Falling equity markets this week are likely to signal the onset of a bear market, responding to a combination of the coronavirus spreading beyond China and persistent indications of a developing recession.
This has provoked a flight into US Treasuries, with the ten-year yield falling to an all-time low of 1.31%. This will prove to be a mistake, given US price inflation which on independent estimates is running close to ten per cent, exposing US Treasuries as badly overpriced.
After this short-term response, much higher US Treasury yields are inevitable. Foreigners, who possess more dollars and dollar investments than the entire US GDP will almost certainly sell, driving bond yields up and the dollar down, leaving the Fed the only real buyer of US Treasuries.
This article goes through the sequence of events likely to destroy value in US financial assets and the dollar as well. And what goes for the US goes for all other fiat-currencies and their financial markets.
In my last article I pointed out that the cumulative effect of central bank intervention has led to bond prices that have come badly adrift from reality. Taking a more realistic estimate of the dollar’s purchasing power than that implied in goal-sought CPI numbers, plus an estimated amount for the time preference involved, ten-year US Treasuries should yield closer to 10% to maturity, not the 1.31% implied today. If a ten-year bond has a coupon such that it is currently priced at par, the price should halve.
Those who put our monetary misfortunes down to the coronavirus have missed the point. Yes, it will be fatal, both economically and unfortunately for some of us as individuals as well. It is early days in what is definitely becoming a pandemic, that is to say an epidemic that is not restricted to national boundaries. Not only China, but other nations as well are going into a state of lock-down. Hopes that things will return to normal in the second half of this year are obviously based on a belief that there is nothing else wrong in the global economy.
This is where those who actually understand money and the credit cycle part from the economic establishment, which continuously demonstrates its cluelessness. Note these indisputable facts:
1. Economic destabilisation arises from a cycle of bank credit expansion always followed by a credit crisis. It does not arise from business, but from time to time the willingness of banks to expand credit out of thin air, creating a temporary period of economic optimism which does not last.
2. The expansion of the global money quantity since 2008 has been unprecedented, not only numerically, but in proportion to the size of underlying economies. If nothing else, logic suggests the bust that follows will be proportionately destructive.
3. While their relative magnitudes to each other were different ninety years ago, a combination of trade tariffs and the top of the credit cycle mirrors the conditions that led to the Wall Street crash between 1929 and 1932. That should be warning enough that even without a coronavirus pandemic the world is on the edge of not just a recession, but a vicious slump.
The most important difference between the Wall Street crash and the depression that followed is found in the money. In those days, both the US and UK currencies were on a gold standard, which meant that collapsing commodity prices through the dollar and sterling were effectively being measured against gold. Other factors, such as the rapid mechanisation of farming and the productivity that followed exacerbated the situation for farmers worldwide, until the UK abandoned gold in 1932 and the dollar was devalued the in 1934. In short, the link with gold meant that leading currencies were not undermined by the depression.
Nevertheless, economists in the 1930s blamed the depression on gold, and governments have sought to remove it from the monetary system. Since 1971 there has been no residual link between gold and the dollar and therefore all other state-issued currencies. The quantity of money in circulation has been free to be expanded by central banks, the only limit being the consequential limitation of price inflation. That has now been conquered by statistical method.
From their actions following the Lehman crisis it is clear central banks now feel no constraint on the expansion of the money quantity as a policy tool. The Fed, the ECB and the Bank of Japan are already expanding base money before the crisis stage of the credit cycle has materialised, which should alert us to the catastrophic failure of monetary policy. Keynes’s concept of reviving animal spirits with a kick-start of inflation has morphed into a continual and accelerating monetary inflation over the whole cycle.
Collectively, in the post-war years we all bought into monetary inflation by shifting investment allocation progressively from bonds into equities to protect long term savings. But since the interest rate spike in the early 1980s, bond yields have generally declined to the point where in dollars, euros and yen they yield less than their values of time preference. In the two latter cases investors are now even paying for the privilege of lending money to their governments.
The abolition of meaningful yields has been achieved through a combination of statistical suppression of price inflation and monetary expansion. But this is just the start of it. Imagine for a moment a collapse today akin to the 1929-32 Wall Street crash, followed by an economic slump on a 1930s scale. Freed from apparent restrictions on the expansion of money and having a mandate to do whatever it takes, combined with demands for the financing of soaring government budget deficits the expansion of money will go into hyperdrive – everywhere at the same time.
Not only do we have that problem, but we now have a viral pandemic that has all but shut down the largest manufacturing economy in the world, disrupting the overwhelming majority of supply chains elsewhere. And that assumes the coronavirus is contained to China and that early signs of it turning into a global pandemic turn out to be false. But the signs are that it is becoming a pandemic on the eve of Wall Street crash Mark II, bringing forward and amplifying the economic destruction that always follows a period of credit expansion. The effect of the virus threatens to turn an economic slump, perhaps a once in a century event, into an outright production and consumption collapse.
What lies before us will be radically different from the past. Understanding money and the effects of changes in it as a circulating medium have rarely been more important. This article outlines the effects of what lies ahead, likely to commence in a collapse of financial asset values and the purchasing power of currencies.
The Fed will lose control
The Fed’s monetary policy has been all about exercising control over markets, ostensibly targeting a rate of price inflation at 2% and maximum employment consistent with it. This power is continually abused in the name of neo-Keynesian economics, and monetary debasement has become a permanent feature of US Government financing since 2001. Consequently, US Government debt is now larger than GDP and financing it at heavily suppressed rates absorbs almost 40% of a trillion-dollar deficit.
The policy controllers at the Fed can least afford an out of control financial system to reflect realistic bond prices. With the Bureau of Labour Statistics having successfully tamed the inflation numbers, the Fed has managed to keep the lie alive about monetary inflation not being reflected in a declining purchasing power for the dollar and therefore higher bond yields. The Fed is not alone in this, but in a dollar reserve monetary system other central banks and their currencies are just bit players and a critique of US monetary and economic policies is sufficient for an understanding of what lies ahead.
The crucial question is over the likelihood that having distorted markets to the point where government debt is now substantially overpriced, can the authorities maintain the illusion?
So far, there have been two classes of economic actors which have supported this overvaluation. The first is foreign investors, in the main building an accumulation of dollars and dollar investments through the US trade deficit. As the US economy grew along with the government’s unfunded spending, foreign owned securities, short term paper (less than one year) and correspondent bank balances amassed to the tune of about $24.8 trillion, which is more than the US’s nominal GDP[i]. Furthermore, since the date of the last annual TIC survey, the value of foreign-owned securities will have increased even more due to higher portfolio valuations.
We can see two reasons for these flows to reverse. The first is the global economic slowdown, particularly in international trade. A deteriorating trade outlook reduces the required cushion of holding dollar liquidity, encouraging traders to stop accumulating them, or even to see them winding them down to support ailing cash flows in their businesses back home. Foreign governments are also increasingly questioning the dollar’s reserve role in a world that has radically changed over the last forty years, encouraging Asian central banks to reduce the dollar component in their reserves.
The absence of foreign investors, who in the past have absorbed almost all of the increase of new US Treasury debt as a counterpart of the trade deficit, will be a considerable headache for the Fed at a time of rising US Government funding requirements.
The second class of economic actor is hedge funds, which through the fx swap market profit from the yield differential between US Treasury bills, or coupon-bearing bonds, and negative interest rates in euros and yen. Since the dollar’s trade-weighted index began to strengthen shortly after President Trump took office, these positions have increased as hedge fund managers saw this as a slam-dunk trade. But its profitability depends on a stable or rising dollar, and any sign of that being reversed will to lead to a substantial unwinding of positions to the detriment of the dollar.
Demand for liquidity to provide fx swaps for the hedge funds is one of the two reasons the Fed has been forced to aggressively enter the repo market, the other being the increasing amounts of Treasury bills and bonds accumulating as inventory at the prime brokers. While foreign demand for dollars has cooled, which was formally supplied directly or indirectly by bank credit expansion, the liquidity pressures in the New York money markets have increased in the absence of this source of liquidity, threatening the Fed’s control over interest rates, as the spike in the repo rate to 10% last September illustrated.
Clearly, without the Fed injecting tens of billions of dollars into the repo market interest rates would be far higher than the Fed Funds Rate, currently pegged at 1.5-1.75%. But this can only be a temporary fix, lasting so long as the dollar maintains its value in the foreign exchanges. And if the dollar begins to slide, whether foreigners or the hedge funds are responsible is immaterial. It will mark the start of a reassessment of US monetary policies by the markets becoming acutely aware that they have failed, and the Fed is boxed in.
For a time, the Fed can pretend that the economic slump and/or the coronavirus justifies an acceleration of money-printing, most likely through quantitative easing. They will cite the demand-driven outlook for core inflation and unemployment. But when the vote from the foreign exchanges is a no-no, that will only wear for so long. Markets will eventually realise that the only buyer for increasing quantities of Treasury debt at these yields is the Fed itself through the mechanism of QE. It will be foreigners who will likely be first to abandon the Fed’s managed market environment, and a dollar crisis will ensue. And with a dollar crisis there will also be a crisis in the US bond market.
So far, markets have just begun to wake up to the likelihood of a slump induced by the coronavirus. A thousand-point decline in the Dow last Monday was probably the break point in the concept of low bond yields being good for equities on a relative return basis. Suddenly, equities are being associated with risk, raising the ghost of October 1929 when markets began the first phase of the Wall Street crash.
Today’s children of inflationism that pass for investment managers have responded in the only way they know by reallocating portfolio exposure in favour of perceived safety by buying US Treasuries, driving the 10-year bond yield down to 1.31%, significantly less than the 13-week T-bill rate of 1.48%. Initially, this appeared to be partly at the expense of investment allocations in favour of foreign investments, strengthening the dollar in recent days.
Given that an economic slump with or without a spreading coronavirus will lead to a rapidly increasing government budget deficit that can only be funded by inflationary means, the collapse in bond yields will likely be short-lived. If the dollar begins to be sold in the foreign exchanges a reassessment will take place. Then the pace of liquidation of dollar-denominated securities by foreign owned portfolios is bound to increase, bearing in mind that they totalled $19.4 trillion, plus $5.3 trillion in liquid short-term securities and correspondent banking deposits at the last count. Hedge funds will also be reducing their fx swaps, adding further pressure on both the dollar and US Treasury bond prices.
Selling pressure on the dollar is likely to be measured in several trillions. Having suppressed the evidence of the fall in the dollar’s purchasing power in the internal economy, domestic investors imagine the Fed can continue to hold the Fed Funds Rate at close to the zero bound while they more or less singlehandedly fund the government’s deficit. What will make this impossible is a fall in the dollar’s exchange rate driven by foreign selling, even measured against fiat currencies with interest rates below zero. Commodity prices will begin to rise reflecting dollar weakness, despite falling real demand. And dollar hedges, such as gold, silver and even bitcoin will rise even more strongly. The risk hedge for US citizens will not be US Treasury stock, but precious metals and imported commodities.
When the Fed loses control there will be substantial losses for those currently seeking the safety of US Treasury bonds. It will be a double hit, not only through rising bond yields, but through a falling dollar making it vital for any foreign entity to liquidate portfolio and dollar positions while it can.
Beware of the bear
It is common practice to regard portfolio investment as entirely separate from day-to-day spending. The distinction is false in the sense that financial investments only exist because the attraction of prospective returns make it worthwhile for consumers to divert some of their income from current consumption. This is important, because rising prices for financial assets requires sustained money inflows. If people on balance stop investing prices fall.
This fact undermines the assumption that in a bear market a portfolio with a valuation of a million can simply rearrange that million into different investments to preserve value. In a bear market, a significant portion of it simply disappears without any transactions taking place. Bond and stock prices fall across the board, leaving an investor wondering what to do with the balance.
Having been occasionally brutal, recent equity bear markets have been little more than indigestion in a continual inflation-fuelled bull market. The bear now due promises to be different. Hanging on in hope of better days has worked favourably for investors in the past eventually, but maybe not this time, because the scale of bond mispricing is without precedent. The Fed and other central banks believe they can handle a mild to moderate recession but have no leeway to handle anything worse. If the dynamics behind the 1929 market crash and the depression that followed are a template for today’s markets, what will evolve in the coming months will break the Fed’s control over financial markets.
In that case, fortunes will be lost. Ordinary investors who have handed investment responsibility to investment managers and financial advisors have thereby proved themselves incapable of taking an investment decision. They will lose their nest-eggs because their appointees are either perpetual bulls or simply brainless when it comes to investing. They all talk of diversifying, which means buying a synthetic index, or investing in funds that cover so many companies as to be similar. None of them have experienced a proper bear market, where nearly every bond and equity investment collapses. The Wall Street crash wiped out 89% of the value of the Dow. That should be our guidance.
Driving it will be a bear market in US Treasuries. As fleeing foreigners sell their holdings and their dollars, the single buyer of them (the Fed) will be forced to raise interest rates. But if the Fed persists in funding the government deficit at suppressed rates, foreigners will merely accelerate their liquidation of dollars and dollar-based securities. Britain faced similar conditions in the 1970s, when the UK Treasury was always behind in its funding until it was forced to jack up gilt coupons, as far as 15¼ per cent. Sterling fell from $2.62 in March 1972 when equities peaked to $1.59 in 1976, and then fell further close to parity in 1985. And that was against a dollar that was also losing purchasing power. In the 1972-75 bear market, UK equities fell by 72% measured by the FT-30 Share Index.
In an economic slump, the ability of investors to hang on to their rapidly falling investments is compromised by rising unemployment. The flows from portfolio liquidation into the underlying economy are required to maintain body and soul. Furthermore, with the dollar’s loss of purchasing power being accelerated due to selling by foreigners, domestic living costs becomes more expensive.
Stage two for the collapsing dollar
With foreigners owning a combination of cash and securities valued at about $24.8 trillion and hedge funds short of euros and yen perhaps to the equivalent of a further four or five trillion dollars equivalent, a change in financial market conditions seems almost certain to trigger an avalanche of dollar selling. US ownership of foreign securities is less that half that at $11.3 trillion (Dec 2018), with foreign currency deposits and CDs the equivalent of $618bn.[ii]While Americans are bound to liquidate some of these foreign holdings in a slump, it will not be sufficient to offset foreign selling of the dollar.
By driving the dollar down, pressure will be put on domestic prices to rise. This will make the Fed’s position of funding government debt through QE at rates linked to a suppressed Fed Funds Rate untenable. Markets will be making their own assessment, instead of the Fed’s, when it comes to securities pricing. Given there will be a growing realisation that prices will then be rising at a faster rate than the annual 10% rate currently estimated by independent analysts, government finances and their funding will demonstrably be spiralling out of control.
It will be a systemic collapse centred not on an element of the private sector as was the case with Lehman, but of the entire government apparatus. With it will be a public realisation that the full faith and credit of government is the only thing that stands between the dollar’s value of the day and its value on the morrow. Increasingly, members of the population will be likely to regard the residual values of their financial assets as a source of funding for necessities, the dollar being little more than a collapsing bridge between the two.
Those prescient enough to anticipate these events will be hedging not into US Treasuries, which in truth offer no security with government funding almost certain to spin out of control, but into gold, silver, perhaps bitcoin and related investments. They will realise it is time to give up on the Fed’s put, or any other government guarantees because they have become worthless.
[i] See Foreign Portfolio Holdings of US Securities (June 2018) Exhibit 1T on Page 4. For bank deposits and securities maturing in less than one year seehttps://ticdata.treasury.gov/Publish/bltype.txt.
[ii] See https://ticdata.treasury.gov/Publish/bltype.txt and https://ticdata.treasury.gov/Publish/shca2018_report.pdf Exhibit 1T on page 5.
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