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Rising Instability and Its Impact on Financial Markets

Rising Instability and Its Impact on Financial Markets

As we navigate the complex and ever-changing world of financial markets, it is crucial to understand the rising instability that is shaping our current landscape. This article will delve into the U.S. fiscal debt and deficit system and its implications for the bond market, providing valuable insights for investors and traders.

Long Duration Bonds Face Historical Drawdown

The bond market has experienced unprecedented turmoil, with long duration bonds enduring their worst drawdown in history. This drawdown has surprised even seasoned analysts, signaling the depth of the ongoing instability in the financial system.

While the worst of this drawdown may be behind us, it is important to consider alternative investment options in this “macro heavy” environment. Treasury Inflation-Protected Securities (TIPS), for example, are worth exploring due to their positive real yields. However, it is crucial to acknowledge that the overall fiscal picture remains highly problematic.

An Unstable Financial System

To better understand the current state of the financial system, it is helpful to examine the concept of stability in engineering. Stable systems exhibit bounded output that reduces over time in response to a bounded input. In contrast, unstable systems have unbounded output, causing oscillations to grow larger over time.

When applied to the financial system of a developed country like the United States, it becomes clear that most financial systems are inherently unstable. The percentage of sovereign debt relative to GDP keeps escalating over time, leading to an unsustainable imbalance that must be addressed through measures such as default or inflation.

While these financial systems have long frequencies, which means it takes decades for instability to reach a critical point, it is essential to recognize the need for periodic resets, recapsitalizations, or restructuring to maintain stability.

Three Eras of Financial Instability

Through a historical lens, we can divide the modern era into three major global financial orders, each characterized by its own set of challenges and instabilities.

International Gold Standard (1871 to 1914)

Prior to the invention of the telegraph, the international gold standard operated from 1871 until the outbreak of World War I in 1914. Under this system, gold served as the base layer of money, with countries pegging their currencies to gold at fixed rates.

Although this system appeared stable on the surface, it was inherently unstable due to excessive abstraction and leverage. This instability became evident when gold pegs were broken during the interwar era, resulting in defaults and sharp devaluations.

Bretton Woods System (1946 to 1971)

Coming out of World War II, the Bretton Woods system aimed to stabilize the global monetary system. The U.S. dollar was backed by gold and served as the global reserve currency, while other countries could peg their currencies to the dollar.

However, this system also proved to be unstable, as the United States faced persistent trade deficits and diminishing gold reserves. Ultimately, President Nixon defaulted on gold redemption promises in 1971, marking the transition to a fiat currency system.

Dollar Reserve System (1974 to present)

In 1974, the United States reinforced the dollar’s reserve currency status through a deal with Saudi Arabia and other OPEC nations. This system relies on structural trade deficits and rising debt levels, making it inherently unstable.

Structural trade deficits, resulting from the strong monetary premium on the dollar, perpetuate the flow of dollars out of the country. Additionally, rising debt levels relative to GDP further contribute to the instability of the system.

Determining the Timing and Implications

Currently, the Federal Reserve is attempting to rein in inflation by tightening monetary policy, but it faces challenges in achieving its goals. High interest rates have mixed results, influencing bank lending while simultaneously increasing the fiscal deficit.

Furthermore, as the reverse repo facility is drained, the market may question the Fed’s ability to control inflation. The Treasury’s deficits and the need for buyers to maintain Treasury market liquidity could shift the perception of who holds the power.

In the long run, persistent above-target inflation or waves of inflation punctuated by temporary disinflationary slowdowns may occur due to uncontrolled fiscal deficits and the limited tools of central banks.

Final Thoughts: Embracing Change

The current state of financial instability can appear bearish and even “doomy.” However, it is essential to recognize that significant monetary changes have occurred throughout history, leading to periods of disruption and ultimately yielding new opportunities.

As we navigate these changes, it is crucial to maintain a broader perspective. It is a privilege to navigate financial systems that, despite their challenges, offer stability as compared to many developing countries.

While it is important to consider alternative investment options such as gold and bitcoin, it is equally valuable to explore other avenues such as T-bills, TIPS, oil producers, real estate, and select equities. The ability to adapt and find opportunities is key in navigating the dynamic financial landscape.

Moreover, it is imperative to appreciate the resilience exhibited by individuals living in countries facing severe financial crises. Life goes on, and people continue to work, learn, and thrive even in the face of significant challenges.

Therefore, let us embrace the uncertainty and focus on building a better future, knowing that instability can bring forth positive change.

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