Why the World Is Rethinking Bonds | Daniel Lacalle

The interest rates on the U.S. debt is going up significantly. At the same time, many central banks are still buying gold, and they're trying to increase their gold reserves over dollars. Today we sit down with European economist Daniel De La Calle to find out what's going on with the U.S. debt and its currency. Also what's happening to the European countries and what is the impact of the interest rates going up globally. What we are seeing is not a de-dollarization, but a de-fiatization. Many central banks all over the world are rebalancing the asset base. The entire financial system as we know it is predicated on the idea that sovereign bonds are the lowest risk asset. However, something broke and very fast in 2020-2021. Bonds have stopped being the cushion that provides a real economic return in periods of market uncertainty. I'm Siamak, and this is Market Insider. Daniel, it's great to have you back. Welcome back. Always a pleasure. Thank you very much for inviting me. The treasury rates are going up. At the same time, central banks are buying more gold, and there's more talk of replacing gold with dollar. Are you seeing that? What are you seeing out there right now? Okay, I think that what we are seeing is not a de-dollarization, but a de-fiatization. Let me explain why this is very, very different. If there was a real substitution out of the US dollar, we would be seeing a significant increase in the utilization of the euro, the yuan, or any other of the currencies of the world. There is no substitution effect, and there's certainly no real change in terms of the asset base of major central banks in terms of fiat money. What is true is that many central banks all over the world are rebalancing the asset base, i.e. reducing the percentage of bonds from developed economies, and treasuries in particular, and increasing the amount of gold. But that doesn't mean that they're not buying dollar assets. It means that they are buying more gold than dollar assets, but they continue to hold the largest percentage of their reserves in dollars. In summary, what we are seeing globally is that the dollar continues to be the world reserve currency, that there is no real contender, that global demand for US dollar assets is soaring and rising to all-time highs. But at the same time, you have central banks that in the past two decades significantly reduced their holdings of gold, rebalancing. Tell us about the fiat side of things. De-fiatization means that in the past two decades in particular, central banks all over the world were reducing the size of gold in their asset base, and increasing the size of sovereign debt. Euro bonds, Japanese bonds, UK bonds, and US treasuries. That means that they were increasing the exposure to fiat currencies relative to commodities and precious metals like gold. What we have seen, particularly since 2022, is that those bonds issued by developed nations have stopped being a reserve asset, because as so many market participants have seen, bonds have stopped being the cushion that provides a real economic return in periods of market uncertainty. So when markets go up, bonds actually perform a little bit worse. And when markets go down, bonds actually don't give you that strength that they used to. So a few central banks, led by Asian central banks, etc., decided to have an asset, gold, that is fully de-correlated from the move of sovereign bonds. And with financial repression, which means low interest rates and constant money printing, what these central banks have also found is that treasuries or euro bonds are not giving them the real economic return that they so desired two decades ago when they were hoarding those sovereign bonds. And Daniel, what are you seeing that is telling you this story? The Central Bank of China, the Central Bank of Poland, so many others, Turkey, etc., are increasing the purchases of gold. They increase the purchases of gold, and I think that this is interesting also, even in periods in which the price of gold is rising. So it's a real desire to increase that percentage in their asset base. And the other one, the other impact that we are seeing globally, is that when we look at, for example, the yield of sovereign bonds, treasuries, German bonds, French bonds, UK bonds, Japanese sovereign bonds, all of them are actually rising the yields in tandem, which means that it's not, for example, that people are selling treasuries and buying German bonds, which used to be a typical way of behaving of investors in the pre-2022 period. Usually, if you were concerned about US finances, you would buy German bonds. Or if you were concerned about the euro area and the challenges of the European Union, you would purchase, I don't know, UK bonds, something like that. But what we're seeing is actually the opposite. What we're seeing is that global investors are demanding higher yields from all of the developed nations, and at the same time, reducing their percentage of ownership of bonds, even in pension funds, which is something that is quite incredible. And what about China? There is one country that the rest of the developed nations, the yields are going up, but for China, the yields are going down. What are you seeing there? Number one is obviously that China is suffering from a risk of deflation, while in the other developed economies, what we're seeing is the problem of persistent inflation, which I think is quite significant. The other is more challenging, or at least difficult to explain to people, is that many people look at the yield of Chinese bonds and say, look, the yield is declining. That means that there is more confidence in Chinese bonds. But you have to adjust it to the reality of people's real perception of where the currency of China, the yuan, would be in real terms. A lot of people see that these Chinese bonds simply are impossible to add to many of the pension funds and central bank balance sheets, because you don't have a currency that is trading freely like the US dollar, like the euro, like the Swiss franc or the UK pound. So the problems that are coming in the financial sector in China don't appear in the yield, they appear in the lack or at least lackluster demand of those sovereign bonds. They're basically held by the Chinese financial system, and very, very few, certainly relative to the size of the economy, very few pension funds or investment funds add to those holdings. Now, in terms of the impact of all of this, you mentioned defiatization, so the paper money is not as valuable as before. What's the impact of this? Oh, it's huge. It is huge because basically you have to think that the entire financial system as we know it is predicated on the idea that sovereign bonds are the lowest risk asset, and that at the same time, in the mentality and in the mindset of the vast majority of investors globally, you would have the idea of a 60-40 portfolio in which 40% would be in bonds. When markets corrected, those bonds would give you a real economic return. However, something broke and very fast in 2020, 2021. First, developed economies, central banks decided that there was no risk of inflation and that they could do whatever they wanted. That was obviously a mistake. In 2021, inflation started creeping up and it came fast and nasty. And instead of reacting aggressively to avoid that inflationary pressure, they allowed the easing to continue with very, very loose monetary policy and very loose fiscal policy. In 2022, when they started to hike rates, it was already too late. Bonds had already fallen. Yields were already high. Even when central banks started in 2023 to cut rates, it did not even matter because the market immediately absorbed the news and you would continue to see bond yields creeping up. It didn't matter if it was in the euro area, Japan, the UK or the United States. All of those bond yields have been rising in tandem under the impression of, and correct impression of most investors, that on the one hand, these developed economies have surpassed the inflationary limit and now they're facing persistent inflation, but also the economic and fiscal limit. The economic limit, which means that adding more debt does not improve growth or productivity. And the fiscal limit, which means, as we are seeing, for example, in France or in the UK, that increasing taxes and having relatively stable rates does not reduce the deficit, does not reduce the problems of over expenditure, overspending that so many of these countries are suffering. Now, Daniel, in terms of the impacts to the everyday people, you know, like businesses, do you think their interest rates will stay high for a long time? And how would it impact the business community and also assets? I think that in the first phase, interest rates are going to continue to be much higher than what people would have expected. And that obviously means that the rates that we see in our Bloomberg screens or in the media every day is just the base rate. For small and medium enterprises in America, the current Fed fund rate means that the average level of debt cost moves between 6.5 to 11 percent. So it's huge. Now, very, very expensive cost of debt for families and for businesses. So the impact on each person is quite significant because on the one hand, you have the inflationary tax, you have the persistent inflation that doesn't come down and people are seeing it more difficult to make ends meet day by day. On the other hand, getting credit, borrowing more expensive, not even a question of only cost, but access to credit. When you see central banks hiking rates, a lot of banks will, and logically, decide to hoard part of their cash in the central bank rather than to lend to citizens. So it's basically a massive contraction of the access to credit for the most vulnerable part of the economy, but also the most important part of the economy, which is consumers and small and medium enterprises. Now, do you see this trend continuing? And somehow this trend started again after the war started. So some people are connecting the two. What are your thoughts on that? My concern is that central banks act in the middle of a war in which the inflationary pressure is coming from an external geopolitical risk, the same way that they react when there is an excess of demand or when there is an excess of credit. And they decide to hike rates. To be fairly honest, hiking rates in an inflationary pressure coming from energy makes absolutely no sense. It is not going to change the price of oil or natural gas, and it's going to hurt, as I said prior, the most vulnerable part and the most important part of the economy, which is families and small businesses, for nothing. So that is my biggest concern. And therefore my concern is that now we're talking about persistent inflation and an economy that is not doing badly. The economy is growing. There is very little risk of a recession. But they, central banks, may engineer a recession by applying a tool that has absolutely no impact on energy prices, zero impact on government spending and on geopolitical risks, and an enormous one on families and businesses. Now, do you see this inflationary pressure coming from de-fiatization, or is it coming from the energy? Yeah, it's a great question, because we have to, let's say, separate two elements. One is the transitory or short-term impact of the war, which is pretty evident that it's coming only from energy. It's similar to what happened in 2022, if you remember, when the Ukraine war started. The energy component of CPI, consumer price inflation, rose very, very quickly and then came back when the geopolitical risk at least was absorbed or at least mitigated. But that's one. But the most important one is the one that everybody is talking about when you talk with your family or with friends or with businesses, which is the persistent inflation, which is that we saw prices go up very, very fast in 2021 to 2024, but they're not coming down. They are rising at a slower pace, but they're still rising. So it's normal that people talk about levels of price when central banks are talking about rates. So central banks decided to cut rates in an environment in which there was absolutely no need to cut rates because there was no recession risk, because there was no problem in the economy and certainly no problem in the bond market. And now they're hiking rates at the worst possible period. Obviously, there's a lot of debate of whether they should hike rates or not. But there's one thing that we know and that is very clear, is that hiking rates is not going to change what drives persistent inflation, which is government spending, massive money printing, huge units of currency coming into the system above what the private sector demands. That is the problem, let's say, that we are most worried about. But to address it by hiking rates doesn't change it because actually it's not only that there is no single developed economy government that is going to reduce government spending or try to reduce deficit spending via cutting on expenditures. It's even worse, is that a lot of developed economies governments, when they see persistent inflation, instead of recognizing that they are the culprits, they present themselves as the solution and then say that they're going to give subsidies and that they're going to give grants and that they're going to spend more, which is more inflationary. So that is the problem. On the one hand, you have the geopolitical risk premium attached to energy prices, which is not solved by hiking rates and the persistent inflation, core monetary inflation that we are seeing every day, that is not going to be changed by hiking rates because there is zero government that is going to cut spending because of a rate hike and there are zero governments that are going to cut on their free money that is always very expensive policies. Now, from what you're saying, essentially the core reason behind this defiatization and the persistent inflation is the government spending across these developed countries, is that deficit spending. It is excessive spending. Deficit is a consequence, but the fact that we have seen over and over again that in periods of growth, most governments not only don't cut spending, but they actually add to spending. If you think about it, in America, we saw an extraordinary expenditure in 2020 because of COVID and in 2021, 2022 and 2023, the government added two trillion dollars to what was supposed to be an extraordinary expenditure. Instead of bringing it back to the level of 2019, they added to it. And this is not just in America. That happened in the Euro area, et cetera. We've seen, for example, how Germany, which was almost like the last of the independents, that seemed to have a prudent fiscal policy, decided to go all crazy and start to spend as if there was no other option, when the problem of Germany has absolutely nothing to do with government spending. It has to do with shutting down nuclear terminals. It has to do with the Ukraine war and the impact on energy, et cetera, et cetera, the de-industrialization and all those problems. So adding to expenditure is going to be a very negative. That is why what concerns me the most is that if we were in an environment in which people were worried about the U.S. debt or worried about, I don't know, the fiscal situation of the U.S. government, we would see a very significant buying pressure in German bonds. We're seeing the opposite. In fact, the worst performing bonds in sovereign debt have not been the U.S. bonds, have not been treasuries at all. Actually, they're not even in the top category. It's the UK, France, Japan. Think about this, the UK, France, and Japan, what do they have in common? Three economies in which what we have seen always is an increase in government size, increase in government spending, and no austerity at all. So you're seeing the source of this inflation being government spending, but there's also other thoughts and ideas right now to give. There was one thought that to give $5,000 to each citizen here. What are your thoughts on that? Do you think that that type of proposal would create inflation? Yeah, I mean, if we think about, let's start from the headline, no? The government is going to give a check of $5,000 to every American. We know from the stimulus checks of 2021, 2020, sorry, that that may have an inflationary effect. However, those stimulus checks did not have an inflationary impact because most people, instead of spending, decided to invest it, which is quite interesting, no? The thing about this is what are they going to do? What I read from the Trump administration is that they are going to use the extraordinary revenues coming from trade and coming from investments into the country to give it back to citizens. What I hear from Secretary of State Mr. Besant or Mr. Lutnik, both of them have said that it's not going to become from deficit spending and it's not going to come from taxpayer money. Okay, let's assume that that is the case, no? If that is the case, then it's not inflationary because it's dollars that come into the economy. The same dollars, instead of being in the pocket of the government, is going to be in the pocket of citizens. If it is in the pocket of the government, it is spent multiple times over. If it is in the pocket of the private sector that earned it, you either save it, spend it or invest it. Two of those three elements have no inflationary impact, no? So it's a much more complex situation than just saying, oh, it's going to be about 1.2 trillion of higher money supply and therefore that will generate higher inflation. We have to be very cautious about that analysis because we don't know what it is going to do if it is implemented to money velocity. Is that going to increase or decrease money velocity? My take is the following. If it's not going to come from deficit spending, not going to come from taxpayer money, and the government wants it to come to citizens as a sort of dividend, then it should not be inflationary because it is the same units of currency going to the pockets of the private sector. The way to make 100% sure that it would not be inflationary is if it is implemented in a sort of tax rebate type of system. The moment that you get those extraordinary revenues, you start to give tax rebates and that basically means no new money creation and certainly no increase in money velocity. So I'm happy to take the word of the Secretary of State when he says that it's not going to come from taxpayer money or from deficit spending, but in general, new units of currency, 100% spent by the government, have more risk of generating inflation and increasing money velocity than that same unit in the hands of the private sector. Why is that? It's very simple. The government always overspends. We have seen it. You have record tax revenues, they spend more. You have a crisis, they spend more, no? So the government sees one unit of currency coming into the system, it is going to spend it. The administration almost... So there's no saving, there's no investing. It's like pure spending. Even worse, when they call it investing, most of the times it is an absolute disaster that generates even more demand of new units of currency because it is not economically profitable, no? But to make it for people simple to understand, if the economy creates one unit of currency, the private sector has that currency, that is either invested, saved, or spent. But it's never going to be 100% spent. Nobody on earth, if they receive a $5,000 check, rebate, you name it, is going to go out and say, yoo-hoo, let's go. If it's in the hands of the government, it's all systems go. In fact, usually, which is the case of, for example, France, every new unit of currency that comes to the government, they spend 1.2. So you even create a bigger deficit and debt problem. So in a sense, I get that the intention of the Trump administration is what Scott Besant was saying about bringing back the economy to the private sector, i.e., if you're getting extraordinary revenues, don't give it to the government because it's going to spend it and more. Give it to the people that are creating jobs, that are investing, and that are creating the productive part of the economy. That is my perception. What I would prefer as an economist, obviously, is a tax rebate because that would not have any short-term deficit impacts, no? Yeah, and now, what are you seeing? Are these governments continuing to spend? Because you mentioned that this is the reason for the defiatization. And are you seeing more inflation coming? And when is the time that things might change? Well, ultimately, what we have to understand is that when it is such a widespread problem, we as voters and as citizens have a lot to blame because we're voting for parties that promise more and more and more and more spending. But there will be a moment, and it has happened in the past numerous times, when somebody comes and says, look, this is ridiculous. The government needs to step back, needs to strengthen the private sector, needs to make small companies larger, needs to allow citizens to get into the property ladder, to purchase a home, to sell it and purchase another one, all those things, as we saw in the 80s. Right now, the idea created in 2008 that every economic problem needs to be solved by higher spending, higher money printing, and higher levels of deficit has created this enormous debt problem. And it's very difficult to stop because if you look, for example, in France, there is not one single party in parliament that is calling for a reduction in spending. Some of them are calling for higher, for a lot higher or incredibly higher. So we need to, at some point, educate people into understanding, and I think that it's happening little by little, into understanding that when the government promises free stuff, you're going to pay multiple times over in inflation, in lower productivity, in weaker wages, and in lower growth. Daniel, you don't see any problem with the US debt at these levels that we are in. The market is not questioning it, based on what you said about Germany. The market is certainly not questioning the role of US debt as the most interesting sovereign debt asset of developed economies, or one of the most interesting. But that doesn't mean that there is no problem in US debt. I think that we need to be aware that the United States needs to solve its fiscal problem through three measures, but they all have to be at the same time. Higher economic growth, lower spending, and an improvement in the trade balance of the nation. The Trump administration has very obvious strategies in that regard, but I don't know if those will work, or if those are the best. But what I do know is that the United States will not solve its debt problem only by cutting spending. It will not solve its problem only by growing, or only by addressing the trade deficit. But one thing that we all know, because now nobody can say that it's not been tried, tested, repeated, over and over again. One thing that we know for sure is that the way in which you're not going to reduce debt in any shape or form is by raising taxes. If raising taxes and increasing government spending were the solution to sovereign debt, the French bonds would not be the second or the third worst performers in the G8 economy. So no, France has tried the revenue side by increasing taxes and increasing the pressure on the private sector massively. It has the highest tax wedge on businesses and families in the world, and the fiscal situation is completely atrocious. So the solution is higher growth, better trade balance, not necessarily a trade surplus, but a better trade balance, and certainly control of spending. How would assets perform in this kind of environment where we have higher yields? Historically, when we see higher yields, one would imagine that it would be a time to buy bonds and sell equities, no? Because you get a higher return from sovereign bonds than from equities. But when there is a widespread concern about the sustainability of public finances and a widespread concern about persistent inflation, that doesn't work. That's why equities and bonds are so correlated. And that is not a good thing. So the way that I see it is that you need to build a portfolio to understand that when there's a correction in equities, this is a good time to buy. It's a good time to buy those companies that are giving you a cushion and that are hedging you against the defiatization that I was mentioning. So those that don't have an erosion of margins, don't have a destruction of demand, et cetera. On the other hand, instead of looking for sovereign bonds as a hedge, you need to have gold. You need to have silver. You need to have commodities that are going to give you that real hedge to persistent inflation, no? Ultimately, commodities are not a cause of inflation. They are reflecting monetary inflation. So if we build a portfolio with equities, a little bit of gold, a little bit of commodities, and some corporate debt of those companies that don't have the fiscal, the balance sheet problem of governments, then you're going to do fine, in my opinion. And what about real estate? Do you think the real estate market would get hit significantly because the rates are going up? The real estate market is going to suffer on average. But like everybody that looks at the real estate market in general, it's a very good environment because it is true that it will be hit, but it will be hit in the areas in which the level of demand is not as sticky and as robust as in others. So you need to be very specific. You need to be very prudent. And you need to choose the asset in which you're going to invest. Any real estate is not a good idea. I still remember a good friend of mine that in 2008 said that the best investment you could make was to buy real estate in Detroit. And it's 2026. He has not recovered his money yet. So it's not any real estate. It's the real estate where demand, supply and fiscal conditions are positive. You also have to think, a lot of people talk about real estate in nominal terms. It's gone up X. Now you need to think about it in real terms and after taxes. And in a lot of places, governments look at real estate as a stranded asset that they can confiscate via taxes. So take into account the taxation system, take into account the real level of demand and the supply. And that's the way to look for opportunities in real estate, which obviously exist. Daniel De La Calle, it was great to have you back on Market Insider. Please come back and update us in the near future. Always a pleasure. Thank you so much. Tell us what do you think about the fiat money? Do you think the paper dollars and paper currencies are losing their value significantly? Make sure to tell us in the comments. I'm Siamak, this is Market Insider. We'll see you next time.