Investing in Real Estate

In Monday’s update, we compared investing in stocks to investing in financial securities and concluded that stocks offer better long-term performance. Today, we use long-term data series for US and Australian real estate to evaluate their comparative performance.

US real estate data was sourced from Prof Robert Shiller, who created the Case-Shiller Index series. The chart below shows that US home prices from 1933 to 2023, a period of ninety years, appreciated to 69.5 times their original value.

Home Price Index

Adjusting for inflation, we get real appreciation of 2.9 times.

Again, CPI seems to understate inflation. Comparing the home price index to Gold, rather than CPI, provides a more accurate measure of appreciation in real terms. Gold appreciated 94.5 times over the same period, so the home price index actually lost value.

Calculation: 69.5/94.5 = 0.735 (i.e. a 26.5% loss of value)

Comparing data sources

A second source of home price data compares median prices, based on sales of existing homes, from 1953 to 2023. That shows growth of 22 times over the past seventy years, which is close to the Home Price Index appreciation of 21.25 over the same period.

Median Home Prices, Existing Homes


Australian housing data is harder to come by but we found an excellent source of long-term median house price data in the 2007 UNSW thesis of Dr Nigel David Stapledon. Using data from within the thesis, we were able to adjust nominal house prices to reflect constant quality (house values with no improvements) below.

Median Home Prices, Existing Homes, Constant Quality

Australian house prices appreciated 191.4 times between 1933 and 2006.

Unfortunately the data ends there, so we had to calculate a weighted average of median houses for 2007 to the present.

CoreLogic kindly provided us with values for their hedonic Home Value Index (for 5 Capital Cities) which also adjusts for quality:

Property Type	31/01/2007	31/07/2023
Houses		$399,182	$891,747

The gain of 2.23 is slightly higher than the 2.14 calculated from weighted average data for the 8 capital cities provided by the ABS.

Median Home Prices, Weighted Average of 8 Capital Cities

We opted for the higher figure from CoreLogic as likely to be more in line with the earlier Stapledon data. That gives a total nominal gain, adjusted for quality, of 426.8 for the ninety years from 1933 to 2023.

The price of Gold fines was fixed at £6-3/9 per troy ounce fine according to the Sydney Morning Herald on 2 January 1933, that converts to 12.375 Australian Dollars. Total gain for Gold in Australian Dollars over the past ninety years is therefore 232.9 times (A$2881.90/12.375).

We calculate the real gain for Australian house prices as 1.83 times over the past ninety years (426.8/232.9).


The US Home Price Index lost 26.5% in real terms, over the past ninety years (1933 – 2023), when compared to Gold.

The S&P 500 appreciated 6.8 times over the past ninety years when measured against Gold, and 9.7 times compared to US real estate (Home Price Index).

Using Gold as the benchmark, we conclude that Australian real estate prices appreciated faster than US real estate over the past ninety years, growing 1.83 times in real terms, whereas the US depreciated to 0.735 of its original real value.

We suspect the difference is largely due to the substantial fall in US real estate values after the 2008 sub-prime crisis, whereas Australian home prices continued to grow. We expect that performance of the two will converge in the long-term.

Lastly, when measured against Gold, US stocks outperformed Australian real estate. The S&P 500 grew 3.7 times against Australian home prices, in real terms, over the past ninety years.

This does not mean that we should ignore real estate as an investment medium. But a portfolio concentrated in real estate, without diversification into stocks and precious metals, could underperform in the long-term.


Fed Faces Three Uncomfortable Truths

IMF deputy head Gita Gopinath

IMF deputy head, Gita Gopinath, recently highlighted three uncomfortable truths for monetary policy:

  1. Inflation is taking too long to get back to target.
    Financial conditions may not be tight enough and sustained high inflation could make the task of bringing inflation down more difficult.
  2. Central banks’ price and financial stability objectives conflict.
    Central banks can provide liquidity to struggling banks but are not equipped to deal with problems of insolvency which may be caused by a sharp rise in interest rates.
  3. We face more upside inflation risks.
    The past two decades of low inflation are over and the global economy faces inflationary pressures from:
    • On-shoring of critical supply chains;
    • Rising geopolitical tensions (with Russia, China and Iran);
    • Transition away from coal, oil and gas to low-CO2 energy sources (renewables & nuclear); and
    • Spiraling demand for critical materials needed to meet the above challenges.

Balancing monetary policy is going to be difficult, especially where prices are under pressure from a number of challenges. We expect central banks to tolerate higher inflation for longer in order to preserve financial stability.

Fed only expects to hit 2.0% inflation target in 2025

Fed Chairman Jerome Powell recently highlighted the above conflict between policies to tame inflation and maintain financial stability. During a recent ECB panel discussion, Powell indicated that he only expects the Fed to hit their 2.0% inflation target for core inflation in 2025.

The Fed Chair says job creation and real wage gains are driving real incomes and increased spending. That raises demand which in turn drives the labor market. (WSJ)

Unemployment increased slightly to 3.7% in May but remains near record lows. The tight labor market continues to fuel strong growth in hourly earnings.

Unemployment, Average Hourly Earnings Growth

Tighter monetary policy would drive up unemployment — as demand slackens and layoffs increase — and dampen inflationary pressures. But at the risk of financial instability.


Further monetary tightening is necessary in order to increase the slack in labor markets, weaken demand, and curb inflation in the short-term. But the required policy steps — rate hikes and QT — are likely to crash the economy.

Rather than create financial stability through vigorous monetary tightening, the Fed is likely to tolerate higher levels of inflation — above their 2.0% target — for a longer period.

A less-hawkish stance from the Fed would be bullish for Gold.

A bi-polar world

There is much talk in the media of a multipolar world, with the split between the West and the BRICS, led by China & Russia. That may be relevant in the long-term but the immediate challenge for investors is a bi-polar world, where some markets are rallying strongly while others are collapsing. Even within the US market, we have some sectors rallying while others are collapsing.

The S&P 500 is still in a bear market but the index has rallied to test resistance between 4200 and 4300. Breakout would confirm the bull signal from 250-day Rate of Change crossing to above zero.

S&P 500

The big 5 technology stocks — Apple, Amazon, Alphabet (GOOGL), Meta Platforms, and Microsoft — have all rallied strongly since the start of 2023.

Big 5 Technology Companies

Volatility is elevated but declining peaks on Twiggs Volatility (21-day) suggest that this is easing.

S&P 500 & Twiggs Volatility

However, the rally is concentrated in big tech stocks, with small caps struggling to hold above support. The Russell 2000 iShares ETF (IWM) is testing the band of support between 164 and 170. Breach of support would signal a second downward leg in the bear market.

Russell 2000 ETF (IWM)

The Treasury yield curve is also inverted, with the ever-reliable 10-Year minus 3-Month spread at its lowest level (-1.49%) since 1981. Recessions tend to only occur after the spread recovers above zero — when the Fed starts cutting short term rates — which tells us that the recession is only likely to arrive in 2024.

Treasury Yield Spread: 10-Year minus 3-Month

The longer than usual lag may be the result of the “pig in the python” — a massive surge in liquidity injected into financial markets during the pandemic.

Commercial Bank Deposits/GDP

We are already seeing cracks in the dyke as liquidity starts to recede. Regional banks are in crisis, caused by the sharp hike in interest rates and the collapse in value of their “most secure” assets. Risk-weighted capital ratios are meaningless when bank investments in Treasury and Agency securities — which enjoy the lowest risk weighting — fall sharply in value. True levels of leverage are exposed and threaten bank solvency.

The S&P Composite 1500 Regional Banks Index ($XPBC) is testing support at 75 after a sharp decline. Not only do regional banks have solvency problems, caused by losses on Treasury and Agency investments, many are also over-exposed to commercial real estate (CRE) which faces a major fall in value, primarily in the office sector as demand for office space shrinks due to the shift to work-from-home after the pandemic.

S&P Composite 1500 Regional Banks Index ($XPBC)

There is always more than one cockroach — as Doug Kass would say — and regional banks are also threatened by a margin squeeze. Short-term rates have surged to higher than long-term rates, pressuring net interest margins. Banks are funded at the short-end and invest (and lend) at the long-end of the yield curve.

The Fed is unlikely to solve the regional bank problem easily, especially with the political impasse in Congress — needed to support any increase in deposit guarantees.


Falling commodity prices warn that the global economy is contracting.

Brent crude is in a bear market, testing support at $70 per barrel. But US cude purchases — to re-stock their strategic petroleum reserve (SPR) — may strengthen support at this level.

Brent Crude

Copper broke support at $8500/tonne, signaling another test of $7000. Sometimes referred to as “Dr Copper” because of its “PhD in economics”, the metal has an uncanny ability to predict the direction of the global economy.


We use the broader Dow Jones Industrial Metals Index ($BIM) to confirm signals from Copper. The base metals index breached secondary support, at 167, warning of a test of primary support at 150.

Dow Jones Industrial Metals Index ($BIM)

Iron ore has also retraced, testing support at $100/tonne. Breach would warn of another test of $80.

Iron Ore

Dollar & Gold

The Dollar is also in a bear trend, testing support at 101. The recent rally in our view is simply a “dead cat bounce”, with another test of support likely. Breach would warn of another primary decline in the Dollar.

Dollar Index

Gold is in a bull market as the Dollar weakens. Dollar Index breach of 101 would likely cause a surge in demand for Gold, with breakout above $2050 signaling another primary advance — with a medium-term target of $2400 per ounce.

Spot Gold


The ASX 200 recent (medium-term) bull trend is losing steam, with the index ranging in a narrow band between 7200 and 7400 since April.

ASX 200

Breakout from that narrow band will provide a strong indication of future direction. Breach of 7200 is, in our view, far more likely — because of weakness in global commodity prices — and would warn of another test of primary support between 6900 and 7000.

ASX 200

The All Ordinaries Gold Index (XGD), however, is in a strong bull trend. Respect of support between 6900 and 7000 would strengthen the signal, while breakout above the band of resistance (7500 – 7700) would signal another primary advance, with a medium-term target of 8200.

All Ordinaries Gold Index


The US market is bi-polar, with large technology stocks leading a rally, while small caps and regional banks are struggling. The lag between an inverted yield curve and subsequent recession may be longer than usual because of the “pig in the python” — large injections of liquidity into financial markets during the pandemic.

Commodities are in a bear market, with falling crude and base metals warning of a global recession.

The Dollar is weakening and we expect a primary advance in Gold — with a medium-term target of $2400 per ounce — if the Dollar Index breaks support at 101.

The ASX medium-term rally is weakening and breach of 7200 would warn of another test of primary support. Two major influences are global commodity prices and major Wall Street indices.

Our outlook remains bearish despite the rally in the US technology sector. We are underweight in growth, cyclical and real estate sectors and overweight in gold, silver, defensive stocks, critical materials, cash, money market funds and short-term interest-bearing securities.

Hard or Soft Landing?

Almost every recession in history has been preceded by speculation that the economy is in for a “soft landing.” After the early warning signs, nothing much happens. The stock market keeps climbing despite rising interest rates, raising hopes of a “lucky escape”.

The four most expensive words in the English language are: “This time it’s different.” ~ Sir John Templeton

The economy takes time to adjust to changed circumstances and there can be a lag of two years or more between the first rate hikes and the inevitable rise in unemployment. Plenty of time for self-delusion as stocks keep rising and unemployment stays low.

The difference between a hard and soft landing is best measured by unemployment. At 3.5%, the March reading shows no sign yet of an approaching recession.


The lag between an inverted yield curve — caused by Fed rate hikes — and unemployment can vary quite widely between recessions, depending on other influences. The chart below shows how an inverted yield curve in July 2000 was followed by the first sign of rising unemployment in January 2001, and shortly afterwards by a recession in March. The next yield curve inversion started in February 2006, the first sign of rising unemployment in July 2007, and the recession only in December of that year. Red bars below represent the lag between yield curve inversion and the first sign of rising unemployment.

Treasury Yields: 10-Year minus 3-Month & Unemployment

The current yield curve inversion (10-Year minus 3-Month Treasury yield) started in November 2022, so the earliest we are likely to see a rise in unemployment is late-2023.

Treasury Yields: 10-Year minus 3-Month

Why is unemployment expected to rise?

Every yield curve inversion (10-Year minus 3-Month above) since 1960 has been followed by the NBER declaring a recession within two years.

Every time the Conference Board Leading Economic Index declined below the red line at -5.0% has signaled recession.

Conference Board Leading Economic Index

Why do we expect a hard landing?

Every economy runs on credit and the US is no different. The severity of a recession is determined by the extent of the contraction in credit growth, as shown by the red circles below. Note how late the contraction generally is, often occurring after the official recession (gray bar) has ended.

Bank Credit

What determines the size of the credit contraction?

Firstly, bank net interest margins.

Banks tend to borrow short-term and lend long, enhancing their net interest margins in good times. But an inverted yield curve pulls the rug from under them, with short-term rates spiking upwards.

The more that net interest margins of commercial banks are squeezed, the more they avoid risk, restricting lending to only their best clients.

The percentage of domestic banks tightening lending standards on C&I loans climbed to 44.8% in March 2023.

Commercial Bank: Tightening Credit Standards for Commercial & Industrial Loans

Second, is the level of uncertainty facing banks.

The S&P 1500 Regional Banks index plunged after the collapse of Silicon Valley Bank (SVB), Silvergate Bank and Signature Bank.

Bank Credit

Shocks in the financial system tend to occur in waves. Latest is the threatened collapse of First Republic Bank (FRC) which has lost almost 100% of value in the past few months**.

First Republic Bank (FRC)

The CSBS Community Bank Index of Business Conditions is lower than at the height of the pandemic.

CSBS Community Bank Sentiment

Third is liquidity.

A strong surge in money market assets, warns that money (+/- $450 bn) has flowed out of the banking system and into the relative safety of money market funds.

Money Market Fund Assets

Money market funds are primarily invested in Fed reverse repo and Agency and Treasury securities, bypassing the banking system.

Money Market Fund Investment Allocation


Bank net interest margins are being squeezed, uncertainty is rising following the Silicon Valley Bank collapse, liquidity is being squeezed, and banks are tightening lending margins. The only party who can prevent a severe credit crunch is the Fed. By reversing course and injecting liquidity (QE) into financial markets, the Fed could attempt to create a soft landing for the economy.

But the Fed is bent on taming inflation and restoring their lost credibility after their earlier “transitory” error. The cavalry is likely to arrive late and low on ammunition.

We expect a hard landing.

Latest News**

Reuters: First Republic Bank (FRC)


EPB Research for the Conference Board LEI chart.

Economic Outlook, March 2023

Here is a summary of Colin Twiggs’ presentation to investors at Beech Capital on March 30, 2023. The outlook covers seven themes:

  1. Elevated risk
  2. Bank contagion
  3. Underlying causes of instability
  4. Interest rates & inflation
  5. The impact on stocks
  6. Flight to safety
  7. Australian perspective

1. Elevated Risk

We focus on three key indicators that warn of elevated risk in financial markets:

Inverted Yield Curve

The chart below plots the difference between 10-year Treasury yields and 3-month T-Bills. The line is mostly positive as 10-year investments are normally expected to pay a higher rate of investment than 3-month bills. Whenever the spread inverted, however, in the last sixty years — normally due to the Fed tightening monetary policy — the NBER has declared a recession within 12 to 18 months1.

Treasury Yields: 10-Year minus 3-Month

The current value of -1.25% is the strongest inversion in more than forty years — since 1981. This squeezes bank net interest margins and is likely to cause a credit contraction as banks avoid risk wherever possible.

Stock Market Volatility

We find the VIX (CBOE Short-term Implied Volatility on the S&P 500) an unreliable measure of stock market risk and developed our own measure of volatility. Whenever 21-day Twiggs Volatility forms troughs above 1.0% (red arrows below) on the S&P 500, that signals elevated risk.

S&P 500 & Twiggs Volatility (21-Day)

The only time that we have previously seen repeated troughs above 1.0% was in the lead-up to the global financial crisis in 2007-2008.

S&P 500 & Twiggs Volatility (21-Day)

Bond Market Volatility

The bond market has a far better track record of anticipating recessions than the stock market. The MOVE index below measures short-term volatility in the Treasury market. Readings above 150 indicate instability and in the past have coincided with crises like the collapse of Long Term Capital Management (LTCM) in 1998, Enron in 2001, Bear Stearns and Lehman in 2008, and the 2020 pandemic. In the past week, the MOVE exceeded 180, its highest reading since the 2008-2009 financial crisis.

MOVE Index

2. Bank Contagion

Regional banks in the US had to be rescued by the Fed after a run on Silicon Valley Bank. Depositors attempted to withdraw $129 billion — more than 80% of the bank’s deposits — in the space of two days. There are no longer queues of customers outside a bank, waiting for hours to withdraw their deposits. Nowadays online transfers are a lot faster and can bring down a bank in a single day.

The S&P Composite 1500 Regional Banks Index ($XPBC) plunged to 90 and continues to test support at that level.

S&P Composite 1500 Regional Banks Index ($XPBC)

Bank borrowings from the Fed and FHLB spiked to $475 billion in a week.

Bank Deposits & Borrowings

Financial markets are likely to remain unsettled for months to come.

European Banks

European banks are not immune to the contagion, with a large number of banking stocks falling dramatically.

European Banks

Credit Suisse (CS) was the obvious dead-man-walking, after reporting a loss of CHF 7.3 billion in February 2023, but Deutsche Bank (DB) and others also have a checkered history.

Credit Suisse (CS) & Deutsche Bank (DB)

3. Underlying Causes of Instability

The root cause of financial instability is cheap debt. Whenever central banks suppress interest rates below the rate of inflation, the resulting negative real interest rates fuel financial instability.

The chart below plots the Fed funds rate adjusted for inflation (using the Fed’s preferred measure of core PCE), with negative real interest rates highlighted in red.

Fed Funds Rate minus Core PCE Inflation

Unproductive Investment

Negative real interest rates cause misallocation of capital into unproductive investments — intended to profit from inflation rather than generate income streams. The best example of an unproductive investment is gold: it may rise in value due to inflation but generates no income. The same is true of art and other collectibles which generate no income and may in fact incur costs to insure or protect them.

Residential real estate is also widely used as a hedge against inflation. While it may generate some income in the form of net rents, the returns are normally negligible when compared to capital appreciation.

Productive investments, by contrast, normally generate both profits and wages which contribute to GDP. If an investor builds a new plant or buys capital equipment, GDP is enhanced not only by the profits made but also by the wages of everyone employed to operate the plant/equipment. Capital investment also has a multiplier effect. Supplies required to operate the plant, or transport required to distribute the output, are both likely to generate further investment and jobs in other parts of the supply chain.

Cheap debt allows unproductive investment to crowd out productive investment, causing GDP growth to slow. These periods of low growth and high inflation are commonly referred to as stagflation.


The chart below shows the impact of unproductive investment, with private sector debt growing at a faster rate than GDP (income), almost doubling since 1980. This should be a stable relationship (i.e. a horizontal line) with GDP growing as fast as, if not faster than, debt.

Private Sector Debt/GDP

Even more concerning is federal debt. There are two flat sections in the above chart — from 1990 to 2000 and from 2010 to 2020 — when the relationship between private debt and income stabilized after a major recession. That is when government debt spiked upwards.

Federal & State Government Debt/GDP

When the private sector stops borrowing, the government steps in — borrowing and spending in their place — to create a soft landing. Some call this stimulus but we consider it a disaster when unproductive spending drives up the ratio of government debt relative to GDP.

Research by Carmen Reinhart and Ken Rogoff (This Time is Different, 2008) suggests that states where sovereign debt exceeds 100% of GDP (1.0 on the above chart) almost inevitably default. A study by Cristina Checherita and Philip Rother at the ECB posited an even lower sustainable level, of 70% to 80%, above which highly-indebted economies would run into difficulties.

Rising Inflation

Inflationary pressures grow when government deficits are funded from sources outside the private sector. There is no increase in overall spending if the private sector defers spending in order to invest in government bonds. But the situation changes if government deficits are funded by the central bank or external sources.

The chart below shows how the Fed’s balance sheet has expanded over the past two decades, reaching $8.6 trillion at the end of 2022, most of which is invested in Treasuries or mortgage-backed securities (MBS).

Fed Total Assets

Foreign investment in Treasuries also ballooned to $7.3 trillion.

Fed Total Assets

That is just the tip of the iceberg. The US has transformed from the world’s largest creditor (after WWII) to the world’s largest debtor, with a net international investment position of -$16.7 trillion.

Net International Investment Position (NIIP)

4. Interest Rates & Inflation

To keep inflation under control, central bank practice suggests that the Fed should maintain a policy rate at least 1.0% to 2.0% above the rate of inflation. The consequences of failure to do so are best illustrated by the path of inflation under Fed Chairman Arthur Burns in the 1970s. Successive stronger waves of inflation followed after the Fed failed to maintain a positive real funds rate (green circle) on the chart below.

Fed Funds Rate & CPI in the 1970s

CPI reached almost 15.0% and the Fed under Paul Volcker was forced to hike the funds rate to almost 20.0% to tame inflation.

Possible Outcomes

The Fed was late in hiking interest rates in 2022, sticking to its transitory narrative while inflation surged. CPI is now declining but we are likely to face repeated waves of inflation — as in the 1970s — unless the Fed keeps rates higher for longer.

Fed Funds Rate & CPI

There are two possible outcomes:

A. Interest Rate Suppression

The Fed caves to political pressure and cuts interest rates. This reduces debt servicing costs for the federal government but negative real interest rates fuel further inflation. Asset prices are likely to rise as are wage demands and consumer prices.

B. Higher for Longer

The Fed withstands political pressure and keeps interest rates higher for longer. This increases debt servicing costs and adds to government deficits. The inevitable recession and accompanying credit contraction cause a sharp fall in asset asset prices — both stocks and real estate — and rising unemployment. Inflation would be expected to fall and wages growth slow.  The eventual positive outcome would be more productive investment and real GDP growth.

5. The Impact on Stocks

Stocks have been distorted by low interest rates and QE.

Stock Market Capitalization-to-GDP

Warren Buffett’s favorite indicator of stock market value compares total market capitalization to GDP. Buffett maintains that a value of 1.0 reflects fair value — less than half the current multiple of 2.1 (Q4, 2022).

Stock Market Capitalization/GDP


The S&P 500 demonstrates a more stable relationship against sales than against earnings because this excludes volatile profit margins. Price-to-Sales has climbed to a 31% premium over 20-year average of 1.68.

S&P 500 Price-to-Sales

6. Flight to Safety

Elevated risk is expected to cause a flight to safety in financial markets.

Cash & Treasuries

The most obvious safe haven is cash and term deposits but recent bank contagion has sparked a run on uninsured bank deposits, in favor of short-term Treasuries and money market funds.


Gold enjoyed a strong rally in recent weeks, testing resistance at $2,000 per ounce. Breakout above $2,050 would offer a target of $2,400.

Spot Gold

A surge in central bank gold purchases — to a quarterly rate of more than 400 tonnes — is boosting demand for gold. Buying is expected to continue due to concerns over inflation and geopolitical implications of blocked Russian foreign exchange reserves.

Central Bank Quarterly Gold Purchases

Defensive sectors

Defensive sectors normally include Staples, Health Care, and Utilities. But recent performance on the S&P 500 shows operating margins for Utilities and Health Care are being squeezed. Industrials have held up well, and Staples are improving, but Energy and Financials are likely to disappoint in Q1 of 2023.

S&P 500 Operating Margins


Commodities show potential because of massive under-investment in Energy and Battery Metals over the past decade. But first we have to negotiate a possible global recession that would be likely to hurt demand.

7. Australian Perspective

Our outlook for Australia is similar to the US, with negative real interest rates and financial markets awash with liquidity.

Team “Transitory”

The RBA is still living in “transitory” land. The chart below compares the RBA cash rate (blue) to trimmed mean inflation (brown) — the RBA’s preferred measure of long-term inflationary pressures. You can seen in 2007/8 that the cash rate peaked at 7.3% compared to the trimmed mean at 4.8% — a positive real interest rate of 2.5%. But since 2013, the real rate was close to zero before falling sharply negative in 2019. The current real rate is -3.3%, based on the current cash rate and the last trimmed mean reading in December.

RBA Cash Rate & Trimmed Mean Inflation

Private Credit

Unproductive investment caused a huge spike in private credit relative to GDP in the ’80s and ’90s. This should be a stable ratio — a horizontal line rather than a steep slope.

Australia: Private Credit/GDP

Government Debt

Private credit to GDP (above) stabilized after the 2008 global financial crisis but was replaced by a sharp surge in government debt — to create a soft landing. Money spent was again mostly unproductive, with debt growing at a much faster rate than income.

Australia: Federal & State Debt/GDP


Money supply (M3) again should reflect a stable (horizontal) relationship, especially at low interest rates. Instead M3 has grown much faster than GDP, signaling that financial markets are awash with liquidity. This makes the task of containing long-term inflation much more difficult unless there is a prolonged recession.

RBA Cash Rate & Trimmed Mean Inflation


We have shown that risk in financial markets is elevated and the recent bank contagion is likely to leave markets unsettled. Long-term causes of financial instability are cheap debt and unproductive investment, resulting in low GDP growth.

Failure to address rising inflation promptly, with positive real interest rates, is likely to cause recurring waves of inflation. There are only two ways for the Fed and RBA to address this:

High Road

The high road requires holding rates higher for longer, maintaining positive real interest rates for an extended period. Investors are likely to suffer from a resulting credit contraction, with both stocks and real estate falling, but the end result would be restoration of real GDP growth.

Low Road

The low road is more seductive as it involves lower interest rates and erosion of government debt (by rapid growth of GDP in nominal terms). But resulting high inflation is likely to deliver an extended period of low real GDP growth and repeated cycles of higher interest rates as the central bank struggles to contain inflation.

Overpriced assets

Vulnerable asset classes include:

  • Growth stocks, trading at high earnings multiples
  • Commercial real estate (especially offices) purchased on low yields
  • Banks, insurers and pension funds heavily invested in fixed income
  • Sectors that make excessive use of leverage to boost returns:
    • Private equity
    • REITs (some, not all)

Relative Safety

  • Cash (insured deposits only)
  • Short-term Treasuries
  • Gold
  • Defensive sectors, especially Staples
  • Commodities are more cyclical but there are long-term opportunities in:
    • Energy
    • Battery metals


  1. The Dow fell 25% in 1966 after the yield curve inverted. The NBER declared a recession but later changed their mind and airbrushed it from their records.


1. Which is the most likely path for the Fed and RBA to follow: the High Road or the Low Road?

Answer: As Churchill once said: “You can always depend on the Americans to do the right thing. But only after they have tried everything else.” With rising inflation, the Fed is running out of options but they may still be tempted to kick the can down the road one last time. It seems like a 50/50 probability at present.

2. Comment on RBA housing?

We make no predictions but the rising ratio of housing assets to disposable income is cause for concern.

Australia & USA: Housing Assets/Disposable Income

3. Is Warren Buffett’s indicator still valid with rising offshore earnings of multinational corporations?

Answer: We plotted stock market capitalization against both GDP and GNP (which includes foreign earnings of US multinationals) and the differences are negligible.

SVB update

SVB Financial Group (SIVB) reported Thursday that it needed to raise $2.5 billion to cover losses on security investments. Its subsidiary, Silicon Valley Bank was closed Friday, with regulators appointing the FDIC as administrator.

Total liabilities of the group are $195 billion, according to its last report, including $173 billion of deposit liabilities. The FDIC guarantees deposits up to $250,000 but many silicon Valley tech companies and hedge funds had far larger deposits at SVB. Assets consist of $74 billion in net loans after provisions and $121 billion in securities investments, including $92 billion of mortgage-backed securities (MBS).

It appears that the bank suffered capital losses due to its maturity-mismatch: investing in longer-term securities which they funded with far shorter-term deposit liabilities and loans. This a typical bank scenario, borrowing short at low rates and lending long to profit from the interest rate margin. Steep rate hikes by the Fed scuppered the bank’s strategy, with interest margins turning negative as short-term rates spiked.

The FDIC are auctioning the failed Silicon Valley Bank, with bids due late Sunday afternoon.

Treasury Secretary Janet Yellen suggested in an interview that a bailout is out of the question but regulators are discussing the creation of a backstop for uninsured deposits.


We consider it unlikely that uninsured deposit holders will incur losses. Even if we double the capital shortfall to $5 billion, this represents only 2.6% of total liabilities. The bank is worth more than the sum of its assets as a going concern, with a strong client base amongst tech companies and hedge funds in the greater San Francisco area. We expect auction bids to reflect this.

If strong bids fail to materialize, regulators are likely to organize a rescue by a consortium of banks — as has been done many times in the past — backed by incentives from the Fed/Treasury (despite Yellen’s protestations).

This was not a liquidity crisis, with the bank holding large amounts of readily-marketable securities — this was a solvency issue.

Other regional banks may have been similarly impacted by the sharp rise in interest rates and we expect the Fed to hold a review (stress test) to assess the impact of rate hikes on other banks, to allay market fears.

The long-term impact is that financial market nervousness will remain high, with banks increasingly reluctant to lend to their peers other than through (secured) repo markets. The problem is far wider than just banks, with many highly-leveraged hedge funds and private equity firms having gorged themselves on cheap debt. If there is going to be a crisis it is likely to emerge from the unregulated shadow banking sector — as has happened many times before* — and not from the regulated banking sector.

We are edging closer to a credit contraction that would precipitate a recession.

Latest News

From Wolf Richter, March 12:

….Now we got it officially, in a joint announcement by Yellen, Fed Chair Jerome Powell, and FDIC Chairman Martin Gruenberg. The bailout of uninsured depositors has arrived, so now all depositors of Silicon Valley Bank and Signature Bank, which was shut down today, will be made whole, not just insured depositors. The banks that are still standing can borrow from the Fed under a new facility. But investors in failed banks are on their own.

“After receiving a recommendation from the boards of the FDIC and the Federal Reserve, and consulting with the President, Secretary Yellen approved actions enabling the FDIC to complete its resolution of Silicon Valley Bank, Santa Clara, California, in a manner that fully protects all depositors. Depositors will have access to all of their money starting Monday, March 13,” the statement said.


* Shadow banks precipitating a financial crisis go as far back as 1907, when collapse of the Knickerbocker Trust caused a widespread banking crisis that led to creation of the Federal Reserve in 1913. The LTCM collapse of 1998 is another such example. More recently, the sub-prime crisis of 2008 led to the absorption of highly-leveraged major investment banks into the regulated banking system.

Warren Buffet: Fiscal Deficits and Runaway Inflation

“During the decade ending in 2021, the United States Treasury received about $32.3 trillion in taxes while it spent $43.9 trillion. Though economists, politicians and many of the public have opinions about the consequences of that huge imbalance, Charlie and I plead ignorance and firmly believe that near-term economic and market forecasts are worse than useless…..Berkshire offers some modest protection from runaway inflation, but this attribute is far from perfect. Huge and entrenched fiscal deficits have consequences.”

~ Berkshire Hathaway Newsletter to Shareholders, 2022


There are three potential sources of funding for fiscal deficits of which two are inflationary:

  1. The private sector. Deficits funded by the private sector have no impact on inflation. The rise in public spending is offset by a decline in private spending/increase in savings.
  2. Commercial banks. Inflationary. The bank simply swaps one asset on their balance sheet for another: bank reserves at the Fed are exchanged for Treasury securities. Public spending rises but is not offset elsewhere.
  3. Foreign investors (including banks). Inflationary. Public spending rises but there is no offset. The inflow on capital account is matched by an outflow on current account.

Stocks retreat as Treasury yields rise

The S&P 500 retreated from resistance at 4100. Reversal below 4000 would warn of another test of primary support at 3500. We remain in a bear market, with 12-month Rate of Change below zero.

S&P 500

The recent rally was caused by falling long-term yields, with 10-year Treasuries testing support at 3.5%. Rising yields are now precipitating a retreat in stocks.

Treasury Yields: 10-Year

Slowing Treasury issuance, ahead of debt ceiling negotiations, may have contributed to declining yields but this has been offset by foreign sales, notably by the Bank of Japan.

Bank of Japan Sales

The Treasury yield curve remains inverted, with the 10-Year minus 3-Month at an alarming -0.97%, warning of a recession in 6 to 18 months.

Treasury Yields: 10-Year minus 3-Month

Commercial banks borrow short, with most deposit maturities less than a year, while lending on far longer terms in order to capture the term premium. When the yield curve inverts, net interest margins are compressed, making banks willing to lend only to the most secure borrowers. Credit standards (green below) are being tightened but credit growth (pink) remains strong. Credit growth is likely to decline in the months ahead and would warn that a recession is imminent.

Domestic Banks Tightening Standards & Credit Growth

Fed operations reduced liquidity in financial markets but this has been partially offset by Treasury’s running down their General Account (TGA) at the Fed (which injects money into the economy). The net result is a $1.2 trillion reduction in liquidity.

Fed Net Asset Purchases

The breakdown is illuminating, with the Fed reducing its balance sheet (blue below) by $469 billion to the end of January, while reverse repo operations (green below) removed $2.4 trillion. Treasury, however, partially offset this by running down their TGA account (red) from $1.8 trillion in July 2020 to $0.5 trillion in January 2023.

Fed Net Asset Purchases

The net effect is a fall in the money supply (M2) relative to GDP, from 0.90 to 0.82. But there is still a long way to go. The ratio of M2 to GDP should ideally be a constant, with money supply growing at the same pace as GDP. Lax monetary policy instead allowed money to grow at a faster pace than national income, resulting in high inflation as aggregate demand runs ahead of output.



The primary cause of bull and bear markets is liquidity. Stock prices could well remain high, even while the Fed hikes interest rates, if financial markets are awash with cash. Only when credit growth slows, and the Fed sells more Treasuries, are prices likely to collapse. External factors, like foreign investor sales, may also shrink liquidity but are a lot harder to predict.

The pig is still in the python. The large gap between deposits at commercial banks (blue below) and bank lending to private borrowers (pink) is represented mainly by commercial bank holdings of Treasury and agency securities.  Only when that has been worked out of the system will financial conditions be restored to some semblance of normality.

Bank Credit & Deposits


Christophe Barraud for the Bloomberg link on BOJ Treasury sales.

A bear market for bonds?

In 2009, Warren Buffett wrote:

“Economic medicine that was previously meted out by the cupful has recently been dispensed by the barrel. These once-unthinkable dosages will almost certainly bring on unwelcome aftereffects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation…..”

He was wrong about inflation. The next decade enjoyed low inflation, despite loose monetary policy, for two reasons. First, globalization had flooded the global economy with hundreds of millions of Chinese workers — earning a fraction of Western wages — a huge deflationary shock that depressed wages growth. Second, a contracting US economy, after the global financial crisis, added to deflationary pressures. The combined effect offset the inflationary impact from profligate monetary policy.

Manufacturing wages

The world has now changed. On-shoring of critical supply chains and geopolitical tensions with Russia and China are stoking inflationary pressures. Warren Buffett’s warning now seems prescient as the Fed struggles to cope with inflation fueled by combined fiscal and monetary policy during the pandemic.

The abrupt reversal in Fed monetary policy has increased the risk of recession. All traces of the word “transitory” have disappeared from press announcements, switching to the mantra “higher for longer”. The Fed funds rate is expected to reach 5.0% in the next few months, causing job losses later in the year.

Fed Funds Target Rate

10-Year Treasury yields broke former resistance at 3.0%, reaching 4.0% before retracing. Respect of support at 3.0% would confirm that the almost forty-year bull market in bonds is over.

10-Year Treasury Yield

Falling long-term yields caused a massive surge in private debt during the bull market, with non-bank debt more than doubling relative to GDP.

Non-Financial Debt/GDP

Federal debt, even worse, grew four times relative to GDP.

Federal Debt/GDP

The surge in debt inevitably fueled speculation in real assets, with a similar rise in stock market capitalization relative to GDP.

Stock Market Capitalization/GDP


The significance of debt to GDP ratios should not be underestimated.

Increasing debt to fund investment in real assets is a sound investment strategy in a bond bull market, so where’s the harm?

When an individual or corporation invests, their goal is to generate income from the investment. The income stream is applied to pay the interest on the debt and repay loan capital over a reasonable period. An investment that fails to generate sufficient income and requires the borrower to capitalize interest against the loan is generally considered a failure. And likely to lead to a forced sale when the economy contracts and access to credit dries up.

The overall economy is headed for a similar predicament. When debt growth outstrips income, it warns that borrowers are capitalizing interest and headed for a disaster. The Fed can attempt to postpone the day of reckoning by suppressing interest rates and injecting liquidity. But this just encourages more debt growth and investment in even riskier assets, compounding the problem.

We are now approaching a watershed. An inverted yield curve warns that credit growth is about to dry up. Banks borrow short and lend long, so a negative spread between long-term and short-term interest rates discourages lending.

Treasury Yields: 10-Year minus 3-Month

The Fed faces a tough choice: (A) allow a bond market to cause a sharp fall in asset prices and an inevitable deep recession; or (B) kick the can down the road, suppressing long-term yields to postpone the inevitable collapse, but make the problem even bigger.

Recent falls in CPI do not mean that the Fed has won the fight against inflation. This is likely to be a long, protracted battle. Winning the first round is a good start, but does the Fed have the political cover to stay the distance?

The bond market is pricing in rate cuts by the end of the year, expecting that the Fed will pivot to plan B.

Gold investors appear to share their conviction.

Spot Gold