Today, as I write this piece, it is Monday, August 16th of 2019. Precisely 48 years ago, on Monday, August 16th of 1971, the link between the US dollar and gold was severed. On the night before, in a historic television address, President Nixon announced the end of the gold backing of the US dollar.
The history of interest rates goes back thousands of years. In Sidney Homer’s book “History of Interest Rates”, the logic and purpose of interest rates is explained. I would love to see an update on that book today. The world of money and interest rates we currently live in bears little, to no, resemblance to any of the episodes described in Mr. Homer’s book.
Ten years after the end of dollar gold backing, long-term yields rose to more than 15%. Then, over the following 4 decades, we saw interest rates in a continuous decline. Back in the summer of 2016, when the yield on 30-year US Treasuries dropped below 2.1%, I was convinced the bond market rally was over. Today, a little over three years later, the 30-year Treasury yield dropped below 2%! And it may still not be done falling. Around the globe and in the chambers of the US Federal Reserve, negative interest rates appear to be “the plan” for economic survival.
I remember my first year at university and the concept of the risk-free rate and the valuation of projects and investments based on CPV (current present value) calculations. Today, amid negative interest rates everywhere, I find it increasingly challenging to reconcile these concepts with the present day “Easy Money” realities.
Money Scarcity in the Midst of Helicopter-Money Policies?
Is it possible? Money scarcity and a lack of liquidity during outright “money-for-free” policies? Yes, it is. Despite government “money factories” working overtime, the world is witnessing an overall deceleration in money supply.
As Felix Zulauf succinctly explains in his August Investment Comment, the Fed’s tapering attempt has in fact led to a global liquidity scarcity and the central bank may (once again) have been too late to recognise the recessionary signs:
“We are aware that Fed easing is usually bearish for the US currency. But this time is somewhat different – yes, these are dangerous words! We have explained in previous reports that liquidity will tighten due to the Treasury manoeuvre and despite the rate cut. While Fed Chairman Powell believes this is a mid-cycle slowdown, we wonder how he could know. The Fed has not seen one of all the recessions coming since WWII. Why should they see better this time? And why should investors believe them and not the fixed-income markets that have a much better forecasting record?”
Felix Zulauf also points out that world dollar liquidity (US monetary base plus foreign central bank holdings of Treasuries) is still in negative territory, while different global liquidity measures, such as the aggregate balance sheet of the Fed, ECB, BoJ, plus forex reserves, forex reserves and central bank holdings, have all entered into negative territory on a rate of change basis.
“Tight and tightening liquidity – yes, despite a rate cut in the US – is bullish for the US unit. Moreover, other major central banks may use any US rate cut to ease on their side, as recent cuts in Brazil and South Korea have shown. Moreover, the US dollar is a counter-cyclical currency due to its very low manufacturing part, and due to the world economy still being on a USD (non-) system. Whenever the world economy slows, the US dollar strengthens and vice-versa.”
Easy Money Tantrums
Of course, we must remember that central bank monetary policy is not a precise science. At best, it is an art, and an abstract one at that. Personally, I like to imagine the policy-setting process as a group of professors, with ink on their white robes, tinkering with sensitive explosives…
They are trying to pump new money into circulation against the deflationary tide rolling over the world. Parallel attempts are being made to hand the banks and other lenders new “money”, so that they can redistribute it as new loans, all in a futile attempt to reignite a credit expansion.
Over the past few months, we were rudely thrust into the next phase of Easy Money “tantrums”, accompanied by political strife and financial market turbulence. The only asset that has provided shelter to investors was gold, which of course takes us full circle back to the beginning of this article.
Today’s world is best described as a battle of INFLATION versus DEFLATION. After decades of government-orchestrated monetary inflation (central banks desperately adding more liquidity to global markets), the world now faces the potential of a deflationary twister.
Don’t get me wrong, we may not go from the current state into that deflationary zone immediately or linearly. It will be a bumpy ride, with ups and downs in financial markets and politics. But, instead of describing this precarious economic situation myself, I’ll use a quote from Jens O. Parsson’s must-read book “Dying of Money”, published in 1974:
“Everyone loves an early inflation. The effects at the beginning of inflation are all good. There is steepened money expansion, rising government spending, booming stock markets, and spectacular general prosperity, all in the midst of temporarily stable prices. Everyone benefits. No one pays. That is the early part of the cycle. In the later inflation, on the other hand, the effects are all bad. The government may steadily increase the money inflation in order to stave off the later effects, but the later effects patiently wait. Then, with terminal inflation, there is faltering prosperity, tightness of money, falling stock markets, rising taxes, still larger government deficits, and still roaring money expansion, soon accompanied by soaring prices and ineffectiveness of all traditional remedies. Everyone pays and no one benefits. That is the full cycle of every inflation.”
This describes very well where we stand today. This crisis may not play out as one would deduce from any past personal experience, and certainly not based on the economic rules and principles we studied in school. We are coming to the end of a full-blown credit cycle. As pointed out by Jens Parsson, the later effects of government-orchestrated monetary inflation “patiently wait”. Accordingly, you will need to be patient too and accept that an overly inflated balloon may not always pop. More often than not that balloon will deflate with a hiss, and yes, a sound of flatulence here and there.
Over the coming months and years, successful wealth management will require PATIENCE, combined with acute ALERTNESS. What will kill you is COMPLACENCY! Get solid advice, study the facts, consider alternative scenarios and how they will affect your wealth moving forward. Then, take informed and decisive action!