China on the ropes

At the beginning of summer a series of US protectionist tariffs has been implemented, including both allies and rival markets. The legitimacy of such an economic solution is secondary now, as the decision has already been made. The reasoning is mostly based on false assumptions and observations regarding world trade, and even real problems – such as the Chinese market barriers or intellectual property rights handling – could have been handled more effectively by undertaking reciprocal measures on the US market (e.g. entry only through a domestic partner).

China retaliated with its own package of tariffs on US goods. The targeted products were mainly picked by political considerations, and aimed at producers and sectors who are predominantly Trump supporters. Nonetheless, people started to make guesses on how can China more effectively retaliate against a new rounds of US tariffs on Chinese goods. Capital market measures are among the cards, at least according to several websites and magazines. China is among the biggest US government debt holders with a stock of 3 trillion USD and a market share of 15 percent. The discussion talk about a range of possible solution, from analytically reasoned lower purchasing volumes to click-bait published sell-it-all solutions.

As China is keeping to its mercantilist economic policy in order to export capital and expend its strategic influence or build strategic funds to compensate later for its rapidly aging population, the Chinese economy needs a feasible asset for keeping its savings safe. Thus selling their stock would hurt their own long-term interest too. Firstly, in order to fire-sell  such an immense amount (both in absolute and relative terms) you must accept lower prices, making a loss for yourself if there is no buyer. Secondly, even if such sale would be possible, the leadership should find and equal alternative to park its savings.

The only viable buyer one can consider is the Fed itself. Since collapsing bond prices would drag on interbank activity to household and company balance sheets to the public sector due to the bills and bonds’ central role in modern monetary politics, the Fed should step up to safeguard the economy from the turbulence. As the mandate of the Fed (on financial stability) makes this solution possible, money pumps could run wild once more.

As a last resort for the Chinese retaliation, the devaluation of the yuan is also among the cards. On one hand, a weaker yuan could counterbalance the negative price effect of tariffs in yuan terms. On the other hand, the Chinese private sector is heavily loaded with both local and foreign currency debt. A devalued yuan might spark a dollar buying frenzy to hedge against increasing liabilities, creating a slippery slope for the Asian currency. To manage the float the PBoC should sell dollars once more and buy its own currency, resulting in a de facto monetary tightening and higher domestic debt-servicing costs. Between a rock and a hard place.

After we considered all these technical details, I find a capital market retaliation an unlikely, tail-risk scenario.

The dawn of the dollar

The beginning of the summer brought nice weather and American protectionist tariffs to a significant part of the world this year. The US already imposed tariffs on Chinese steel and aluminum products earlier this year. By the end of the spring it has also imposed those tariffs on Europe, Japan, Mexico, and Canada. The impacted countries hastily retaliated by imposing their own tariffs on products and services coming from the States. Furthermore, Japan and the EU issued a joint declaration, condemning the American move and criticizing it for obstructing international trade and jeopardizing growth. Additionally, Canada also filed a WTO complaint against the US.

Seemingly, the United States is ready to make sacrifices in order to isolate itself from the global economy, it won’t even exclude its trade relations with its own allies. The Trump administration tries everything to declare the 5th Avenue a foreign-car-free zone. The only problem is that Trump’s Manhattan friends probably have very good personal reasons for driving a Mercedes, it is not an enforced decision. Logically you can expand this reasoning to the entire economy as well. Any good or service is preferred due to its higher perceived cost/value ratio. To break it down: something can be preferred either by getting higher value for the same price, or by getting the same value cheaper. However, we must point out that value in case of consumer products is a highly subjective term. Yet, German manufacturers face the same subjectivity as their American peers.

The isolation, or voluntary self-exclusion of the United States from the global economy carries countless political, economical, and social implications. Let us focus on a plain, yet extremely crucial aspect for now: its currency. The US Dollar undoubtedly serves as the world currency in the contemporary economic setting. It is present in case of offshore lending, and it is a crucial instrument of the intra-regional trade for several emerging economies. Most of the commodities on the world stage are denominated in dollar terms, hence making the dollar a non-excludable element of international commodity trade. The greenback is the most wide-spread reserve currency too, creating the precondition of a liquid dollar market for the stability of emerging currencies (one must buy/sell dollars to safeguard the value of its own currency).

The countless uses and the liquidity of global markets are guaranteed by the US financial system, not to mention its trade deficit with the rest of the world as well. Each year the US economy pumps billions of dollars of available liquidity onto the global economy, guaranteeing a continuous de facto monetary expansion. Notwithstanding, it would be foolish to think that this symbiosis is a lopsided phenomenon, or that the flows described above are part of a giant zero-sum game. The excess dollars in circulation are used to provide cheap credit for the US economy, and to help its lavish consumption. Moreover, it is a further advantage for the domestic users of the world currency to gain resistance against world price fluctuations (e.g. a Brazilian soybean producer must keep and eye of both soybean prices and the Brazilian real, whereas her American peer has to focus on only one).

In case the United States want to forcefully decrease its deficit – by using tariffs, quotes, or sanctions in extreme instances – the global economy can be easily left without sufficient supply of liquidity. This scenario would lead to opposing implications on the two sides of the American border.

On the one hand, within the States an isolationist policy will result in less and/or more expensively available goods, while the money in circulation would initially increase, since it cannot leave the economy through foreign trade channels. Both factors support inflationary forces and leads to the diminishing value of onshore dollars. The Fed could counterbalance this by hawkish monetary policies, however, it is questionable whether such policies would be feasible once cheap foreign credit dries up.

On the other hand, the rest of the world would experience a shortage of greenbacks and piling of unsold goods simultaneously. Within the financial sphere, the lack of available liquidity leads to increasing funding costs, aka nominal yields. The lack of money and the abundance of goods points towards deflation otherwise. The real yields of offshore USD will almost inevitably increase. The biggest winners of the divergence in the difference between onshore and offshore prices are the financial institutions who can play this arbitrage opportunity.

If we take the base scenario of an escalating trade war between the US and its partners, investing in offshore USD money markets can be an attractive trade/hedge. Nonetheless, persistent financial conditions can easily create the need for a new world currency; and it leads to the breakdown of the US dollar’s hegemony.

Real threat of AI

Google’s presentation about AI assistants calling hairdressers and restaurants rattled the news. The conversations definitely seemed to pass a Turing-test, raising moral and ethical questions about the use of AI. Google says that such AI interactions will inform the other end about the nature of the call, so we have little to worry about. Beyond the arguments whether the spread of AI will lead to a dystopian future, where James Cameron’s Terminator or the Wachowskis’ Matrix will become reality, I found the economic argument just as threatening.

The rise of internet based economy, robotization, and machine learning already turned most economic sectors, thus most people’s lives upside down. There were no need for machines turning on humans, we did it ourselves, mainly through protest votes and sometimes by putting incompetent populists into leadership positions. How governments, decision makers, and the market will regulate AI will be more interesting to follow than speculating on how to defeat SkyNet.

Firstly, let’s look at a simple example: who was the main benefactor of industrial revolution in the UK? The technological advancements definitely increased profits of the clothing industry, but mainly through economies of scale, lowered costs, and thinner margins on each product. The more compelling answer is that, as always in economics, the coin has two sides. The clothing industry definitely benefited from the implementation of new production methods, but so did consumers who could buy affordable clothing. Who are the losers? Inefficient competitors and a portion of the workers.

Secondly, let’s decouple the phenomenon with economic terms. As I always say, get rid of the money factor in such analysis. What we end up with is a part of the economy, who produces clothing, and another part which produces something else and demands clothes. They exchange at a given rate, determined by relative prices. If suddenly I can produce more clothes with the same effort I will have extra purchasing power, extra goods I can exchange. How is this extra welfare captured?

If the other side of the economy has no demand, the extra value will be zero for both of us. If they have demand, but no spare capacity then I can only outbid someone else with my extra clothes, and receive the same amount of goods. The outbid people might not get what they originally wanted, but my vendor captured the entire extra value, which she can exchange yet for something else. As you can see in the latter case the value is actually not captured by the innovative producer (me in the example), but by my consumer. However, my consumer can once again use the extra purchasing power, which can be passed on until it finds extra capacity somewhere. On an aggregate basis it sounds attractive. Yet this path restructures the economy which always carries the risk of turbulence, or market failure in extreme cases. The last possibility of value capturing is the most desirable and simple. I have extra clothes, my consumer/vendor of other good has spare capacity. Both of us end up with more goods what we desire.

Thirdly, have a look at today’s case. The rise of AI, just as any other efficiency improving technology, will create extra value in industries where they are implemented. If a wide segment of the economy is able to leverage on it simultaneously, that is the closest we can get to the most desirable scenario.

Finally, we must talk about redundancy and its effects on labour. Once again, if the broad segment of the economy is affected by the change the demand will increase alongside the capacity. Thus there will be no need to sack people. However, this has one condition. People must be able to produce by using the new technology. The biggest threat to implementing AI is not its visioned rise against humanity, but the uneven development and the faith of unskilled labour.

Trade and price wars

The US Presidential decision the impose tariffs on steel and aluminium imports at the beginning of March threw a rock into the still water. It would be convenient to deem the action as another short-sighted protectionist move, or as a part of the political agenda to favour the American Rust Belt. As no political move exists in vacuum, there is a high probability that those claims stand as well, and it was a ‘two birds with one stone’ action. However, there is an additional factor which must be weighted in to understand the circumstances and the lead-up to the imposition.

The clash of world ideologies is far from being over. Even though the number of democratic countries has more than tripled during the post-WW2 era, the political ideology rivalry – which shaped the 20th century – has arrived to yet another turn. The liberalization wave of the late ’80s and early ’90s brought another 1.2 billion people’s lives under democratic insititutions, and a similar number of people – not necessarily from the same groups – has entered the global labourforce as well.

The two opposing sides are the pluralist market economies and their centrally planned–or at least closely supervised–peers, with the difference also mirrored in their political institutions. During the second half of the 20th century it seemed that the trend will lead to the dominance of market economies. The inefficiency of central planning in adapting to external shocks made them fall behind in the arms-race and economic competition. These inefficiencies eventually rattled into the political system. The West saw an opportunity in this socio-economic connection. Supported by the Friedmanian perspective of economics, the political leadership’s new agenda was to trade with a broad segment of socialist and semi-socialist systems, which would create middle-classes who will push for economic reforms and pluralism from the inside.

The theory didn’t work out as planned though. China, the focus of this instance, has recently moved away from any form of democratization, and back towards complete authoritarianism. Unfortunately, this is not only a local political issue. It also affects world trade, and indirectly even domestic politics of other sovereign countries. Party leadership, cronyism, and state-planned economics all have their influence on supply chains and business decisions. It only makes the situation worse if the Party has a mercantilist ideology where they view the global economy as a zero sum game.

Let’s take the example of the Chinese steel industry. The Communist Party’s political agenda is to conserve jobs in the heavy industry to satisfy fullest employment possible, and to obtain foreign assets by exporting extra capacity. The leadership has several incentives – let it be personal or ideological – to subsidise the sector in order to meet its goals. However, direct subsidies are not allowed according to WTO rules, which China more or less tries to meet to create the illusion of a benevolent, inward focusing developing market. Hence an alternative way must be found.

This alternative is using political power to pressure the financial sector to issue below market rate loans for favoured producers. Historically the only form of savings were bank deposits, making cheap financing more easily available. However, nowadays with increased financial sophistication within the system more direct supervision is needed, bringing the central planning measures to the surface. Practically speaking, the banking sector passes a share of its profit to the exporting industries, which creates de facto subsidies. As China is not playing according to the rules, it is less of a surprise if the US wants to use its sticks where the carrots failed.

Even though it seems unfair in the short term, the long term implications are just as bad. Firstly, artificially adjusting market prices leads to longer term inefficiencies. The profits missing from the banking sector will obstruct credit growth, and reduce the loss absorbtion capacity of the financial institutions. Secondly, favouring certain sectors create a ‘Dutch disease’-like situation, where (unnaturally) efficient sectors absorb capital and labour from the system, thus creating a headwind for other industries. Lastly, such political agendas obstruct creative-destruction in order to keep employment high and ‘reliable’ businessmen in leading positions. Unfortunately we are all dead in the long-run, as Keynes wisely concluded before, hence waiting for these trends to take effect might not worth the effort.

Sinister Signs

In the latest post I examined the fundamental side of BitCoin, and concluded what points are missing to create an economically viable currency. We saw that the bubble phenomenon generally means that an asset’s valuation substantially diverts from its underlying utility to the upside. Hence the rally reflects a speculative mood, where the only reason of the purchase is to sell it to a higher bidder, and cannot be explained by the improved fundamentals of the asset. A typical instance is the equalizing prices of tulip bulbs and properties in Amsterdam during the peak of the mania. Even though the utility of a flower is a highly subjective matter, it is hard to believe that an entire market can be indifferent between adoring the beauty of a plant and having a shelter in the buzzing economic hub of the 17th century Netherlands. However, as the personal value or utility is absolutely subjective, it is hard to precisely define what is the turning point in an asset’s life where we can start to call it bubble. For example, today’s lofty price of crypto-currencies would be justifed if one would believe that they can actually replace their traditional peers in the longer run. Yet, their limited presence in commerce, lack of regulation and supporting financial system makes it a bumpy ride towards their mainstream use and stable demand.

Although investors’ expectations vary, are often based on subjective judgements, and can be subject to cognitive bias, there are signs which can raise the alarm if the end is near. I won’t bore the reader with the well-known effects of housewives and psychological cases of pensioners. Furthermore, I will also avoid graph analysis, even though some of these tools are also good precursors of upcoming sudden volatility. Instead, let me focus on two technical factors of investing: the appearence of competitors and the use of derivatives. As we will see, there is no exact correlation, but these factors can highly contribute to the rise and fall of new asset classes.

The jealousy of the competition

As the basic economic principle holds, the higher the price, the more willing people become to supply the concerned good (or service). Regarding financial markets, the big central banks partly tried to leverage on this oversimplified assumption after the financial crisis and great recession when they pressured the yield-curve. The higher the bond prices become, the more willing corporations will be to sell them to the public and obtain funds.

The case of crypto-currencies is not any different. As soon as potential suppliers realise the business opportunity and purchasing power of the markets behind cryptos, they will try and jump on board the hype-train to issue their own revolutionary virtual coins. While the total value of ICOs (Initial Coin Offering) barely touched the 62 million USD limit in 2016, the last calendar year brought an astonishing increase to 2 200 million USD for first time issuers.

I already discussed the realtion between a currency’s usefulness and its market capitalization in my last article. In the case of financial markets, it is beneficial to view market capitalization in an alternative way. While an existing asset’s capitalization theoretically can be increased by just passing a single piece back and forth, using relatively low amounts of liquidity to raise the total value of the stock, initial offerings are different. The 2.2 billion USD mentioned above actually flew from one market participant to another, absorbing liquidity from the market. As we have seen, in the case of an initial offering the entire capitalisation has to be backed by funds, therefore the appearence of imitators facilitates the absorbtion of purchasing power in a soaring market.

Besides the simple phenomenon of new-comers on the market, another detail can also foreshadow the beginning of the end. The key here is the quality of the product. In traditional commerce it is an ancient trick in the book to raise prices by deteriorating the quality of the final good, and  leaving the nominal price unchanged. In the case of virtual currencies, the phenomenon occurs through fundraisings where the investors don’t get a piece of code, only a promise that they will get one upon the completion of the project. It is easy to see that selling a future good which is currently in production doesn’t only raise the price through present value calculations, but also by an added risk factor. On top of all this, this unregulated environment paired with a buying frenzy provides the perfect condition for scams.

Derivatives on the stage

Even though financial derivates are not the root of all evil, there were several instances where they were associated with market bubbles. They are indeed significant factors in forecasting the beginning of the final chapter when it comes to bubble stories. Similarly to the competitor aspect, the appearence of derivatives has a technical role in facilitating a frenzy and its collapse. These instruments make leveraged trades feasible for the masses, where investors only have to pay a fraction of the valuation during the transaction.

On the one hand, leveraged trading can give a boost to soaring asset prices. Since paying a couple of dollars more for a call option or forward contract can cause the underlying valuation to jump several hundred dollars in some cases, it is easy to see how a buying craze about this ‘cheap’ alternative can cause extremly volatile asset prices on the spot market. On the other hand, the downside risk of invetsing also gets amplified by the introduction of leveraged speculation. A couple of percentage points of correction on the primary market can wipe out the entire postion of leveraged holders, leading to margin calls and loss of wealth. These leveraged players might be tempted to cover their losses by selling their positions on Main Street, inducing a vicious circle between the derivative and spot markets.

The first test of the integrity of these instruments is when the contracts first come due and investors have to pay the remaining amount as forward contracts become spot ones.

Conclusively, there is no certain way to forecast market collapses or bubble bursts. However, accounting for technical factors and knowing the mechanism of different kinds of trades can help us to come up with an educated guess regarding the dawn of a mania.

Modern Tulipmania

Bitcoin’s value surpassed the 7 000 USD psychological limit during the first days of November. Most of the investors are cheering, however, it is not surprising given that there is a bubble inflating on its market, fuelled by wild speculation. Such euphoria is not unusual when an asset price reaches a new high each week. The tulip bulbs of the 21st century are not exceptions.

The Blockchain technology backing the digital currencies can actually be valuable. It is a decentrerlized, immediately available information system can save money, effort, and time compared to its linear peers. For instance, in case of an online marketplace, whether it is for physical goods or invesments, used or new, the use of a mediator during the transaction is almost universal. The role of these mediators vary between providing payment methods, IT infratructure, financial clearing, or acting as an agent for the parties; but it is almost always a common denominator. The spider web like, immediately available information is superior in its efficiency compared to the individually sent bits and pieces. Digital accounting might be the real innovation, not digital currencies. Wouldn’t be the first time in history that the application of a new accounting method and more efficient informational system, not the modern currencies improved the efficiency of commerce.

Regarding the financial application, the viability of the system is just as straightforward. Replacing multilayered interbank transactions with P2P technology, where each party can see the changes right away, can save days for clients. In case of investing and margin payments even hours can make a difference, but the saved time is also significant from cash-flow and working capital management perspectives. Unfortunately, the creators of the digital currencies are precisely aiming to break down the banking system by introducing P2P solutions, hence these benefits can not be harvested. Controversially Bitcoin and its peers try to create an alternative for cash payments, the exact type of transactions which are mostly between only two parties, leaving no leverage for the technology, and no effective need to ‘inform’ the entire network of the transaction other than its operative use. Consequently the technology becomes counterproductive, and economies of scale becomes diseconomies of scale. The more participant there are the more redundant information channels will be created. According to ING’s calculation, Bitcoin is one of the least efficient payment method when it comes to the costs of making a transaction (see charts).

So what creates the value of a Bitcoin? In order to understand the phenomenon, let us see what supports the value of traditional money. Primarily the value of money is created by basic economic (supply and) demand for currency. Purchasing goods and services requires an intermediate of exchange, creating demand for liquid assets. As a second step, add the debt markets and financial intermediaries to the equastion; the big picture remains mostly unchanged. Investors and speculators give credit in exchange for interest or principal appreciation, however, they need demand for liqudity on the other end to be able to lend money. Once again, the other end means demand for goods and services, where the debtors use proceeds to finance their physical investments or consumption. Of course we could say that loans could flow towards other financial assets, but once again real economy must stand at the end of the financing line, or we deal with mindless speculation, just like in the case of Bitcoin.

But how does the case of Bitcoin look like? The digital currency’s market capitalization (value of a coin x number of coins in circulation) is around 117 billion USD. To put it into context, the Fed’s balance sheet, providing liquidity for the global market of US dollars, is approximately 4 500 billion USD. In order to measure whether market cap is too high, let us think about the goods, services, assets, commodities and bonds USD liqudity can be exchanged for gloablly (creating demand for the greenback), and then compare it to the ubiquity of Bitcoins in commerce. Compared to these measures, there is no real demand behind Bitcoin, other than the trust that there will be a bigger fool than me, who will buy it at an even higher valuation. Since everyone plays according to this rule, once inflows dry up there will be no buying power and everyone will try to sell at the same time.

Advocators of the digital currency often cite low volatility and high turnover/financial liquidity (in terms of Bitcoin exchanges to other currencies) on its market. The second part might be true due to speculation and the asset’s ability to circumvent authorities in case of international settlements. Likewise, historically low volatility is rather the sign of a smooth, increasingly suspicious upswing in the rate, rather than a balanced market of supply and real demand. Lastly, a thought regarding an appreciating currency and its commercial viability. Since there is no banking sector which could counterbalance the appreciation (deflation) of the currency with low nominal yields, every percentage points of increased value counts as real interest. Nowdays, when real returns are scarce, it is not puzzling that speculators will jump onto an asset with such remarkable appreciation. The only issue is that why would you spend something if in the future its value will increase, and why would a vendor price anything in a unit which’s value changes by the minute.

Bitcoin, in its current form, is not viable. It is a free floating nothing, supported by speculation and some benevolance. A necessary collapse, which also seems to be inevitable, could kickstart digital currencies. After the price settles on a lower level, where market capitalization is in tandem with its real demand, the commercial use becomes more likely. However, the diseconomies of the technology even then remain unsolved… and immerse amounts of ‘wealth’ have to evaporate until that moment.

Orthodox unorthodoxy

Did you think central bankers are out of bullets? They are just getting started!

A couple of years ago, during the immediate aftermath of the financial crisis, central banks rolled out a bundle of monetary measures, considered to be unorthodox at the time. Liquidity injections, swaps, asset purchasing programmes, and later negative interest rates and asymmetric interest rate corridors were all in the magazine. These policies seemingly reached their limit, yet leading central banks are still struggling to generate wage growth and substantial inflation throughout the global economy.

For the last more than half a century there has been a status quo regarding the correlation between the two factors. However, new times require new paradigms. The theoretical foundation of contemporary monetary policy is called the ‘Phillips-curve‘. Besides that the original theory was formed around the UK labour market in the 1950s, describing a non-globalised, manufacturing heavy, technologically limited Western economy, policymakers often miss other flaws of the model. Even from a technical perspective, the model does not suggest the necessity of increasing inflation as a consequence of tight labour market. The function also accounts for inflation expectations, and external shocks (meaning: changes not in the inflationary or labour environment). After 30+ years of decelerating inflation, opening of economic borders, structural changes in the economies, and shifting demographics it would be hard to argue that tight labour market (which, by the way, is only relying on a single metric of headline unemployment) is the single most significant factor in inflation generation. However, one must give credit to the fact that in lower competition for job openings workers’ negotiating power certainly increases.

Enacting loose monetary policy, central bankers around the world could stop the bleeding by pumping enormous amount of liquidity on the markets, thus lubricating financial transactions. The result is ultra cheap money, high valuations, and capital cost optimisation through corporate leveraging. They were able to keep the enterprises and workplaces afloat, even though negative side-effects arose, such as the deteriorating marginal efficiency of wealth effect, or the emergence of a zombie sectors, whose debt-servicing capabilities rely on ultra low yields.

The next stage is going to be a bit more complicated. As I mentioned above, wage growth is still missing, while asset prices are soaring. This is especially troubling for some millennials who trying to get their first home and have to save up for the deposit. Some central banks – sensing that they have reached the limit of orthodox unorthodoxy – surpass their mandate, and deploy a brand new policy tool: make direct recommendations to the public instead of nudging them by setting financial conditions. The Reserve Bank of Australia urges employees to negotiate for higher wages. However, in a globalised marketplace with no inflation, and cheap financing for automation, it is hard to nudge the labour market to negotiate for higher nominal wages. As every policy tool, this measure can be used as a two-edged sword as well. In Indonesia, deputy governor Rosmaya Hadi asked religious leaders to preach against lavish spending, trying to curb inflation numbers.

The gridlock of inflation

Paradoxically, generating inflation, alias accelerating it, would be easier if we had some currency depreciation in the first place. Somewhat, but meaningfully positive nominal rates would make debt-servicing costly for zombie companies, provide cash flow for fixed income investors, and help banks to recapitalise to start lending again; all without putting real interest burden on the economy. These are just a couple of reasons why economists argue for higher inflation targets. However, it is not an easy job to convince the generation of central bankers, who grew up in a double digit inflationary environment, to change their mindset about higher targets.

Just as generals always try to win the last war, central bankers always try to respond to the last crisis. This contributed to the high inflation in the 1970s, when policymaker – remembering the deflationary pressure in the 1930s – fell behind the curve and let real policy rate go well below zero (see graph). Nowadays, when the memory of taming inflation is still vivid, the challenge won’t be coming up with newer policy measures to make someone else do the job. It will be to turn back to ‘ye olde’ monetary tools and raise the inflation target. That will be the unorthodox game changer.

Policy lag

Debtful future with ‘silver’ lining

During monetary tightening short term debt is one of the best instruments you can bet on. Turning to the short end of the yield curve limits your risk, your portfolio can trace policy rates, and gives you the freedom of liquidity. The strategy won’t turn you into a self-made millionaire – unless you are already one – but provides a prudent way to hedge against rising interest rates. If you were following the markets in recent weeks, you might have noticed something irregular. The difference between 6-month and 3-month T-bills turned negative, which means that quarterly paying bills yield higher returns. (see graph)

If you are familiar with the importance of yield curves you know what it means. If you are new to the topic let me sum it up for you. The longer the duration, the higher the interest rate is supposed to be. The reasons include liquidity, interest rate, and default risks. Furthermore, the shape of the curve follows the expected policy rate between maturities, making it one of the most reliable indicators when it comes to forecasting recessions. If you want to know more about its predictive qualities click here. Since we are in the middle of a tightening cycle and interest rates don’t tend to go back and forth within a couple of months, we can conclude that policy rate expectations play little role here; it must be something from a risk perspective.

As the end of September is approaching, the U.S. Congress is supposed to create the budget for next year, however, there is a bump on the road. The debt ceiling is in the way.

A little background about the debt ceiling: the measure was introduced in 1917. As a part of its involvement in World War I, the U.S. acquired debt from the private sector in order to finance its operations and its allies in the Old World. Since its establishment Congress had to approve new debt issuance, but the wartime required a more time efficient measure. The Second Liberty Bond Act made this time efficient solution feasible by only limiting the amount of new bonds issued. To reach its current shape, a second World War was needed. The debt ceiling reached its current form in the early years of World War II, accounting for gross federal debt in nominal terms.

I have a couple of problems with the measure. Firstly, it measures gross debt. Given that the government acquires assets, and not just fills the gap in the budget, the gross number might give you a false impression about the indebtedness of the system. For a real life example look up the difference between Japan’s gross and net national debt figures. Almost a 100 percent difference. Secondly, it is in nominal terms. Inflation and increasing economic activity (ceteris paribus regarding taxation) makes it easier to service nominal debt mountains. Fixing nominal levels result in a volatile real burden, often in the way of supportive – or at least not restrictive – economic policy, assuming a growing business activity.

The new budget, proposed by the Trump administration, is about to hit the ceiling. If it can not be raised, the Congress has to find alternative financing solution to borrowing, or risk a shut down. Before we get back to those sweet, inverse short-term yield curves, let me write a couple of words about public financing.

Most entities in the economy- let it be a household, firm, or municipality – rarely aim to deleverage by paying back nominal amount of debt. The most common way is to raise capital either from the market, or gradually by improving revenue streams. The Federal Government is not an exception. Paying back one bond means issuing new ones and rolling the debt, keeping the size of the balance sheet up. Hence, if they can’t refinance, the default risk is increased. Now get back to the bonds.

The ones which are going to mature 3 months from now are just after the predicted hit of the ceiling. Without a solution, repayment might come short. Before you get the wrong idea, I don’t say that the US will default. It just got itself into an interesting situation which is enough to create some turbulence on the T-bill market. Personally, I think it is a good opportunity with limited risk to get ahead of the Fed tightening curve and get a couple of basis points for ‘free’.

Bad solution, worse solution – the old stock and flow argument

One of my favourite point is when they confuse stocks and flows in the economy. I admit, it’s not straightforward, as most of the stocks have been flows at some time, and some assets – such as capital instruments – can be both at the same time for different parties. If you are interested in the topic, I can recommend reading Minsky’s ‘Stabilizing and unstable economy’.

Once again in monetary history, precious metals can offer a way out from the malaise. I have read two interesting alternative solutions to raising the ceiling. Firstly, we have the Trillion Dollar Coin. The monopoly of minting coins is still in the hands of the Treasury. With minting a coin and selling it to the Fed the Treasury would effectively engage in debt monetization, as the coin has no intrinsic value. This would either inflate the Fed balance sheet even further, opposite to the monetary policy aim, or would create a theoretically insolvent Federal Reserve system by writing off the value of the coin from the books just as it were a zero-coupon perpetual asset – what it effectively would be. Regarding the consequences of the first case let us see the second solution.

The second solution, even though involving precious metal (re)valuation as well, is less unorthodox. However, it would require the Fed to play the role of an investment bank or hedge fund, which it is not. The solution concerns the gold reserves of the government. Long story made short: during the 1930s everyone in the US had to sell their gold to the Fed, which amount was later sold to the Treasury in exchange of gold certificates at $20.67 per ounce. The certificates were reevaluated during the subsequent decades, all the way up to $42.22 per ounce. Today’s market price of ~$1250-1260 dwarfs the official value of the stock. By reevaluating the certificates the Fed could book an eye-watering $315 billion, which could be matched by government deposits on the liability side. Again, pretty much smells like QE.

The problem is that it would be hard to reverse the revaluation as it would cause respective accounting losses. So what happens if the Fed keeps the Trillion Dollar Coin or the reevaluated gold certificates on its balance sheet?  Here comes the problem of stocks and flows. In both cases the asset the Fed would hold is a stock, generating no income. On the other side of the balance sheet they would hold deposits – possibly converted into bank deposits sooner or later – which are cash flows, costing interest (currently costing 1.25 percent annually).

This gold trick probably won’t be implemented, as the Fed is not willing to engage in sneaky QEs. Fortunately, these are not the only, but certainly among the most unusual solutions, worth playing around and asking ‘what if’ questions.


Source: Bloomberg Marketsshort yield spreads US

The death of cash

The global economy is flushed with cash and liquidity, yet we do not see Weimar levels of inflation. After the Great Financial Crisis, when one central bank after another announced their low interest rate and quantitative easing policies, thousands of economists, business, and financial expert cried out that the era of hyperinflation is upon us. From low to high, gold prices soared 147 percent in dollar terms within three years.

Playing around with the numbers: gold appreciated 2 percent annually since the last World War. Accounting for that ‘natural appreciation’, the market priced 33 percent annual dollar inflation into the gold prices in three years on a compounded basis.

Despite low interest rates and the sea of ‘cash’, the expectations turned out to be wrong. Central bankers are still struggling to reach their inflation targets in the West – except the Bank of England due to special circumstances. Even though easy monetary policy affects the real economy through more than one channel, let me focus on my personal favourite: the wealth effect.

According to the general economic narrative, as household and companies become more affluent their willingness to spend increases too. Despite soaring net worth of the US households, personal consumption expenditure did not catch up, in fact a record low amount of their wealth is consumed in the US.

What went wrong? Well, probably you could partly blame the uneven distribution of the wealth effect, or the increased propensity to save since low interests also inflated future obligations, such as pension liabilities. But there is yet an additional, but crucial factor here: there is no income from inflating asset prices. In fact, it erodes income, creating a lack of cash.

A couple of year ago when the ECB started to cut its policy rate into negative territory, fixed-income investors – including myself – were desperately looking for meaningful yields. I managed to find a promising German real estate managing company. They were on a brink of becoming one of the industry leaders in the EU’s biggest economy, their financial metrics showed resilience, had a growth strategy, the macro background looked supporting, and they offered 4 to 6 percent yield on their bonds to finance their expansion. Perfect value target.

The bonds are about to roll over, and the company already issued new ones to refinance their debt from the market. The new bonds offer 0.5 percent coupon on over 5-6 years. Let that sink in, you technically won’t get paid until the end, there is no cash flow to be discounted, except the terminal one. There are two implications. Firstly, because of low interest rates the company can afford to issue debt on such terms. This means that the new instruments will be extremely sensitive to policy normalisation, since the final cash flow must ‘foot the bill’ of a yield increase. Secondly, you have no income to spend in the meantime.

Unluckily, the shopkeeper doesn’t accept one eights of German corporate bonds when I want to do my weekly grocery shopping. Hence, if I want to invest today it won’t add anything to consumption. I have one question to central bankers around the globe: I want to know where my money is, and I want it right now… I mean real, spendable money. Unfortunately, I know their answer

missing wealth effect

Cultural clash, banking, and economics

Recently global trade balances and free trade enjoyed the undivided attention of policymakers, economists, businessmen, and voters all around the globe. With the G20 summit just ended in Hamburg, leaving the city in devastation, it seems that global trade just got new champions. While in the second half of the twentieth century Washington was the main advocator of open trade borders, it seems that the EU with Germany in the lead and China take the role. As the baton is getting passed, even free trade advocators made an outcry about imbalances in international trade.

The gold standard revisited

As my good friend pointed out, Germany’s trade surplus doesn’t primarily flow to the EU periphery. In fact, if any members should be blamed for destabilising the monetary union it should be the Dutch. However, the Netherlands runs the biggest surpluses against the German and the British. Using the logic of the Economist, the former one cannot complain, while the latter is not in the monetary bloc, hence currency movements should be able to offset imbalances.

The main issue of critics regarding the monetary bloc is that in its current form the Eurozone is technically a fixed exchange rate system, where the fixed ratio happens to be one to one. We have seen fairly similar circumstances in the 1920s, after European countries tried to return to the gold standard. Due to different implementations of the return – fixing exchange rate or returning to pre-war price levels – some countries gained a competitive advantage compared to their peers trying to curb inflation by conducting pro-cyclical policies. Such imbalances does not necessarily imply a modern way of mercantilism, as long as the nations, foreign institutions and individuals are willing to lend to each other. The problem – just as in the case of a domestic crisis – is the ebb of liquidity or lost trust in the counterparty… and when the tide goes out we discover who’s been swimming naked, as we know.

So why is Germany’s surplus a problem? Not because it might leave Southern members in debt, but because German companies and states are reluctant to lend to the periphery. What remains is either paying in cash, leading to effective mercantilist trends and deepening deflationary forces on the periphery, or selling capital (real estate, companies, etc.) to German counterparties. While to former one seems unattractive since it demonetizes the economy, the latter one rather receives resistance due to populist arguments.

The back-up plan

As exchange rates have fixed relative prices, real effective exchange rates must adjust through internal devaluation. Expressing it using human language: Germany must become more expensive compared periphery prices if we want to equate trade balances. The ECB got a plan for that, namely conducting idiosyncratic monetary policy. Supporting the periphery with cheap euro and low rates, while also overheating the German economy with the same measures.

The problem is German financial culture is anti-debt. Despite the ultra-low rates nor the government, nor the private sector rushes through the door to get new loans. However, the rest of the Eurozone has no problem with hoarding debt.

Gresham’s law with a twist

Bad money drives out good. It’s not any different when it comes to ‘Italian Euros’ and ‘German Euros’.

The ECB’s monetary policy resulted further undesirable consequences on top of the counterproductive debt trends. As part of the QE programme private investors government bonds are getting purchased by the ECB and local arms, meanwhile they receive deposits in exchange. The problem is that it is not central bank deposit, but belongs to commercial banks. As some periphery investors don’t trust these banks over solvency issues, they rather take their money and put it into a core bank. Eventually this fund will flow back to the periphery, using interbank channels involving ECB guarantee. Not even the rest of the Eurozone wants to fund itself, why would the Germans?

Balance of payments?

As a result of general rejection of taking debt of the protestant business culture, Germany was not as good at ramping up non-financial debt as the remaining of the Eurozone. High savings rate can simultaneously keep wages competitive and the trade balance in surplus. At the same time, German businesses and institutions are struggling to find an acceptable counteroffer, as they don’t really want consumer goods or periphery debt. Capital account redemptions – currency or physical capital – only offer temporary solution, just as the inter-state lending.

Who to be blamed? Nobody. You cannot blame the lender if they are not willing to lend to a client with deteriorating credit rating. Nor can you accuse the upper-middle class with being careless if they don’t want to bail out the economy using their savings during a recession, and say ‘they should consume more’.

The gold standard broke down once countries ceased to be willing to lend each other. Today is not different. The Eurosystem helps to mitigate the risk for now, but the first bank failure could undermine the trust if (among others) German taxpayers had to recapitalise the ECB. The only accusation you can make is against German ignorance towards the realisation that in one form or another Germany has to foot the bill sooner or later.