From Capital & Conflict (Great Britain)-
It’s a little known fact that in the Great Train Robbery of 1963, the theft of £2.6 million in cash from a Royal Mail train travelling between Glasgow and London was accomplished by tampering with the line signals in order to stop the train. As train robberies go it was audacious. The haul was around £50 million in today’s money.
But as criminals masterminds go, the gang of 15 robbers that pulled off one of the most infamous heists in British history can’t compare to the current gang running the world’s central banks. Those people – Janet Yellen, Mario Draghi, Mark Carney and Haruhiko Kuroda – have managed to pull off an even greater heist.
By tampering with price signals – and here I’m talking about short-term and long-term interest rates – those central bankers have put trillions in global savings at risk. While the world has focused on the risks of Brexit, a bigger and more dangerous risk has emerged. The risk? That the “endgame” for central banks results in a massive fall in both stock and bond prices.
What about Brexit?
The last polls before last Thursday’s vote suggested Remain would take the day. As my college Charlie Morris of The Fleet Street Letter noted, that result would have seen UK equities in general, and British banks in particular, experience a nice surge.
That didn’t happen. Far from it. A Leave victory sparked chaos in financial markets. The FTSE’s down 350 points from its Thursday level, when the assumed Remain victory was already priced in. Banks, meanwhile, have been pounded. The FTSE 350 banks index is down around 17%, with certain big players like Lloyds hit even worse.
I personally think leaving will prove to be the best result for Britain in the long-run, despite this short-term turmoil. We were prepared for that turmoil, covering news as it unfolded on Friday. We’ll be doing the same over the coming weeks.
While the Brexit debate has raged, a bigger and more important story has been brewing. It’s the story of how a small cadre of central bankers took global interest rates to record lows, caused yet another dangerous bubble in financial asset prices (bonds), and managed to put the savings of an entire generation at risk when interest rates rise again.
That interest rates could rise again – contrary to the express interests of central banks – is a claim that may surprise some readers. But it’s precisely when everyone thinks a trend can only go in one direction that you have to force yourself to think differently. The big moves – the ones that ruin some investors and reward others – happen when you least expect them.
You’d have plenty of company in thinking official rates will stay low for a long time. For starters, the US Federal Reserve backed off on its plan to “normalise” rates at its mid-June meeting. The immediate culprit was the weakest jobs report in six years in May. The “experts” expected 160,000 jobs to be added. They got 38,000. That puts paid – or at least a serious dent – to the idea that the US is recovering.
That disappointing number led traders to dial back their expectations of any Fed rate hikes in 2016. Markets now reckon the next Fed rate hike won’t happen until February 2017. Fed Chair Janet Yellen has changed her tune publicly, saying that the current target Fed funds rate of between .25 and .50 basis points is “generally appropriate.”
In response, and partly due to Brexit anxiety, ten-year US Treasury yields touched a low of 1.57% in mid-June. That in itself wasn’t alarming. But what happened next was. The “term premium” on the ten-year went to a record low, as you can see from the chart. What exactly does that mean?
The term premium is the reward you typically get for preferring long-term government bonds over shorter-term ones. As you can see from the chart, until recently there was a premium for buyers of ten-year US Treasuries.
Here’s a question though: when is a premium not a premium?
How about when it’s negative? The term premium on the ten-year US Treasury went negative in June. That’s why the line on the chart above goes below zero on the right hand side. In other words, you’re not getting any extra compensation for lending long-term to the government. You’re getting slightly less loss, which is compensation of a sort I suppose.
In a highly risk-averse market – like the one we had in the lead up to the Brexit vote – no one wants any compensation for risk taking. They want safety and capital preservation. Any port in a storm, as the saying goes. The negative yield on government bonds is, then a kind of “capital preservation premium.”
But I want to suggest to you that the collapse of the Treasury term premium is, by definition, extraordinary. It’s a high-water mark for bond prices and a low-water mark for bond yields. It’s a turning point in this era of quantitative easing and low rates which almost no one noticed. And I’ll get to its implications in a moment.
Of course it’s possible that if growth stays sluggish the Fed could follow the European Central Bank and the Bank of Japan (BoJ) and adopt a negative policy rate. The implications of such a move are vast (and massively bullish for gold). But the subject of negative Fed rates is beyond the scope of this week’s story. Let’s turn to yet another reason why investors believe it’s impossible for rates to go higher from here.
Swiss 30-years go negative
For a brief time in June, the entire Swiss yield curve – bonds of all durations, from short-term to 30-year – was negative. That’s right. The yield on a 30-year Swiss government bond went negative. That reflects extreme anxiety and risk aversion – a panicked flight to safety among institutional investors that was also reflected in the negative yield on ten-year German bunds and the lowest-ever yields for ten-year gilts.
Risk-aversion is prudent in the same way that locking yourself in the basement during a tornado is prudent. But you know we’ve reached an unusual point in economic and financial history when perfectly rational behaviour – the behaviour of financial self-preservation – leads you to accepting a small destruction of your wealth to avoid a larger one. What exactly do I mean?
This is really the heart of the matter. It’s why negative rates can’t last forever. And why we’re closer to the endgame of negative rates than the beginning. With over $10 trillion in government bonds having a negative yield, the seeds have been planted for a devastating wipe-out in the bond market. When you have governments issuing 20-, 30-, 50- and even 100-year bonds at low rates, and when you have investors eagerly buying them up, you have a dangerous situation.
Let’s turn the a normal yield curve for answers. A yield curve describes how a bond market normally works. The shorter the maturity of the bond, the lower the yield. The yield is lower because as an investor, your risk is lower (at least in theory). By “risk” I mean the risk that you won’t get your money back, or that inflation will lower the real value of your money when you’re repaid as the bond matures.
The key element is time. The shorter the time period of your loan to the government – and that’s what a bond is, a loan to the government – the less likely interest rates are to rocket up quickly. It could happen. But the risk is low. That’s important because, as you know, bond prices move inversely to bond yields. Or, in plainer terms, rapidly rising interest rates mean falling bond prices.
If you’re investing in short-term government bonds, you may not get a high-yield. In fact, these days, you’ll get next to nothing. Or worse, you’ll get a negative yield. But you are likely to get your money back, or most of. Because your time horizon is short, your risk is relatively low.
That’s not the case for longer-term bonds. And again the issue is time. The more time passes, the less we know. Or, in terms of the future, the longer-term your forecasts are about interest rates, the less reliable they’re going to be.
It doesn’t have anything to do with your intellect or the quality of your knowledge. It’s just a knowledge problem in general, and one we’d all do well to remember: no one knows what the future brings. No one.
Long-term bond investors are compensated, usually, for this ignorance of the future with higher interest rates. If you’re going to lend your money to the government for a long time, tie up your capital, and put it at risk to rising interest rates, the government will pay you a higher yield for your risk. That’s why a normal yield curve rises over time.
Here’s the point: a yield curve where all bonds of all maturities yield less than zero is not a normal yield curve. It’s not a yield curve at all. It’s a yield flat line. It’s a dead market. But in terms of risk, uncertainty, and prices, what is the flat yield curve really telling you?
If you’re buying a long-term government bond at a low interest rate, you’re not getting compensated for the uncertainty about future interest rates. Quite the contrary, in fact. You’re taking on extraordinary risk should interest rates rise.
And when interest rates are at all-time lows, well doesn’t that seem like the point of maximum risk about future yields? Can they go anywhere but up from here?
The answer, right now, is that they can go negative. But again, think about it in risk terms and you’ll realise why the status quo can’t last. Your capital is at risk with a long-term bond, because any future long-term bond with a higher yield (or even a slightly shorter maturity) will become more valuable. By “become more valuable” I mean the price of the new higher-yielding bond will go up and the price of the lower-yielding bond will go down.
That’s just competition and prices at work. Make it an issue of future bond supply and it becomes even easier to understand. Imagine interest rates going up very slowly over the next ten years. Britain’s government – which continues to run deficits – issues debt to finance its spending habit. That debt is issued at the prevailing (and steadily higher) interest rates.
The new higher-yield debt will be more attractive, and thus go up in price, then the older higher-yield debt. Why? Because given relatively equal maturities, one pays you more for your future risk than the other. The one that pays you more risk ought to be more valuable and thus go up in price.
The systemic risk of low bond yields
I hope you’re still with me on this descent into the bond market rabbit hole. But it really is an important point. When so much money is tied up in long-maturity government bonds at low yields, that money is massively at risk if and when you get a rise in interest rates. That rise can be by design. Or it can be sudden, driven by external events that nobody saw coming.
Let me return to the earlier question: How can interest rates rise if central bankers don’t raise them?
It’s a good question. But just remember, central banks only target the short-end of the yield curve with their policy rates. They aim to influence the price of short-term credit through their open market operations.
They don’t control the long-end of the curve and they haven’t tried to, at least not yet. The market controls long-term rates. That is, long-term interest rates are determined by what level of compensation investors demand for unknown long-term risks. And that’s why we have a problem today.
Central bank bond buying – and the general climate of fear about the endgame of this whole monetary experiment – has driven long-term yields down to record lows. From here they can go marginally lower. Or, they can stay low for a long period of deflation and stagnation (in which case bonds make perfect sense).
Or they can go up higher and faster than anyone currently imagines.
It’s the last scenario that worries me the most. It’s exactly what usually happens… when money dies. When people lose confidence in government issued money, when it becomes apparent that huge government debts will never be paid, or can only be paid with an inflated currency, then the market’s perception of long-term risk changes too.
Prices follow and rise. Inflation – once thought dead and buried – is off and running. The whole system is put at risk. Let’s look more closely at how it all may go down.
Three pronged failure in Japan
Here we are then, near the endgame. We know the negative interest rates incentivise dangerous risk taking. When central banks hoover up trillions in government and corporate bonds, not only do they push interest rates down or negative (incentivising more borrowing and debt) they force other investors to take greater risks with their capital in the chase for yield.
By “other investors” I mean banks, insurance companies, hedge funds, institutional investors, individual investors, and even central banks themselves. You might do a double take that central banks are negatively impacted by negative rates. But they are some of the largest holders of said bonds at the moment. Rising rates threaten central bank balance sheets bloated with government bonds.
The absurdity and the irony!
But what will be the catalyst for the big breakdown? Janet Yellen has paid lip service to the prospect of the Fed raising US rates at least two times in 2016, back toward a more “normal” 1% Fed funds rate. But what Yellen says and what she does are two different things.
“Considerable uncertainty about the economic outlook remains,” Yellen said in her bi-annual testimony in front of the Senate Banking Committee. She said, “The latest readings on the labour market and the weak pace of investment illustrate one downside risk – that domestic demand might falter.”
That doesn’t sound like a price fixer with conviction. Under questioning, Yellen acknowledged that Brexit could trigger a major restructuring of the European Union, which could generate even more “uncertainty” about global growth. Brexit is likely to be resolved by the time you read this. But there are other issues which make higher Fed rates unlikely this year.
Yellen didn’t mention China’s debt burden or global demographics or automation. But those are three other factors contributing to the global debt deflation theme and make the prospect of rising rates even more distant.
All of which leads to the question of the hour, the day, the year, and the decade: how will interest rates rise, bond prices crash, and inflation run rampant from here? Can they? Or are negative yields here to stay?
You must look to Japan for the answers. It’s been at the forefront of unconventional policy ever since its stockmarket bubble popped in 1989. First it was government spending on projects nobody needed which economists call “fiscal stimulus.” That made Japan the only Western-style economy with a government debt-to-GDP ratio in excess of 200% (it’s currently 229%).
But Japan has taken the monetary madness to new levels since Haruhiko Kuroda took over at the BoJ in 2013. It was three-pronged strategy (not to be confused with Abenomics). Prong one, buy up Japanese government bonds to push down rates and increase bank lending. Prong two, purchase exchange-traded funds (ETFs) and other assets as part of its asset purchase programme. Prong three, take deposit rates negative to dis-incentivise the hoarding of cash under the futon.
The BoJ has reached the limits of each of those policy goals. For example, it now owns a third of the entire Japanese government bond market. Its monthly asset purchase program of $745 billion (¥80 trillion) has driven down the yield on Japan’s 30-year bond to just 0.25%. Nearly two-thirds of the world’s negative yielding government bonds are Japanese.
Not content with monstering the bond market, the BoJ spends nearly $30 billion a year (¥3 trillion) on exchange-traded funds to pump up asset prices. The policy goal of pumping up ETF prices is opaque. But the facts are not. The BoJ is now, through its ETF holdings, a top ten shareholder in 200 of the 225 companies in the Nikkei 225 index, according to Bloomberg.
In April it added a twist to the ETF buying. It began spending $2.7 billion a year on ETFs that track companies who use their cash to raise wages and invest for growth. The only problem was that, at the time, no such ETFs existed! Ever eager to sell product, the financial industry promptly responded and created new ETFs for the BoJ to buy.
The third prong is taking deposit rates negative. Japan followed others in Europe by lowering the overnight deposit rate (the rate commercial banks receive/pay on excess reserves held at the central bank). But in contemplating taking rates negative on individual bank accounts – your savings, in other words – the BoJ gives you a clue of the next move you can expect to see from central bankers who are unable to produce economic growth through money creation.
Wages, Mrs Watanabe, and Weimar
Not much of the future is foreseeable. But let’s assume a post-Brexit world remains mired in stagnation, with low growth, low inflation, and seemingly no way out. What’s the next move from central banks? And how does it bring us closer to the endgame?
There are three things to watch for: helicopter money, negative deposit rates on your savings, and “stamped money,” or cash that expires. Let’s look at each of them in turn and then, finally, what you can do to prepare.
You’ve probably heard the phrase “helicopter money.” But what does it mean? It means getting cash into the system as directly as possible, by any means necessary. In Japan’s case, it could take on two meanings in 2016. How badly each fails will determine if other central banks follow the BoJ’s lead.
First is what economists call “debt monetisation.” That’s when a central bank prints money to buy government bonds directly. Debt monetisation is part of the endgame because it leads to a collapse in confidence in all government debt. If the only buyers of government are central bankers printing money, a crisis can’t be far away (if only a crisis of confidence that policy makers are intellectually bankrupt).
Japan actually tried debt monetisation in 1932, after leaving the gold standard in 1931 (the same year Britain left it). Then-Japanese finance minister Korekiyo Takahashi – sometimes referred to as the “Keynes of Japan”– ordered the BoJ to print money and buy government bonds. The BoJ then sold the bonds in the “secondary” market to investors and banks.
The whole aim, of course, was to “underpin confidence” in the economy. It certainly underpinned the financing of the Japanese war machine in the 1930s. The inflation or hyperinflation that would normally result from debt monetisation was avoided by increased government spending on the military. That’s an ominous precedent and even less desirable than hyperinflation.
But you can see the point, can’t you? Debt monetisation increases money supply and decreases confidence. That’s how deflation can become hyperinflation faster than you can say “Banzai!”
Normally, central banks don’t buy bonds directly from the government. Governments sell new debt to primary dealers, or banks that have agreed to be a market maker in government debt. It’s notable that in early June, Bank of Tokyo-Mitsubishi UFJ threatened to resign its status as one of 22 primary dealers in for the BoJ.
It did so for precisely the reasons I mentioned earlier. The mammoth presence of the BoJ in the Japanese government bond market has driven down yields and increased the risks of holding government debt. Yet that’s precisely what a primary dealer agrees to do – buy government debt in bulk and hold it if it can sell it to investors.
UFJ wants out because it’s too risky to hold long-term government debt sold at historically low yields (and high prices). It won’t be the last bank to get cold feet. That’s why helicopter money in the form of debt monetisation is what Japan could try next.
If it sounds complicated, it isn’t. It’s really just fiscal policy – government spending – financed by money printing (not borrowing or tax increases). The government would issue “perpetual bonds” that have zero coupon (pay no interest) and are continuously refinanced with the BoJ as buyer of first and only resort.
Cash and coupons
The other, less conventional helicopter money option is also something Japan tried in 1999 and 2009. It both cases, the government distributed “shopping coupons” directly to consumers in an effort to increase consumption and spending. It didn’t work. Why?
The coupons applied only to certain consumer goods. And most of them had an expiration date of six months. In other words, the coupons weren’t a cash equivalent and there was no real penalty for not “spending” them quickly. Plus, they were only good for certain items.
The next coupon initiative will have to improve on these previous failings. Future helicopter money will have to get a cash-like substance directly into the hands of consumers and then introduce an element of “time decay” so they want to spend it. Which brings me to…
Negative deposit rates
One way to get Mrs Watanabe, the proverbial Japanese housewife who buys government bonds, to spend is to tax her savings. I won’t go into the effect of negative deposit rates on your banks savings. Tim Price has already written about it extensively in The War on Cash. But it is worth nothing that even banks themselves – I’m thinking of Commerzbank in Germany – have taken to hoarding cash in vaults rather than paying negative rates to hold it with the European Central Bank.
A bank which hoards physical cash in an actual vault it owns is expressing a strong preference for taking possession of a physical asset. You only do that if you worry about liquidity in a crisis. Or you worry about the security of your claim to own something.
Think about that. If banks are worried about security and liquidity, where does that leave you?
In Japan, it’s led to soaring sales of safes and the stuffing of mattresses with banknotes. The policy produces exactly the opposite effect of what it was designed for. A measure to increase spending actually increases hoarding, thus accelerating the coming of the monetary endgame.
Gessell and “stamped money”
Prior to the abolition of cash or the creation of digital legal tender created by governments which replaces cash, there is that awkward phase where governments will have to punish people for cash hoarding – all in the name of stimulus of course! Luckily, there is a plan for that.
“Stamped money” is money that requires a government stamp on it to be considered legal tender and used for every day transactions. The concept was developed by 19th century German anarchist Silvio Gesell. His ideas were briefly implemented in 1932 in the German town of Wörgl. Money that depreciates is money that has to be spent before it becomes worthless.
You can see how it would work. First, the stamp tax itself acts as incentive to spend. You have to pay the government for the stamp. Imagine larger denomination notes having a higher tax. Or imagine paying a lower tax the more money you bring in to get stamped. Or imagine that money without a stamp is simply money that has expired, completely worthless despite the face value.
As crazy as it sounds now, this is probably how cash will be phased out when the monetary endgame arrives. You need to also introduce an alternative digital currency in parallel to physical cash. But then you need to penalise the use of cash to herd people into the new digital currency (where negative rates can be imposed with a keystroke). Cash that expires if not used by a certain date, well, that’s about as powerful an incentive as you can think of to spend money.
Money is not wealth
“If you wish to destroy a nation, you must first corrupt its currency”, wrote Adam Fergusson in his 1975 classis on the Weimar inflation, When Money Dies. “Thus must sound money be the first bastion of a society’s defence,” he added. It was sage advice during the last period in our economic history when inflation destroyed the savings and retirement dreams of an entire generation.
Modern central bankers have made the destruction of sound money their central project. Quantitative easing and asset purchase programmes have inflated financial asset prices to benefit the financial class. Meanwhile, real wages have fallen for a labour force facing the triple deflationary forces of globalisation, demography and automation (robotics).
A new monetary crisis is coming. Government bonds and even cash itself may provide no refuge, although both provide liquidity of last resort in a deflationary crisis. This puts investors and savers in the extraordinary position of having to decide how much of your wealth you’re willing to lose in the coming crisis (holding negative yielding securities to maturity and accepting negative rates on your savings).
And I hope I’ve persuaded you here that desperate policies designed to avoid deflation actually accelerate the switch to hyperinflation. Rates go low and stay low. Central banks take extreme actions to stimulate demand. Their failure and the lack of confidence in the system destroys confidence money.
You can sit by and watch all this happen. Or you can so something else. You can own tangible assets outside the financial system (precious metals). But what else? Are you powerless in the face of the coming crisis?
This is the question I’ve put to all the editors and writers here at MoneyWeek Research. It’s the single most important investment question you have to deal with in the next ten years. And it’s not simply an investment question. It’s about the preservation of your wealth and the security of your retirement.
I believe the question is so important that I’ve made it the sole focus of this year’s MoneyWeek Conference. It’s called When Banking Dies: How to Prepare for the Monetary Endgame. It will be held on Monday 3 October here in London. Attendance is limited to 300 tickets, but we’ll be recording the event.
What comes next? I can’t tell you for sure. But I hope I’ve showed you here that we are approaching the endgame of this grand monetary experiment. It could come methodically or all at once. But come it will. Prepare yourself now.