This week we try to grapple with perhaps one of the most confusing topics in modern financial history, that is the phenomena of negative interest rates. It is perhaps one of the biggest side-effects of modern monetary policy and quantitative easing. To take a Greek analogy, it is the ultimate Pandora’s Box.
Before we start, please forgive the five second summary of the old Greek myth. Zeus, in retribution for Prometheus’ stealing of fire from the gods/heaven and giving it to man, presents Prometheus’s brother, and thus humanity (Prometheus had his own eagle-based punishment which we shall not delve into), with a gift, Pandora, who subsequently opened a jar/box also left in his care. Opening this box released sickness, death and other evils onto the world while leaving behind a little thing called hope when the box was quickly closed. While this example might be a little extreme, it is analogous to how little central bankers knew about the ensuing chaos in the modern economic system. Ask yourself the question, how is it logical that someone would pay to loan someone money? How is it that people pay to put money in their bank accounts? It seems illogical and attacks the very foundations of modern financial theory, in this environment the time value of money is almost flipped on its head. With many allocators, as we have previously elaborated upon, gravitating toward higher risk securities just to sustain a nominal yield.
The Start of QE…
This is a trend that is prevalent across the planet though only in Europe is it immediately visible. Quantitative Easing (though the Federal Reserve refuses to call it that) was undertaken in the US as recently as a month ago in the repo markets. We have a simple contention, that the belief system and economics we have been taught in terms of rational capital markets has reached a stage of stagnation. We need to rethink and experiment more, just as Volcker did in the 80’s despite the flak he received at the time. Simply put, QE as a phenomena was led by a select group of bankers, minds like Bernanke, Geitner et al., who were fixated on the history of the Great Depression and the ensuing catastrophe that it created. They were so fixated upon the notion of supply and demand equilibrium and the question of bubbles that they created the ultimate anti-bubble. A term we came across recently coined by a gentleman by the name of Diego Parilla, who posits that every bubble creates its mirror opposite. Think of the S&P 500 and VIX complex, while the S&P 500 might enter bubble territory, the fluctuations in the VIX is almost an antithesis to this.
Now coming back to the phenomena of negative interest rates. There are a plethora of factors that enable this to take place, namely summed up below:
Lets try and grapple with central bank policy first since it is the most obvious. When QE was first introduced in the western world by the US of A, the bankers of the time - these men had their groundings in studying the Great Depression - were fixated on avoiding a repeat of that particular disaster. What was immediately clear was that the balance sheets of the major institutions in the US were in need of rapid recapitalisation to prevent a run on banks and the contagion. In trying to achieve this goal they effectively nationalised the banking system for a period of time when the private banks and their CEO’s wouldn’t play ball in merging or buying out distressed institutions. The immediate repercussion was TARP (Troubled Asset Relief Program) with direct injections of government money into the financial system. The Europeans, fearing similar repercussions and led by the ECB, not only lowered interest rates towards zero but started a bond buying program that stabilised the system in the short run.
While the stability did come, it came with a price. Firstly, the bond buying program effectively pushed up the nominal value of bonds squeezing out private capital which then rather than go towards more productive assets became even more conservative. This was the ultimate conundrum since low interest rates and a ready of supply of credit should incentivise people to spend right? The problem that they hadn’t figured was that the markets are not always rational beasts. The only reason I would put money in the bank when I have to pay for it is if I truly believe that my money would be worth considerably less in the future than what I would lose at the bank. On top of which, while the rational economic theory is to promote credit growth by essentially forcing banks to lend more since the opportunity cost of holding reserves is higher and higher (especially when negative interest rates are taken into account), they forgot one thing, banks cannot lend when there is no one to lend to and people refuse to spend money.
Market Sentiment Rules
Figuratively speaking, market sentiment goes like this, while low interest rates make it more worthwhile to spend, the very fact that central banks are lowering rates tells us that they are uncertain about the economic climate, therefore we defer spending to a future date. On top of this, in the old days when a supply of liquidity would translate into inflation, in a day of rapid technological shifts that are deflationary, an increasing amount of people delay spending. For example, if inflation expectations were sky high, then I would be incentivised to spend today as opposed to tomorrow since my money is worth less tomorrow.
Think of it like the ultimate supply and demand conundrum, in an era of excess liquidity that ultimately beats demand for investable assets, you have a problem. What little you have in productive assets increase in value but the converse is not true. The valuations do not necessarily translate into real income or boost the real economy. Here is the problem that monetary policy is facing. The key to remember is, if market sentiment is working against you, there aren’t enough tricks in the playbook to actually impact the real economy. It also has the added problem of a slow but steady strangulation of the financial system. If it costs money for banks to keep their money in reserves (something they are required to do by regulation and Basel accords) and they cannot find proper credit growth because of market sentiment then they will 1) have to pass on the costs to deposit holders; or 2) get the excess liquidity out of the system as quickly as possible because of the cost associated. Typically done by passing it on in the form of negative rates (which is less than the cost of holding the capital). This basically creates a system where, unlike what we’ve been taught to believe in, it is a question of too much. This shows up in the prices of bonds where increasingly the risk profile changes and even companies can start to issue at less than CPI (hot potato much).
Ultimately it might come to the event that we have been talking about and central banks ultimately fear, if productivity growth is going to be limited by lack of investment by the private sector then it will ultimately be up to governments to pick up the slack. We have previously mentioned that this might end up being a solution to the problem. One of the key reasons that the post WWII economy in western countries was relatively strong, especially in the US, was this very fact. During the war, the government had effectively crowded out private spending (as opposed to central banks) and the private sector had no other choice but to repay existing debt obligations. What you ended up with was a massive demographic change as the Baby Boomer generation sprang into existence and private debt in the economy had fallen to historic lows as a percentage of GDP. What do you get when the government starts to moderate again? Credit growth and productive investments from the private sector pick up the slack. Think of an economy like a piece of pie, the slices consisting of households, companies and the government, if you want to get yourself out of stagnation then somebody has to pick up the demand. If governments start to spend then they take away equity from households and the private sector.
Unfortunately for western economies, especially in Europe, we don’t see the catalysts such as a demographic shift but what we do see is government intervention. If done right that could kickstart 1) inflation to reduce the real value of debt; 2) productive investments which, if you have negative interest rates, does not take all that much to beat the hurdle. This circumvents the problem of debt overhang with the caveat that bondholders will ultimately have to pay the price. Despite what central bankers think, that is a true market equilibrium. If somebody is winning, somebody has to lose; equilibrium. The alternate theory is the proposed helicopter money which is essentially the monetisation of liabilities on the balance sheet of central banks at which point most central banks, given the structure, would go into negative equity by letting the bonds mature to duration (Japan might be on track for this). Following which, they could even choose to circumvent the democratic process and political system by, wait for it, the all feared helicopter money whereby there would be direct injections of liquidity into the real economy rather than through the financial system. Sound odd or ridiculous? We got around to bailing out the financial system quite easily, why not the real economy?
The Elephant in the Room
In previous articles we have mentioned the centrality of USD as the reserve currency to the global economy and trade. So what does this have to do with negative interest rates in Europe? For one thing, the supply of currency outside of the US is vital for the functioning of the global economy and global trade. If you have a situation, as you did with the Federal Reserve hiking rates last year while the ECB is doing the opposite, then you have a problem. Since the first implication is that liquidity floods out of Europe and emerging markets into US denominated assets. The second implication is that this directly impacts the liquidity and credit growth in the global market. The Federal Reserve is, for all intents and purposes, the central bank of the world.
The above situation in itself is not a problem. However, the US has an advantage that could cost the rest of the world. The blow out of budget deficits and the issuance of more treasuries to fund this debt has meant that money has come into the US markets at the expense of the rest of the world. Creating constant shortages of the currency globally which, contrary to expectations, is exacerbating problems in Europe. Since the negative yield, rather than incentivising companies to spend more, ironically just makes the private sector allocate to US assets like treasuries. This therefore puts a damper on credit growth in the EU and curtailing potential economic growth. Despite the Federal Reserve going back on its original stance, the damage has unfortunately been done. The US currency climbed to new highs and institutional money, which does not have the independence or freedom to go to cash, continue to allocate towards the US despite trade tensions. Perhaps Charles De Gaulle was right in his conception of the reserve currency status of USD as an exorbitant privilege? Effectively it means that the rest of world pays, in some form or another, for expenditure in the USA.
Where does all this lead to & what is the solution?
For one thing, we believe there is a fundamental necessity to make tough choices and rethink the global monetary system as it currently stands. It is not a good idea to outsource the creation of money supply to the private sector given that fiat currency, when backed by nothing, turns into another government liability. Secondly, one of the most fundamental errors that was made is the notion of too big to fail. Capitalism works on the premise of competition and the survival of the fittest. To create and sustain bloated hegemonies creates more headaches than is necessary, quite frankly it is neither a function of capitalism nor fair to create a system whereby the central banks cannot have visibility into the creation of money supply or to have five dealer banks who have primary rights to actually trade and issue treasuries. Why the central bank cannot conduct its own auctions directly is unfathomable to us.
In order to stimulate demand again there has to be credit growth in the real economy and investible productive assets. Buying up corporate debt is not the solution to companies spending more. It creates a conundrum for companies in the sense that market sentiment is against them so therefore the reasonable thing is to use cheap credit to buy back shares or distribute in dividends thus increasing inequality and stagnating wage growth. Negative yielding debt also has the disadvantage of having a situation whereby the longer it continues the harder it becomes to unravel as was witnessed by Japan in its three decade waltz with the idea. The notion of the central bank put has also recently taken off, whereby investors continue to drive up valuations with the expectation that it is a risk free return. Again, not capitalism, but something quite different beyond our description. In a recent memo by Howard Marks, he tried to grapple with the same situation and could not quite understand it. If one of the greatest investors in the world cannot, then you have a problem.
The solution could be the gradual disentanglement of an over-reliance on the USD as a currency which will be difficult as the Chinese have recently found out no doubt. But having artificial equilibriums being created again is not a free market. The currencies should reflect the ground reality and should be similar to an investor assessing a company, a currency should be a true representation of the investors view on the state of a particular countries economy or government policies, not how much demand the rest of the world needs for that currency.
The second solution will be the helicopter money idea whereby balance sheet liabilities and debt is effectively written off, with the caveat of closer coordination between governments and central bankers (despite it going against the logic of an independent central bank which, lets face it, is rather a misnomer). We cannot have a situation where governments implement fiscal discipline, sucking up liquidity, and monetary policy doing the opposite. It just creates evermore dislocations in the market. In terms of market sentiment, we think that the recent changes to the tax code in terms of depreciation and capital expenditure should be replicated, effectively forcing companies to spend or be taxed. Disincentivising distributions will be painful with an aging population but kicking the can down the road is neither fair nor free (future generations will pay).
Our opinion? Please open Pandora’s Box again and let the last sentiment come out (i.e. Hope). With Christine Legarde taking her mandate at the ECB on the 1st of November, we will continue to watch her closely and the policy choices she makes. One thing we can count on is that she will come in with guns blazing, a woman in a traditionally closed-off male dominated role does not choose to play second fiddle to her counterparts (US Fed Chair) nor did she get to where she is by doing so or being complacent. One can only hope that she has a rethink and watches her counterpart in Japan closely as well as come up with alternate theories and experiment. One thing is certain, she has an eight year mandate and a chance to guarantee her place in history. We sincerely hope that that particular form of self-interest allows her to make a clear break from her predecessor, Draghi. She has the ingredients both personally and in the economy. It is hot potato money, she just needs to incentivise companies, from a monetary perspective, to get rid of that money and not in the current way (distributing it to shareholders) but reinvesting. A hard task, no doubt, but we have a feeling and hope that her incentive to leave a legacy will certainly enable her to do so. If she can, she would have her place in the textbooks.
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