial for investors and traders to stay informed about the current U.S. fiscal debt and deficit system. This article explores the ongoing problems in the U.S. bond market and provides valuable insights into potential investment themes amid this macro-heavy landscape.

An Unstable Financial System

To understand the implications of the current instability, it is helpful to compare the financial system to engineering concepts of stability. In the field of control engineering, stability refers to how a system responds to input and maintains its equilibrium.

In this context, a stable system reacts to bounded input by reducing any dissonance over time, ultimately achieving a state of calmness. On the other hand, an unstable system produces unbounded output when exposed to bounded input, causing oscillations to escalate. Marginal systems fall somewhere in between, oscillating without worsening over time.

Surprisingly, financial systems, particularly those of developed countries like the United States, are often classified as unstable. Over time, sovereign debt as a percentage of GDP tends to increase, leading to a constantly growing output. While this instability takes years to manifest fully, it eventually requires a reset or restructuring of the system, often resulting in nominal default or inflation-induced loss of purchasing power for bondholders.

Three Eras of Financial Instability

The modern era of global finance can be divided into three major periods: the International Gold Standard, the Bretton Woods system, and the Dollar Reserve system.

The International Gold Standard (1871 to 1914) relied on gold as the base layer of money, with countries pegging their currencies to gold at fixed rates. While this system appeared stable, it was inherently fragile due to the increasing abstraction of gold through credit. The abundance of paper claims for gold far exceeded the actual gold reserves, leading to the system’s collapse during World War I.

The Bretton Woods system (1946 to 1971) attempted to stabilize global currencies by backing the U.S. dollar with gold and pegging other currencies to the dollar. However, the system proved unsustainable as trade imbalances depleted U.S. gold reserves, eventually leading to the abandonment of the gold standard in 1971.

The Dollar Reserve system (1974 to the present) emerged as a result of the United States backing the dollar with oil after striking a deal with Saudi Arabia. Most countries hold U.S. Treasuries as reserve holdings, and the dollar maintains its position as the primary global reserve currency. However, this system faces two major instabilities: structural trade deficits and rising debt levels.

Structural trade deficits arise from the monetary premium attached to the dollar, causing the currency to remain stronger than expected based on the U.S. trade balance. As a result, the United States runs trade deficits for extended periods, which contributes to the negative net international investment position and exacerbates the imbalance.

Rising debt levels represent another major concern. Developed countries, including the United States, have experienced a continuous increase in sovereign debt relative to GDP. The trend of falling interest rates and rising debt levels, which defined the past four decades, is now facing challenges. Higher interest rates and mounting debt levels are creating an unstable fiscal situation.

Determining the Timing

The current monetary policy landscape is marked by attempts to rein in inflation, decreasing balance sheets, and tight liquidity conditions. However, factors such as the drainage of the reverse repo facility and limitations on bank cash levels may impact the Federal Reserve’s ability to control inflation.

If the reverse repo facility is drained in 2024 and the Fed is forced to stop decreasing its balance sheet, market perceptions about the Fed’s ability to control inflation could shift dramatically. The market might realize that Treasury deficits, not Fed actions, dictate the control of inflation. At that point, instability within the financial system could become apparent.

Looking ahead, the global economy is moving away from the disinflationary era facilitated by China’s economic opening and the fall of the Soviet Union. Inflationary pressures in energy, commodities, and manufacturing, combined with uncontrolled fiscal deficits and limited central bank tools, could contribute to persistent above-target inflation or inflation punctuated by temporary disinflationary slowdowns.

Life Goes On

While discussions about unstable financial systems can sound ominous, it is essential to maintain perspective. In the face of financial challenges, societies continue to function, and people adapt to new circumstances. It is crucial to acknowledge the relative stability and privilege enjoyed by individuals in wealthier parts of the world compared to those in impoverished regions.

When investing in the midst of instability, a diversified portfolio can provide protection and potential growth opportunities. Assets such as gold, bitcoin, T-bills, TIPS, oil producers, and select equities and real estate could prove beneficial in navigating the complex financial landscape.

While the coming years may bring more unpredictability and unprecedented events, it is important to remember that change is a natural part of the financial system’s evolution. With each reset, opportunities for improvement arise, paving the way for new developments and a better future.

Life goes on, and as investors, we must adapt and find ways to thrive in these interesting times.

Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.