May 2002, around 9 months after 9/11, I'm in the Toronto airport after meeting with the CEO of Blackberry.
I see a plane come in for its landing and SPLAT!
The belly of the plane hits the ground and splits the plane in half. Smoke bellows in a cloud. The airport evacuates, fearing it's a terrorist attack. Miraculously, they evacuated everyone in 90 seconds with only minor injuries.
What happened?
When planes are in the air, sometimes they hit turbulence called vertical Wind Shears and just drop 50 feet. No harm, no foul, unless you are coming in for a landing.

This past week, global markets hit a wind shear, with barely-avoided mass casualties. History rhymes (with 2008). "Smart" institutional investors taking risks they don't understand and being caught in a market wind shear. UK pension funds missed the fine print in the yield-enhancing derivatives they had bought hand-over-fist: unlimited losses.

Why Should I Care?

This is a longer, more technical email. I peppered it with stories :) Why read it?

Each market cycle, a catalyst drives markets to their bottom.

For tech in 2000, it was the AOL/Time Warner merger (and behind that the second derivative of people joining the internet slowed that same week).
For 2008, it was the AIG, Fannie Mae and Freddie Mac bailouts in August, followed by the Lehman Brothers Bankruptcy in September.
It looks like the British pound could be this cycle's canary-in-the-coalmine event.

It's worth understanding because we can then see when the dust settles to be able to take more risk.

I will cover:

What happened to the British Pound and why it matters to you even if you buy everything in US dollars
What are Bond Vigilantes and how bond markets and currency markets interact to drive up your own home mortgage.
US Market implications of this crazy week.

1. WTF Happened to the British Pound?

Economic Wind Shears

“How did you go bankrupt?” Bill asked.

“Two ways,” Mike said. “Gradually and then suddenly.”

- Ernest Hemingway’s 1926 novel, The Sun Also Rises.

Like wind shears and bankruptcies, economic forces happen gradually then suddenly:

Too much "free money" (low interest rates that are below what economically makes sense) for too long leads to
Too much risk-taking, out-of-control inflation, and investment in assets that will never yield a return, leads to
Market dislocations, disruptions, and increased likelihood of air pockets

The more governments try "extraordinary" measures like the UK's big unfunded tax cuts, the more likely one or many of these measures have unintended consequences... and investors lose confidence in central banks, governments and markets.

Then global markets hit a wind shear.

My British Pound Experience

Backing up a bit

In 1975, when I was 9 years old, my mother was shopping at Safeway, checked the cork board to see who was offering what, and saw a sheet with phone numbers you can tear away that said "English Nanny"

HIRED! Coxy was my Mary Poppins.

She was in the US on a visitor's visa, so after working for us for 4 months, she needed to go home. My mother asked if Coxy would take me with her. I was sent to the UK to live with a family my mother had met months before via a Safeway supermarket bulletin board.

We (my UK family) were poor.

Coxy and her daughter Joyce were on welfare. We could only afford meat once a week. Our home had no heat.

The railroad had a charity that gave each poor kid a Christmas present. I had been asking for a cash register for years and my mother kept giving me dolls and necklaces. I checked the box for a cash register and got a fantastic toy cash register from the Southampton Railroad!

This was 1975 in the UK.

High inflation, weak economies and terrorism were the norm.

It wasn't just us who were poor.

The British pound was expensive. Food was expensive. Inflation was rampant. Life was difficult for many.

I was in the UK when the Pound hit it's first Wind Shear, going from 2.3 to 1.7 in 6 months (down 25%, a lot for a currency). When I went there, 2.3 British Pounds bought you one US Dollar.

Today? It's nearly 1 to 1. That is a massive decline in purchasing power for the Brits. How did this happen?

Exchange rates are complex.

At their simplest, they represent the relative strength of a country's economy vs other countries' economies.

Money is heat-seeking.

Currency value goes up when more money flows into a country to buy stocks and bonds or invest in real estate or businesses. Do something like the UK did (announce tax cuts you can't afford that will increase inflation you can't control) and investors lose faith in your ability to manage your economy, and they sell stocks, bonds, and more, driving down demand for (and the price of) the currency.

This is just like investors selling a stock when they lose confidence in a management team.

In volatile times, investors run for the exit doors to the "safer" economies, thus the USD goes up and British Pound goes down.

Currency movements are both simple & logical, and super complex.

At their simplest, it's about relative supply and demand: Where do you want to be invested?

But exchange rates are complicated by movements in bonds, stocks, central banks, and politicians. Countries try all kinds of tricks to support their currency and attract investors.

The US is still considered a safe haven...for now.

Typically, other currencies will crash while the US dollar will get stronger when we are in more uncertain economic times. Investors are wanting to hold US stocks, bonds and real estate to reduce their risk.

A strong US Dollar sounds good, but watch out for those unintended consequences

Loving the purchasing power when in Europe (good thing), BUT
Asian and other countries we loan money to are borrowing in USD, but their revenues are in their local currency.
If the USD doubles in value vs their local currency, they now need to earn TWICE as much revenue to pay the loan. This was the main cause of the 1998 Asian Financial Crisis and the 1982 Mexican Debt Crisis.
Bond markets are clearing prices for what companies can borrow at. International bond markets are greatly impacted by currency markets. And those two feed back into equity markets.

2. Enter the Bond Vigilantes

(and how George Soros made $1 Billion on a single trade in 1992)

My first job post-MBA was running a billion dollar bond portfolio for Farmers Insurance. I wasn't seasoned enough to be a Bond Vigilante, but I saw them in action.

In equities, day-to-day valuation is a combination of the company's relative narrative plus market risk appetite. Sure, there are dividend yields, price-to-earnings or price-to-sales ratios, but how often do they hold? When investors want to buy, the price goes up.

Bonds are different.

The price of a bond is the inverse of its yield. Period.

Price goes up, yield goes down.
Risk goes up, yield should go up (what you are paid to take the risk)

If you see two gas stations with the same gas for sale, and one is 30% off, you go to that one. Pretty soon they raise the price. Same with bonds.

Money is heat-seeking.

Bond investors-aka-vigilantes can look across the globe and decide where they are getting the best risk-adjusted yields, AFTER currency conversion.

A bond vigilante is a bond market investor who protests against monetary or fiscal policies considered inflationary by selling bonds, thus increasing yields.

In the bond market, prices move inversely to yields. When investors perceive that inflation risk or credit risk is rising they demand higher yields to compensate for the added risk.[2] As a result, bond prices fall and yields rise, which increases the net cost of borrowing. The term refers to the ability of the bond market to serve as a restraint on the government's ability to over-spend and over-borrow.

- Investopedia

The British Pound has crashed gradually, then suddenly. Several times over the past 50 years.

The UK government doesn't want its people to lose their global purchasing power. So they use interest rates and other strategies to prop up the British pound. But bond investors see the risks: higher interest rates mean slower economic growth, thus higher risk the UK economy does worse than the US economy. With similar yields in the US, bond investors go there, driving demand for US dollars and reducing the value of the British Pound.

The UK government uses tax cuts (big ones last week) to give citizens more take-home pay, but this will drive up their deficit and inflation, hurting their future economy, so bond vigilantes demand higher yields AND on the margin they sell UK bonds and buy US bonds, increasing demand for the US Dollar and decreasing demand for the British Pound.

As the pressure mounted, and the UK government had to use more and more extreme measures.

Talk about unintended consequences. The British Pound goes down as interest rates go up (more something that happens in emerging markets - as normally higher interest rates attract bond investors - unless they have lost faith in the government to manage its finances... which happens often in emerging markets, but not for a top 7 economy)

Last Friday (September 23, 2022), the British pound and bond markets started trading like an emerging market, which means the markets went into distress. Investors, including me, and the IMF (International Monetary Fund) were confused by the Brit's actions.

Gas, brakes, gas, brakes. Enough to give anyone whiplash:

Slowly then all of a sudden... Unintended consequences rear their ugly head.

In 2008 when all mortgage derivatives were modeled using the assumption that nationwide housing prices never declined nationwide, so when they did, the derivatives performed in unexpected and negative ways, leading to the Lehman bankruptcy, AIG, Fannie Mae and Freddie Mac bailouts.

It's highly likely that the UK didn't EVER expect their currency and bond markets to interact like they would if they were an emerging economy (ie bonds and currency go in the same direction)... so that assumption was embedded into those derivatives.

Like a bad sequel to 2008, UK pension funds were investing in interest rate derivatives, called LDIs, (whose fine print said they had potential for unlimited losses) to boost their returns and got caught with their pants down (margin calls that might have severely hurt most UK retirement accounts). So Monday's reversal of injecting liquidity was not a policy change to move back to printing money, but rather a move to prop up pension funds' books because they bought derivatives they couldn't imagine would move the way they did.

From a quick glance at the following chart, you can see that over a longer time frame, the US dollar to British Pound exchange rate is unsustainable at or above 2.0. And over time, as the UK has gotten less competitive vs the US, the rate has drifted down.

It crashed when I was in the UK in 1975-1977 (US exited the gold standard, high inflation, oil price shocks)
It crashed from 1979-1985 following Volker rate hikes in the US and global recession.
It crashed in 2008 with the Global Recession

In 1992, George Soros "went to battle" by shorting the British Pound at 2.0 and walked off with a $1 Billion profit (his big risk/bet that made him wealthy). See that swoon from 2.0 to 1.4 in 1992. That was Soros' big wealth-building moment.

3. US Market Implications

What we are heading into right now:

Layoffs (especially in tech)
High inflation (Eurozone went above 10%)
Spiking bond yields (and mortgage rates)
Large currency swings

Any of these could impact markets. All of them increase the potential of markets hitting a Wind Shear.

Morgan Stanley is warning about the risks of this much US Dollar appreciation:

Crisis: The "recent move in the US dollar creates an untenable situation for risk assets that historically has ended in a financial or economic crisis, or both," equity strategist Mike Wilson said. "While hard to predict such 'events,' the conditions are in place for one, which would help accelerate the end to this bear market."

[fyi, accelerating the end to this bear market means a downward Wind Shear in stock prices... funny how Morgan Stanley makes that sound like a good thing!]

"In the meantime, we remain convicted in our eventual low for the S&P 500 (SP500) (SPY) coming later this year/early next between 3000-3400 (in line with our base and bear case tactical views, respectively)," Wilson said.

"On a year over year basis, the DXY is now up 21% and still rising," he added. "Based on our analysis that every 1% change in the DXY has around a -0.5% impact on S&P 500 earnings, 4Q S&P 500 earnings will face an approximate 10% headwind to growth all else equal

Yes, this seems scary, but just like I wrote in June, near-term we are once again oversold, so poised for a bounce.

It may seem simplistic, but in my career I noticed that if we had a big selloff prior to earnings season.
Then the first week of earnings investors were excited to hear management teams were still alive and some had OK earnings, thus stocks rallied.
It's a bear market "not-as-bad-as-feared" rally, but like we saw from June through July, these can go up 20% or more.

HOWEVER, this rally may be short-lived...

1. The UK may not have enough reserves to defend the British Pound long term (the same bet George Soros took in 1992):

2. The bond vigilantes are alive and well, and the US may not be immune.

There are competing forces. If the US goes back to QE (quantitative easing, ie money printing), then bond markets will rally and yields will come down, thus your mortgage rates may come back down after spiking significantly and threatening a downturn in US housing.

However, QE drives up inflation, which causes significant economic risks, as covered in last week's email. Thus inflation requires the Fed to be diligent with increasing rates.

Finally, the Fed doesn't have the final say on rates. The bond vigilantes do. The fed can set the prime rate, but bond traders decide the price they will trade at, ie risk premium above the prime rate.

Let's keep learning and stay nimble.

"Emmy, I really enjoy your economic newsletter." - My friend
Me: Um, thanks (but this isn't an economic newsletter).
This newletter is about finding leverage, growing wealth and understanding markets. Right now, understanding the economy will get you those three things.

Wealth is built by:

Taking calculated risks
Minimizing drawdowns

In my time working with Billionaires, there are three things I learned about building big wealth:

They benefitted from an early big win (calculated risk)
They shifted focus to minimizing losses to maximize compounding off that first big win
They knew where they came from, ie what their strengths were, and stayed focused on leveraging those strengths.

What does that mean for you right now?

In these volatile markets, the focus turns to minimizing drawdowns while looking for your moment to take calculated risks. And the risk of losses comes from inflation, bond markets, currency markets - ie what is happening as the markets and economy collide.

Wise investors study the economy to best weather this storm.

And I look back at my newsletter over the past several months and it has morphed into an economic newsletter. We won't be here forever, I promise!