In the past months and right after implementing Quantitative Easing Unlimited Edition, the Fed began surfacing the idea that an exit strategy is at the door. With the latest releases of weak activity data worldwide, the idea was put back in the closet. However, a few analysts have already discussed the implications of the smoothest of all exit strategies: An exit without asset sales; a buy & hold exit. I have no doubt that as soon as allowed, the idea will resurface again.
Underlying all official discussions is the notion that an exit strategy is a “stock”, rather than a flow problem, that the Fed can make decisions independently of the fiscal situation of the US and that international coordination can be ignored. This is logically inconsistent and today’s letter will address these inconsistencies. Let’s see…
Monetary expansions are treated as a flow process
Conventional PhD wisdom on monetary things tells us that government deficits represent net credits to the system via reserves, as well as to non-government deposits at banks.
When it comes to bond purchases by the Fed, such wisdom implies that the US Treasury is assisting markets with liquidity. This is not new. As a student, I once heard that “governments must run deficits, so that markets can have a benchmark rate”. My professor meant that “thanks” to fiscal deficits, bonds are issued and markets can proceed with the price discovering process. Today of course, we don’t even have that luxury, courtesy of Quantitative Easing (Not happy with the lesson, I asked Dr. Julio H. Olivera his thoughts on this statement. He chuckled (although Dr. Olivera never really chuckled) and recalled a similar exchange with John Hicks. According to Dr. Olivera, when Hicks was faced with the same proposition, he replied: “The merchant makes the market”. Unfortunately, I cannot prove this exchange, but thought I would share it with you).
But monetary contractions are treated as a stock problem
Why do I bring this up? Because if deficits are welcome by the PhD standard when it comes to monetary expansions, surpluses should not be ignored, when dealing with monetary exit strategies. It’s only fair…Yet, in the past months there has been a timid incursion into the upcoming debate on exit strategies available to the Fed, but without a single comment on fiscal policies. By now, I have become used to typing CTRL+F “fiscal” (i.e. find “fiscal”), whenever I come across any research note on potential exit strategies. If nothing comes up, it looks suspicious to me.
Once such example was Bank of America’s April 10th note titled “The consequences of a “no sales” Fed exit strategy”, from the Global Economics Rates & FX team. This paper has not a single sentence or thought on the fiscal situation and Treasury issuance forecasts of the United States (the word “fiscal” only shows up once). They are not alone. How can mainstream economics afford to ignore the fiscal side of the problem when facing an exit strategy? They simply treat it as a “stock”, rather than a flow problem.
Terms of the “stock” perspective
As a stock problem, mainstream economists look at a “no sales” exit strategy by the Fed, in these terms:
1.-Not to sell means to hold, while principal and interest payments are reinvested.
2.-The target of a 6.5% unemployment rate is reached and there are signs of a firm recovery underway
3.-Losses on their US Treasuries portfolio are manageable, particularly since the Fed announced its accounting policy change on January 6th 2011, where capital losses may be treated as negative liabilities (Truly, you can’t make this stuff up). Even putting this fiction away, mainstream analysis is comfortable with a negative impact on the asset side of the Fed’s balance sheet. To assess that impact, reference is made in terms of 10-yr equivalent duration exposure held outside of the Fed. Growth of 10-yr equivalents is expected to stabilize. As I mentioned in the last letter on the Bank of Japan, I side with Shuichi Ohsaki and Shogo Fujita, from Bank of America’s Pac Rim Rates Research team, who argue that volatility in the Japanese bond market could be diminished if the BOJ announced a schedule for buying operations, with the amounts that would be purchased in each maturity sector. In other words, the market does not look at the stock of government debt as a block of exposure that is sizable in equivalent duration terms.
4.-Reserves management, via interest on reserves, can be used to send short-term signals to the market.
In the next sections, I will seek to demonstrate that it is a huge mistake to ignore the fiscal side of this dynamic picture, and that a smooth, no sales exit strategy is fiction. Moreover, I will show that this is a flow, rather than a stock problem. Before I proceed, let me offer you this interesting exchange between Stanley Druckenmiller and Kevin Warsh, which took place on March 5th (Druckenmiller’s intervention starts on minute 5:41)
The flow perspective of the “no sales” exit strategy
To simplify the exposition, let’s look at the cash flow situation of the US government. Like any of us, the government has to collect taxes and pay for expenses. For this particular discussion, it will not matter if the same are ordinary, extraordinary, operating, capital expenditures etc. All I want to do here is to separate this collection of taxes net of expenses –which I will call Primary Cash flow- from the cash flow that has to be used to service debt obligations. In other words, like any of us, the US government will have, after collecting taxes and paying expenses, a primary cash flow with which to service debt obligations:
If the Primary Cash flow (PCF) is not enough to service the debt, unlike us, the government can issue more debt (at least the US government; at least for now). Additionally, the government can liquidate assets. Therefore:
Let’s now look at the demand for the gross issuance and simplify it, saying that the same is purchased either by the Fed, by the rest of the central banks in the world, and by the rest of the world (ROW, i.e. anyone else in this planet who is not a central bank, either in the public or private sector). Under these terms:
Let’s assume that the government sells no assets. If the Fed stopped purchasing US sovereign debt but did not sell any holdings and kept reinvesting the interest and principal payments it received, re-arranging the terms, we obtain:
Let’s further call a Net Demand of one of the agents (i.e. central banks, rest of the world) the difference between its purchases and the collected interest and debt repayments. We can then say that under a “no sales” exit strategy of the Fed and without asset sales, the primary cash flow of the US government equals the sum of the net demands of the central banks and the rest of the world. This is valid at one point in time as well as when we consider the comparative statics of the issue (the term “D” below denotes temporal change in a variable, between t and t+1):
Having arrived to the identity above (the above notations are identities, not equations), let’s look at the context under which the “no sales” strategy would take place. It is a context of a firm recovery, as the Fed has told us and we have every grounds to believe that for this reason, interest rates would tend to rise, as capital moves out of fixed income and credit, into equities. This means that the Net Demand of US Treasuries by the Rest of the World will likely be negative (i.e. Drucknemiller’s observation) or zero, at best:
Let’s take the optimistic view that the Net Demand of the Rest of the World is zero (Clearly, Mr. Druckenmiller does not share this view…and he has every reason not to be). This means that if neither the Fed nor the Rest of the World add US Treasuries to their balance sheets, the primary cash flow of the US government has to be addressed by the Net Demand of central banks, exclusively.
We can think of three different scenarios for the primary cash flow of the US government: A scenario of surpluses (PCF >0), deficits (PCF <0) or balance (PCF = 0).
If the primary cash flow is negative
This is the toughest scenario. It implies that the negative primary cash flow of the US government will be financed by the central banks of the rest of the world. The question here is: Why would these central banks keep accumulating US Treasuries when the Fed itself does not? From here, it is very clear to me that in the presence of continuing fiscal deficits, regardless of where the unemployment rate is, the Fed has no alternative but to continue monetizing the deficits.
But let’s examine this case further. Let’s suppose that by some miraculous intervention, the central banks of the rest of the world would in fact resolve to continue purchasing US sovereign debt, even if the Fed itself wouldn’t. How would this process take place?
There are two ways. Either the currency zones these central banks operate in generate balance of trade surpluses or their respective nations incur into fiscal deficits.
In my last letter, I explained how the latter way worked in Japan under Shirakawa. With regards to the former, to expect a sustainable recovery in the United States (which is the a priori condition for an exit) within a context of fiscal deficits, increasing sovereign debt and balance of trade deficits is a contradiction. Yet some mainstream economists see this as something very feasible, whereby the Debt/GDP ratio falls because the denominator rises faster than the numerator. If this is true, then I am completely wrong and I have nothing else to say. If you believe in the sustainability of this context, please accept my apologies for having taken your time. If you don’t, please proceed to the next scenario analysis.
If the primary cash flow is positive
If the primary cash flow was positive, the Net Demand of the rest of the central banks would be negative. This would imply a strong and positive savings rate in the United States. The problem is to figure out how the United States can get to achieve a savings rate strong enough to get to this point, in a context of negative to zero interest rates, where nobody has any incentive to save and where the same Fed wants to boost consumption. I asked about this problem (i.e. how the savings rate will improve) to a very well-known economist who gave a presentation this past Wednesday April 24th, at the Oakville Community Foundation. His answer was that the stronger savings rate would come from the public sector. But this explanation seems to me a tautology (i.e. The US government will be cash flow positive because it will save)
The real question in the face of this problem is “What will push the US government and the US to save, when all its deficits are monetized and interest rates are negative?” This is not a new question. In fact, it occupied the mind of Jacques Rueff for decades. Perhaps the first time M. Rueff made public this concern was during an exchange with no other than the same John Maynard Keynes in 1929, during a conference at the Assembly of the League of Nations, in Geneva. M. Rueff suggested that there was indeed an adjustment mechanism for the balance of trade and Keynes asked how such an adjustment could be brought about.
Rueff explained that inflation is nothing else but the creation of purchasing power in a country without a counterpart increase in production. For that reason, it is only possible to run balance of trade deficitsindefinitely –like the US has done over the 20th and 21st centuries- if there is inflation. The opposite should also be true: In the absence of inflation, there would be a balance of trade surplus, until all debts are paid (as in this scenario, where the Net Demand of the rest of the central banks is negative).
In summary, to effect a negative Net Demand of the rest of the central banks in US Treasuries, the purchasing power of Americans should be decreased. But how will the United States ever achieve such a state of affairs, when the Fed targets a 6.5% unemployment rate precisely by inflating the purchasing power of Americans? If the Fed is successful, the opposite will have occurred and the nominal purchasing power of Americans will have increased. Therefore, a positive primary cash flow is not possible, as long as the Fed continues boosting asset prices.
How did Keynes react to this view? We have only the testimony of Jacques Rueff on this, which I reproduce below:
“…Et Keynes, qui marchait de long en large –c’était sur la scène d’un théâtre- s’est arrêté brusquement et a dit: “Tiens, mais, cela c’est une idée intéressante, il faudra que j’y réflechisse.”
Je dis cela à mon ami Largentaye, parce que c’est très important pour l’historie de la pensée keynesienne. Cela prouve qu’en 1929 la théorie de la dépense global n’était pas encore au point dans son (i.e. Keynes’) esprit et que c’est plus tard, dans l’ouvrage que M. de Largentaye a traduit, qu’elle s’est élaborée, d’abord dans le Traité sur la monnaie et, ensuite, dans la Théorie générale. Et cela indique, d’ailleurs, le caractère mouvant de sa pensée; ce n’est pas une critique que je lui adresse, c’est plutôt un éloge; c’était un des esprits les plus actifs qui fût…” (J. Rueff, Le système monétaire international”, presentation given at the Conseil Economique et Social, May 18th, 1965).
Finally, if the nominal purchasing power of Americans will not be decreased by the Fed, the real purchasing power will have to fall, with the devaluation of the US dollar. This is a logical conclusion. In a context of global monetary easing, this can only be achieved against gold and…. why not, commodities in general.
If the primary cash flow is zero
This is a simple theoretical conjecture, just like the existence of general equilibrium in the fractionary reserve system and shadow banking we live in. To discuss it is an intellectual exercise of dubious utility.
In this discussion, I sought to show that:
-The exit strategy of the Fed is not a stock, but a flow problem.
-Just like expansionary monetary policy must address fiscal policy, contractionary monetary policy cannot ignore fiscal deficits.
-The fiscal issue PRECEDES the monetary issue. Without first addressing fiscal policy, it is irrelevant whether or not a labour market objective is achieved (i.e. unemployment rate of 6.5%).
-Any analysis of a potential exit by the Fed that dismisses fiscal deficits and focuses on the management of the balance sheet of the Fed only is surreal. It is not enough to claim that buy & hold is better than selling.
-In the case of the Fed, international coordination is required for an exit strategy to succeed.
Bonus: Was Mr. Druckenmiller correct?
As you may have noticed, I was optimistic and assumed that the Net Demand of US Treasuries by central banks would increase (i.e. international coordination) and that the Net Demand of the Rest of the World would remain unchanged.
What I believe Mr. Druckenmiller had in mind is a more realistic picture, where the Net Demand of the central banks would remain unchanged, while that of the Rest of the World becomes increasingly negative. In this context, with the US government continuing to run negative primary cash flows and the Fed shifting from quantitative easing to a buy & hold stance, the supply of US Treasuries would increase and interest rates would rise exponentially. Mr. Druckenmiller was correct.
“…The two pillars of the current global financial system are therefore (a) the illusion of the existence of a risk-free asset and (b) the repression of that market which demonstrates that the risk-free asset and its derivatives (stocks, bonds, the Euro, all bred in the repo market) are an illusion….”
During the past weeks I have been on the sidelines, waiting for a relevant event to take place but fully aware that I was wrong. I just wanted to hope. Sometimes, it feels good to hope. But since last September, nothing has really changed. At least not fundamentally and that which seems new, is simply the result of the tectonic shift we had back at the end of the summer (of 2012).
It is vox populi that the rise of Spanish and Italian sovereign yields was triggered by corruption scandals that may be of political consequence. They were not alone, as the Libor affair is still making news. I don’t think scandals by themselves bring consequences, but before I go further, let me discuss the topic of corruption itself, for as I will explain, the ongoing policies will bring nothing else but more corruption.
Corruption in government is simple arbitrage. Whenever governments intervene in a market either by restricting supply or demand, capping or flooring prices, the affected goods will have two prices: The government fixed price and the market price. And because prices are nothing else but critical signals for the process of social cooperation (also known as “market”) to work, markets get confused by two different signals from the same good.
If there is restricted supply of a good, or if the price of a good is capped, the market will be willing to bid more than the current price for that good. That bid will be noticeable and the only economic agent capable of acting on the signalled gap will be someone in power: a government official or a politician. This person’s responsibility will be to allocate scarce resources where they are most needed. The public will call him corrupt, but he will just be an arbitrageur. He will offer an additional quantity of that good which is restricted at a higher price, including his fees (also called “bribes”), of course. He will be simply taking over a function that a repressed market cannot perform at that time.
Government corruption is nothing else but the reflection of a repressed market. The immorality lies not in the act of corruption (i.e. arbitrage), but in the market repression that enables it. And as we all know by now, the repression in the financial markets has only grown exponentially in the past years. This may only mean that more corruption is underway. Above all, the two repressed markets we should all be very familiar with are the ones for US Treasuries and gold.
The US Treasuries market is not really a market. As I understand, about 75% of the issuance expected for February will be purchased by the Fed, whose SOMA account already represents about a third of the stock of Treasuries outstanding, across the curve. How an asset that requires that 3/4ths of its flow be purchased by a central bank to maintain its price can be deemed to have 0% risk and be used as collateral is beyond me! As well, I am completely amazed that we still have analysts from the main banks publishing research notes where they try to assess implied future rates…Implied??? By whom?
This brings me to the gold market. As I mentioned in past letters, Keynesians give a lot of weight to the role of expectations. If they manage expectations to make the public believe that the purchasing power of their salaries has not decreased in real terms, they believe they may get an economic system from recession back to growth. In the same fashion, if they already have a benchmark for real value, say gold, all they need is to suppress the price of this benchmark, to control their expectations. They need not lower the value of the benchmark. Making it volatile enough to discourage any inclination to have that asset used as a store of value is enough. Hence, the endless take down in the price of gold triggered by leveraged sales during thin trading. It has coincidentally taken place ever since the rating on the US Treasuries was challenged by those martyrs at S&P. Below, I show the interventions during the last month (source: Bloomberg).
The two pillars of the current global financial system are therefore (a) the illusion of the existence of a risk-free asset and (b) the repression of that market which demonstrates that the risk-free asset and its derivatives (stocks, bonds, the Euro, all bred in the repo market) are an illusion.
On the subject of a risk-free asset, back on September 16th, I suggested that “… for all practical purposes (…) the European Central Bank would set the value of the world’s risk-free rate…”. The assumption behind this conclusion was that, thanks to Draghi’s offer to establish Open Monetary Transactions, “…the market (would) arbitrage between the rates of core Europe and its periphery, converging into a single Euro zone target yield…”. The two charts below (source: Bloomberg) help us visualize the status of the predicted convergence, as well as the relative stability in the long-term German sovereign debt vis-à-vis that of the United States.
With obvious “noise”, the underlying convergence (shown above left) is clear. On the right, we can appreciate how the yield in the 30-yr Treasuries is on the rise, thanks to in spite of billions being bought by the Federal Reserve, while the yield on the German bunds remains within range. We also still have the usual flags I have been calling collective attention to for the past year, and they are all related to repressed markets. The zero-interest rate policies were going to encourage share buybacks, dividend payments and any method to allow the extraction of whatever real value is still available to extract from corporations/businesses by their owners. This meant leverage was going to increase, unemployment would remain high, capital expenditures were going to decrease and the risk of defaults was to going to rise.
A year later, all these symptoms are starting to surface. One more reason to avoid stocks and be long gold. But in my view, it will take longer than many believe, for these imbalances to burst. This is the point I made at the start of 2013, when I wrote that “…during 2013, I expect imbalances to grow…”. Those who hold a view more bearish than mine point to inconsistencies, gaps between valuations expressed by different asset classes. But how can we point to such dislocations and at the same time sustain that markets are being repressed?We must be consistent: If the signals prices send to us are detached from fundamentals, we cannot at the same time call upon them to make our case!That would only be appropriate in a world where markets are not repressed. So… If I am not that bearish but still believe that imbalances in the long term will burst, what will make them burst? On this point, I stick to what I said at the start of 2012:
“…As long as the people of the EU put up with this situation and the EU Council (…) effectively kills democracy at the national level AND as long as the Fed continues to extend US dollar swaps, this status quo will remain…(…)…Whenever the political sustainability of the EU is challenged, we will see a run for liquidity…(…)…The trend is for asset inflation, and will last as long as the people of the EU and the US do not challenge the political status quo…” . Unemployment and the tolerance of those unemployed will tell us when the time has come. If it is not that, it will be the wave of defaults the same unemployment produces. There will still be corrections in between, but they will be just that: corrections. That tolerance, of course, is always tested by corruption cases made public. And as I explained above, the more repressed markets become, the higher the number of corruption cases we will learn from.
In the same fashion that I proposed an analytic framework for 2012, I want to lay out today what I think will be the big themes of 2013. Their drivers were established in September 2012, and I sought to give a thorough description of them here, here and here.
An analytic framework for 2013
In one sentence, during 2013, I expect imbalances to grow. These imbalances are theUS fiscal and trade deficits, the fiscal deficits of the members of the European Monetary Union (EMU) and the unemployment rate of the EMU thanks to a stronger Euro. A stronger Euro is the consequence of capital inflows driven by the elimination of jump-to-default risk in EMU sovereign debt. Below is a drawing I made to help visualize these concepts:
The drawing shows a circular dynamic playing out: The threat of the European Central Bank to purchase the debt of sovereigns (that submit to a fiscal adjustment program) eliminates the jump-to-default risk of this asset class. As explained and forecasted in September, this threat also forces a convergence in sovereign yields within the EMU, to lower levels. As long as the market perceives that the solvency of Germany is not affected, the Bund yields will not rise to that convergence level. So far, the market seems not to see that (Possunt quia posse uidentur). But the resulting appreciation of the Euro will eventually address that illusion.
This convergence, in my view, is behind the recent weakness in Treasuries. I proposed this thesis last September. However, the ongoing weakness in Treasuries does not mean I was right. In fact, I fear I may have been right for the wrong reasons. The negotiations on the US fiscal deficit and the latest announcement of the Fed with regards to debt monetization quantitative easing to infinity may also be behind this move. But until proven wrong, I will cautiously hold to my thesis.
The above factors drove capital inflows back to the European Monetary Union and strengthened the Euro. I believe this strength will last longer than many can endure. The circularity of this all resides in that the strength of the Euro will make unemployment and fiscal deficits a structural feature of the EMU, forcing the ECB to keep the threat of and eventually implementing the Open Monetary Transactions. The alternative is a social uprising and that will not be tolerated by the Euro kleptocracy.
All this -and particularly the strength of the Euro- is not sustainable. Ad infinitum, it would create a Euro so strong that the periphery would drag coreEuropein its bankruptcy. But while it lasts, the compression in sovereign yield will mask the increasing default risks in Euro corporate debt, specially the one denominated in US dollars. Both have been fuelling the rise in the value of equities globally.
The unsustainable framework rests upon the shoulders of the Federal Reserve, which thanks to the established USD swaps and unlimited Quantitative Easing, has completely coupled its balance sheet to that of the European Central Bank. In the end, as this new set of relative prices between asset classes sets in, it will be more difficult for the European Central Bank to sterilize the Open Monetary Transactions.
History provides an example of the current growth in imbalances
By now, it should be clear that the rally in equities is not the reflection of upcoming economic growth. Paraphrasing Shakespeare, economic growth “should be made of sterner stuff”.
Under the current framework, the European Central Bank can afford to engage in the purchase of sovereign debt because the Fed is indirectly financing the European private sector. The Fed does so with the backstop of USD swaps and tangible quantitative easing, which provides cheap USD funding to European banks and thus avoids a credit contraction of the sorts we began to see at the end of 2011.
This same structure was in place between the Federal Reserve and the central banks of France and England in 1927, 1928 and 1929 and, as a witness declared, “(it)transformed the depression of 1929 into the Great Depression of 1931”. Something tells me that this time however it will be different. It will be worse. That little something is the determination of the new Japanese government to devalue its currency via purchases of European sovereign debt (ESM debt).
How fragile is this Entente?
Most analysts I have read/heard, focus on the political fragility of the framework. And they are right. The uncertainty over theUSdebt ceiling negotiations and the fact that prices today do not reflect anything else but the probability of a bid or lack thereof by a central bank makes politics relevant. Should the European Central Bank finally engage in Open Monetary Transactions, the importance of politics would be fully visible.
From earlier letters, you know that I believe quasi-fiscal deficits (i.e. deficits from a central bank) are a necessary condition for a meltdown to occur, and that these usually appear when deposits begin to seriously evaporate. So far, capital is leaving main street (via leveraged share buybacks and dividends), but at the same time, it is being parked at banks in the form of deposits. The case of Wells Fargo and the temporary pause in the flight of deposits from the periphery of the European Union suggest that the process towards a meltdown, if any (and I believe there will be one), will be a long agony. Furthermore, in the short term, at the end of January, European banks have the option to repay the money lent by the European Central Bank in the Long-Term Refinancing Operations from a year ago, on a weekly basis. I expect them to repay enough to cause more pain to those still long of gold (including me, of course).
“…Just like since the beginning of the 17th century almost every serious intellectual advance had to begin with an attack on some Aristotelian doctrine, I fear that in the 21st century, we too will have to begin attacking anything supporting the belief that the issuer of the world’s reserve currency cannot default, if we are ever to free ourselves from this sad state of affairs…”
The intention today was to do a revision of what I had expected in 2012, what happened and what I think will happen. However, we may have to put this aside one more time, given the feedback received on the last post, titled “Anatomy of the End Game”. I seem to have been misinterpreted and to clarify this very important topic, I present a second part to make absolutely clear that:
a) It is misguided to believe that the end game should be blamed on the shadow banking system. Should regulators succeed in leaving regulated banks the role of funding the commodities and futures markets, the end game would not be avoided and its violence would be even greater,
b) Fiscal austerity in theUS, if my assumptions (clearly laid out in the previous post) apply, would be irrelevant unless it produces a sizable fiscal surplus,
c) The approach taken by policy makers addressing this logical outcome (which they mistakenly call tail risk –the tail risk is the reverse: That the game does not end-) is wrong.
The End Game in a world without shadow banking
There are continuous attempts at further regulating money market funds and central counterparties (i.e. clearinghouses), based on the belief that their operations entail risk of a systemic nature. But the systemic nature of the risk is simply due to the leverage built upon the collateral that these players use to provide funding. There is nothing particularly intrinsic to either the players, the markets that use that collateral or the collateral (i.e. sovereign debt, mortgages, etc.) itself, to make them “systemic”. To coerce these players to increase their capitalization or to prevent them from freely disposing of their liquidity as risk varies only increases costs and volatility.
Let’s assume the extreme case where the “shadow banking” sector disappears and banks become the sole providers of funding in the repo market. The figure below describes the situation. In stage 1, we can see the consolidated balance sheets of the financial institutions, traders, and non-financial institutions (private sector). Traders have US Treasuries as assets, which in stage 2, they sell to source cash. This cash is expressed as deposits (in stage 2), which are liability of the financial institutions. Deposits then, are backed by US Treasuries. When these are repudiated (our main assumption) the sustainability of the financial institutions is challenged, precisely at the same time that traders may be suffering a short squeeze on short commodities positions and margins are called. This short squeeze would also affect the commodities and futures markets’ clearinghouses (not shown in the figure). From stage 3, it is easy to see that depositors (non-financial institutions) who are not part of the aggregate “traders” class are the ones who are most at risk. The faith in the US dollar system is lost and a run on the banks is triggered.
We must clarify that the US dollar zone/system is not bound by geographical or jurisdictional borders. A Hong Kong or Brazil based bank that relied on US dollar funding to generate relevant net interest income would be equally affected by the liquidity squeeze, as so many European banks learned in 2008 and 2011.
Under this scenario, and unlike the case where the shadow banking system funds the repo market, the Fed would not have the luxury of choosing whether or not to intervene. It would simply be their duty to do so, and they may believe that they have the option to purchase the US Treasuries from the banks with or without sterilization. But in the end, it would not matter…sadly. Let’s go through the process:
a) The Fed purchases US treasuries without sterilization
This is the easiest option to understand. As the figure shows below, the Fed purchases US Treasuries from the financial institutions and their reserves grow. As the whole context in which this would occur is not positive for economic growth, to say the least, and the private sector delevers: Loans outstanding, on a net basis, decrease. Deposits decrease and the non-financial private sector increases cash on hand. The equity of the financial sector, naturally, suffers. This cash on hand will keep rising as long as the US debt remains repudiated and US Treasuries need to be monetized by the Fed. Eventually, in the absence of alternative investments (as in the current context, with zero to negative interest rates), the cash is simply spent on consumption. In an environment of financial repression, where companies use whatever liquidity preferably to distribute back to owners via share buybacks or dividends (as we expected back in March), the higher consumption facing lower production ends up driving prices higher.
b) The Fed purchases US treasuries with sterilization
If the Fed decided to sterilize the purchase of US Treasuries being repudiated, the market would immediately begin to discriminate between those banks who get the benefit of carrying Fed debt and those who don’t. This is similar to what we see in the Eurozone: Deposits flee banks which are seen at risk of being caught on the wrong side of the tracks, should a break up of the Euro zone occur, to banks in the core of the Euro zone (i.e. banks with continuous access to liquidity lines of the European Central Bank). This arbitrage (why carry cash, which pays no interest, rather than Fed debt?) would drive all banks to buy distressed US Treasuries to make a difference exchanging them for Fed debt. This would be a very perverse process, because banks would drive deposit rates higher to maximize the sourcing of US Treasuries.
At this point, I am aware you may be confused: It doesn’t seem to make sense to first assume that Treasuries are being repudiated and later say that banks seek to raise deposits to purchase them. But this makes perfect sense, when we realize that in this context, the market for US Treasuries would be simply broken, segmented. Only banks with the privilege of access to the Fed’s window would be interested in US Treasuries, because only they would have access to the interest-paying debt of the Fed. The US Treasuries, effectively, would be marked to model by the Fed and as the private sector gets crowded out and deposits drop, the need for liquidity and profitability of the financial institutions would demand that higher interest be paid by the Fed on its debt.
You may ask why should the Fed be forced to pay higher rates, when the private sector would seem to be out of investment alternatives. First, we must remember that in this context, commodity prices would be rising and the nominal rate of return in gold would be a benchmark, just like simply holding US dollars in the ‘80s was a benchmark shaping inflation expectations in Latin America. Secondly, the Fed would be forced to pay higher rates to keep deposits from dropping in a context of decreasing trust in the solvency of the banking system. Those living today in the periphery of the Euro zone understand this. Why should deposits not drop? Because if they do, more currency will be circulating and available to buy real assets (i.e. gold) and the outstanding stocks of US Treasuries being repudiated would not be cleared from the market into the balance sheet of the Fed. Their increasing yield (as the price drops) would be a price signal to the market that the Fed would have every reason to kill.
However, if the value of the US Treasuries falls and the interest the Fed has to pay to sterilize their purchase rises, the Fed will face a net interest loss. The Fed may chose to keep accumulating these losses or may also decide to simply convert its debt in legal tender, to end the arbitrage between currency (not paying interest) and its interest-paying debt. In the first case, we end up with a plain monetization of US Treasuries, which we just analyzed above. The second case (enforcing Fed debt as legal tender) would truly mark the end of the game in terms that would make historians of the 21st century would devote entire volumes…
Why fiscal austerity would be irrelevant without a surplus
A logical outcome, which I think is clear from the two scenarios above, is that no matter how far the spending cuts go, the only way to compensate for the monetization of EXISTING INVENTORY of US Treasuries, is to reach a fiscal SURPLUS. Being only frugal won’t cut it!
In order to avoid being dragged to double digit inflation, there will have to be a fiscal surplus to offset the quasi fiscal deficit of the Fed. However, the implementation of austerity measures (i.e. spending cuts), will necessarily lead to a decrease in activity which would only be temporary if the same are accompanied by a widespread liberalization of markets. It is possible but unlikely, for reasons beyond the scope of this post. All sorts of negative feedback mechanisms could be triggered in this situation, only enhancing the repudiation of the US sovereign debt and the resolve of the Fed to monetize it (For instance, the so called Olivera-Tanzi effect postulates that as inflation rises, access to working capital is restricted and firms delay their tax payments, to get them devalued by inflation. The government therefore receives depreciated tax revenue while its operating costs increase, facing deficits that need to be further monetized, thereby fueling even higher inflation).
In Argentina, this negative feedback was always resolved with the plain confiscation of citizens’ assets: Savings accounts in 1989, chequing accounts in 2001, pension funds in 2008, etc. (I can’t stress enough how important it is for anyone in the financial markets today to study the monetary developments in Argentina between 1972 and 1991)
Policy makers look the wrong way
The natural reaction from policy makers, so far, has not surprised me. Rather than addressing the source of the problem, they have and continue to attack the symptoms. The problem, simply, is that governments have coerced financial institutions and pension plans to hold sovereign debt at a zero risk-weight, assuming it is risk-free.
This problem truly brings western civilization back to the time of Plato, when there was nothing “…worthy to be called knowledge that could be derived from the senses…” and when “…the only real knowledge had to do with concepts…”. In the view of policy makers, the statement “the probability of US sovereign default is zero” is genuine knowledge, but a statement such as “The US government needs to issue about $100 billion per month to finance its fiscal deficit” is so full of ambiguity and uncertainty that it cannot find a place in their universe of truths…(Note: I am paraphrasing Bertrand Russell here. I am certainly not erudite)…and just like since the beginning of the 17th century almost every serious intellectual advance had to begin with an attack on some Aristotelian doctrine, I fear that in the 21st century, we too will have to begin attacking anything supporting the belief that the issuer of the world’s reserve currency cannot default, if we are ever to free ourselves from this sad state of affairs. The following paragraph, from a speech by Paul Tucker (currently Deputy Governor at the Bank of England) says it all:
“…Two strategies come to mind which I am airing for debate. The first would be ‘recapitalizing’ the CCP (i.e. central clearing counterparty) so that it can carry on. The second would be to aim to bring off a more or less smooth unwinding of the CCP’s book of transactions…” P. Tucker, Bank of England, “Clearing houses as system risk managers”, June 2011
Policy makers then believe in recapitalization and coercive smooth unwinds. With regards to recapitalization, I will just say that we are not facing a “stock”, but a “flow” problem. US Treasuries would be repudiated because of fiscal deficits, which are flows. No matter how capitalized a clearinghouse is, once the repudiation starts, the break-up of the repo market and the short squeeze would unfold and develop. Whether there is or not a capital buffer is irrelevant to the problem. In fact, in my view, it would be better that there wasn’t: Why would you want to add more resources to a lost cause?
With regards to smooth unwinds, I think it is obvious by now that the unwind of a levered position cannot be anything but violent, like any other lie that is exposed by truth. Establishing restrictions to delay the unmasking would only make the unwinds even more violent and self-fulfilling. But these considerations, again, are foreign to the metaphysics of policy making in the 21st century.
About a month ago, in the third-quarter report of a Canadian global macro fund, its strategist made the interesting observation that “…Four ideas in particular have caught the fancy of economic policy makers and have been successfully sold to the public…” One of these ideas “…that has taken root, at least among the political and intellectual classes, is that one need not fear fiscal deficits and debt provided one has monetary sovereignty…”. This idea is currently growing, particularly after Obama’s re-election. But it was only after writing our last letter, on the revival of the Chicago Plan (as proposed in an IMF’ working paper), that we realized that the idea is morphing into another one among Keynesians: That because there cannot be a gold-to-US dollar arbitrage like in 1933, governments do indeed have the monetary sovereignty.
Is this true? Today’s letter will seek to show why it is not, and in the process, it will also describe the endgame for the current crisis. Without further ado…
After the fall of the KreditAnstalt in 1931, with the world living under the gold-exchange standard, depositors first in central Europe, and later in France and England, began to withdraw their deposits and buy gold, challenging the reserves of their respective central banks. The leverage that linked the balance sheet of each central bank had been provided by currency swaps, a novelty at the time, which had openly been denounced by Jacques Rueff. One by one, central banks were forced to leave the gold standard (i.e. devalue) until in 1933, it was the Fed’s turn. The story is well known and the reason this process was called an “arbitrage” is simply that there can never be one asset with two prices. In this case, gold had an “official”, government guaranteed price and a market price, in terms of fiat money (i.e. schillings, pounds, francs, US dollars). The consolidated balance sheets of the central bank, financial institutions and non-financial sector looked like this before the run:
And like this after the run:
Indeed, those who claim that today is different and make the dangerous case that “…one need not fear fiscal deficits and debt provided one has monetary sovereignty…” refer to this crucial difference in the balance sheet of the central banks then (i.e. in the ‘30s) and now:
And they are right: There cannot be any arbitrage, because there is no real asset to exchange fiat currency against. Only fiat vs. fiat (i.e. currency vs. government debt). But does this mean that the governments have monetary sovereignty? Does this mean there will not be an end game? I don’t think so. We cannot arbitrage fiat money, but we can repudiate the sovereign debt that backs it! And that repudiation will be the defining moment of this crisis. The key to understand how this will occur lies in focusing in the shadow banking system, rather than the banking system. In the universe of shadow banking we do not back fiat currency with real assets, but we provide sovereign debt as collateral to obtain the fiat currency necessary to establish positions in the commodities markets.
Some preliminary details
Our first assumption is therefore that the debt of the sovereign that issues the world’s reserve currency is repudiated. We can think of many events that would trigger that reaction: A monetary policy of the Fed that continues to enable fiscal deficits (something that already Jacques Rueff explained in the ‘30s) or the coming burst of the European Yankee market bubble (i.e. US dollar denominated debt issued by European corporations). Whatever the reason, the repudiation will have an impact in the repo market, which finances positions in the commodities markets.
Consider a trader in the commodities futures market. To finance his trading activity, he pledges collateral in the repo market, and receives cash. The collateral is often US sovereign debt and those supplying the cash in exchange for it are money market funds, under repurchase agreements. This secured financing entails the actual exchange of ownership, title on the collateral, which is “warehoused” in the balance sheet of the “lender”.
With the funds, the trader enters into a futures contract in the commodities market, but facing a central counterparty (clearinghouse). The trader has to post an initial and a maintenance margin. While the futures contract is in place, the trader (and his counterparty, the clearinghouse) will have an unrealized gain or a loss. As long as the contract is on, the trader will have to adjust the margin according to the gains or losses. At maturity of the contract, the trader can settle in cash or by delivery. At a consolidated level, however, there has to be a delivery of the commodity, at an auction, for the market (usually not higher than 1% of contract settlements). In the end, the trader must repurchase the collateral it had given to the money market funds, at a price equivalent to the principal plus accrued interest (i.e. repo rate). Below we show these steps in a chart, with real samples of how a hedge fund would show these transactions in its financial statements:
The End Game
Now that we are familiar with the steps above, think what would happen, if the US sovereign debt began to be repudiated, just like the debt of Italy or Spain. At the beginning, the repo rate (i.e. the interest rate charged by the money market funds) to lend to the commodity markets players would increase, making trading in commodities futures more onerous. Immediately after, however, liquidity would disappear as those investing in money market funds seek only short-term exposure with minimum risk. As well, given that most central banks hold US sovereign debt as reserves, one would expect an increase in global concern and a flight to safety in real assets.
With the rise in the cost of funding (i.e. repo rate) and the rise in commodity prices, it is to be expected that one trader short of a futures contract may suffer substantial losses. The increase in counterparty risk or the increase of a failure by a central counterparty (i.e. clearinghouse) would jump. And I think the jump would be so significant that even the delivery of physical commodities at auctions would be at risk.
The failure of a central counterparty is not new. In 1974, the Caisse de Liquidation failed on margin calls defaults associated with sugar futures contracts. In 1983, the Kuala Lumpur Commodities Clearinghouse crashed on palm oil futures and in 1987, the Hong Kong Futures Exchange clearinghouse failed also due to futures contracts, in equities.
Should a scenario like the above unfold, the Fed would likely be forced to intervene, inter-mediating between the money market funds and the commodities futures market. It could do so by issuing its own debt to money market funds (or any lender in the repo market) and using the proceeds to enter into repurchase agreements with traders in the commodities markets. The chart below illustrates this scenario:
Let’s take a close look at the balance sheet of the Fed, once it enters the repo market. A few observations are relevant:
a) The Fed would now fund positions in the commodities markets
b) Operationally, the Fed would probably mark the repoed Treasuries to model, not to market. Like the European Central Bank does today with Greek or Spanish bonds.
c) The Fed would not “print” money. They would simply raise funds from the shadow banking system by issuing its own debt. Therefore, they would have to pay an interest rate high enough to entice money market funds to buy it.
d) The Fed would not be able to “refuse” US Treasuries repoed. It would have to buy all the US Treasuries offered in repurchase agreements at their “marked-to-model” rate. But the money market funds could refuse to lend to the Fed, if a market rate is not offered.
And here is the catch, because in order to raise US dollars from the shadow banking system, the Fed would have to pay a higher rate than it would charge for its repurchase agreements. Otherwise, there would be no need to intervene the broken repo market, to start with!
And what would traders in the commodities markets do with the “cheap” financing provided by the Fed? Why, buy gold among other real assets!
This would constitute a much worse scenario, than the laughed at arbitrage that Keynesians so proudly say today is not possible, from fiat currency to gold.
Under this scenario, the rest of the world would get their hands on the reserves of central banks (i.e. US Treasuries) to dump them in the Fed’s balance sheet via the repo market and recycle the US dollars it obtains with money market funds, to receive Fed debt! (See chart below). In the process, the rate the Fed would have to pay to raise US dollars from the shadow banking system would have to spiral, sending a wave of bankruptcies across the US dollar zone, including the Yankee market. The Fed would be forced to increase its currency swaps and at the same time continue doing unlimited quantitative easing. The currency swaps would be extended to delay the inevitable defaults in global US dollar denominated bonds and the quantitative easing would be necessary because, given the high interest rates and defaults, even with austerirty, the fiscal deficits would continue, as tax revenues fall driven by the collapse of activity.
And now, the cherry on the top: How would the Fed cover its net interest losses, between its debt and the US Treasuries it would repo? By issuing currency!! This quasi fiscal deficit would lead us to double-digit inflation and if left unaddressed, would end in hyperinflation. The process would end when the US dollar loses its status as a global reserve currency, a status that the Fed would seek to defend at all costs, repoing Treasuries in the commodities futures markets.
For the sake of intellectual honesty, I want to end this exercise laying out the main assumptions:
The first and foremost critical assumption is that there will be a repudiation of US sovereign debt. The second assumption is that this repudiation will break the repo market enhancing counterparty risk in those markets where the funding is sourced from the repo market. I think these two assumptions are reasonable and the spike in the price of gold to $1,900/oz was in my view triggered first by the speculation and later by the confirmation of the downgrade to AA+ of the US credit rating by Standard & Poor’s. It has also seemed very curious to me that since that moment, and in a very strange way, the gold market became more volatile, with violent triggered sales, on no relevant news (But this is pure speculation, only proper to myself, of course).
The third assumption is that the Fed would intervene in the way I suggest. And this, indeed, is more debatable. It is certainly not the only way the Fed could act. There are other “versions”, but this is the more likely in my opinion and others have led to the same results, in other countries at other times (refer for instance, the “Cuenta de Regulación Monetaria” implemented by Argentina in 1978, where the central bank paid a subsidy on interest-bearing deposits and cashed a penalty on chequing accounts). Also, bear in mind that if this scenario unfolded, nobody would want to take the other leg of the long futures contracts on commodities (for instance, by 1981, the central bank of Argentina had to absorb and finance a loss $5.1BN in foreign exchange swaps from failed counterparties, refer Communication “A” 31 (May 6th, 1981). At the end of 1982, this loss was estimated at $10BN), converting the markets into a one-way ticket to high inflation: The link between forward rates, commodity prices and inflation expectations would be lethal!
Finally, the fact that US policymakers have been busy lately trying to regulate money market funds is to me an indication that I am not alone with these concerns. After a failed attempt by SEC Chairman Mary Schapiro to regulate money funds, on November 13th, the Financial Stability Oversight Council put forth new recommendations to regulate the industry. Of course, some of these recommendations (see “minimum balance at risk”, on page 6 of the document) do not apply to Treasury money market funds, because US sovereign debt is not risky, right?
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