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.

Bumpy road ahead

“Buy When There’s Blood in the Streets” – Baron Rothschild

… and sell when everything seems to be alright. The serenity of the markets might be unsettling for contrarian-investors. The VIX (implied volatility index) is reportedly cheap, hitting multiyear lows, indicating that market players – or at least those who have access to these hedging instruments – expect no correction in the short term, as the index trails only 30 days. However, the concerns are below the surface, hidden in least known indices and instruments.

First a quick catch up for those who are not entirely familiar with option trading and the importance of volatility. Among other metrics and constant, option pricing requires 3 main inputs: the timeframe the option can be called, the risk-free interest rate for discounting purposes, and the expected volatility. However, in the real world the last bit is rather an output, a side-product of trading, rather than an ingredient.

What is the option for? As a hedging instrument option can be perceived as insurance policies. I pay a premium, and if the non-desirable outcome materialized I can make a claim on the multiple of the paid price. The more likely the outcome the more encouraged option buyers will become, while suppliers (insurers) might want to re-evaluate the likeliness of claims and increase their premiums. Both trend points towards higher prices.

Risk-free rates and timespans are known, not changed by the option market`s sentiment. Prices, on the other hand, might very well be a victim of changing attitudes. In order to equilibrate the option pricing formula, the only variable which `must have changed` is perceived volatility in the lifetime of insurance policies. Thus, the implied volatility index has been born by using the above derivation.

VIX measures all the options which are currently out-of-money (the strike price has not been reached yet or the trigger event is still ahead with other words). If it were health insurance it would cover minor injuries just as life threatening ones, a whole bundle of outcomes. The SKEW index (also published by the Chicago Board Options Exchange (CBOE)) rather resembles a life insurance. The calculation merely relies on outstanding options which have a strike price 2-3 standard deviations out-of-money, meaning they are highly unlikely and would be fatal for the underlying market.

Currently the big fish trading such indices kept the general insurance cheap, while the life-insurance policies have been slowly crawling higher as the bull-market matures. Why bother to pay for papercut coverage when we are heading towards the edge of the cliff? At least the narrative of markets suggests it… my takeaway point is only that one should always examine the whole scope of sources, and don’t get deceived by a single metric. The current sentiment is far from calmness, which is also reflected in record amounts of dry gunpowder to support the market a bit longer, or for more prudent fund managers to be used to buy the dip in case of a collapse.


On the value of money

If you ask people about the meaning of money they will either give you the textbook definition of the three roles, given that they are litarate in basic economics, or give you a very confused look. In one form or another, we used it every day for several millenia, yet most of us have never concieved the true meaning of it. ‘I can buy stuff with it, and that’s more than enought to know.’

Except it is not. Approximately a century ago economic litarature and interests were sufficiently developed to examine the phenomenon of inflation, or the change in the value of a monetary unit. The aftermath of a great wars of the 20th century served with the extreme real life experiment for the next decades. Fisher argued that the source of all evil is the changing nature the ‘monetary yardstick’, gold standard must be reestablished, and prices should be fixed. A couple of years later Keynes found that the source of all evil is indeed the change in the ‘price of money’, yet the solution is the manage the change, and let prices float.

But what is this price we are arguing about? Money, whatever form it takes, is a debt. If you own it you have saved, the market (meaning the group of users of the currency) owes you one, while if it is presented the seller supposed to settle the debt. Default is an option too, though it will erode the market. Hence the price of the debt is all the goods it can be redeemed for. Fisher’s dream, that every debt should be settled in commodities, actually has been in place since the beginnings. It’s just the ratio which tends to flucuate. If one can be certain that the debt will be settled, trust is high, capacity exceeds needs the price of money (not to be confused with price of goods!) goes up. If doubts arise about future shipments, vendors quit the market, or productive capacity destructed the price of money goes down, inflation picks up.

On velocity of money and willingess to exchange

Since capacity/consumption/GDP all measured over time and money is just a plain number/stock, we have to convert it to be able to make an apples-to-apples comparision. For this reason economists created the term ‘velocity’ of money, which means the amount of occasions money changed its owner within certain period of time.

Eventually this circulation will determine the price of money. As mentioned above money can be redeemed. Holders of the money stock must be willing to redeem their previous savings, otherwise a vast amount of goods will compete for scarce amount money, increasing the price of money. This in return will make it a good investment, further decreasing willingness to exchange money for goods (increase willingess to sell goods for money), creating a deflationary spiral. In such an environment the amount of money did not change, only the willingness to give it away, indicated by lower velocity numbers.

What Keynesian policy smartly included and contemporary policy is lacking is this willingness. The owner of the newly printed money must spend it, optimally without creating new capacity. In the 30s the governments did not only create the stock, but also velocity and artificial willingness (inducing further willingess on behalf of the private sector and kickstarting economic circulation). If you ever wonder why this time is different, look for this hidden feature of monetary policy conduct, and the austerity measures of governments. The real game changer for markets won’t be the extra stock, but the increased willingness to spend.


Monetary normalization

Ten years after the last financial crisis, most of the big central banks still hold their ultra-loose monetary policies. Even though the ECB seemingly started to taper its QE programme, the money pumps will be on until the end of the year. However, due to base effects (and changing nominal pace of purchases), the ‘tapering’ started more than a year ago by now. The Bank of Japan kept his policy stance so far, although it is questionable how long can they buy assets without jeopardizing the smooth operation of private financial firms or their own solvency. The Fed also switched to a dovish tone lately. Correspondingly, the dollar index went through a mild correction following the Trump-rally in last year’s November and December. One of the reasons might be the fading of the expected policy rate difference between major central banks. Since commodity prices stabilized, inflation returned, and global trade was partly revived, expectations shifted to the upside. Europe might represent an exception, however the weighted 10-year-yield also took part in the global yield rise in the last half a year.

Nowadays the Eurozone still resembles to the international gold-standard system after WWI: fixed exchange rates with balance of payments imbalances. The main issue lies within the solution, governments have to rely solely on internal devaluation by following pro-cyclical policies. The problem with such measurement is its unpopularity, hence can not be held without political turbulences. Realizing the issue, the ECB is constantly trying to inflate the core-economies, while also trying to avoid a debt-deflation spiral in the periphery. Two birds with one stone, we could say. Lowering real debt burden, while they try to restore the balance between economies. Unfortunately, the households of the core do not cheer the measures as they feel the value of their savings eroding.

The strength in the euro and raising core government bond yields are more likely to be due to the favourable result of the French election regarding the unity of the monetary bloc. The insurance premiums (= chance of the Eurozone falling apart * appreciation in national currency) faded, however, the internal imbalances are still present in the system. Given the latter condition, I would be surprised if the ECB would rush with its policy normalization, inflation tolerance will be higher. Negative real rates are still needed and it seems they are here to stay with us.

Lagging policy

The Trump-administration pledged to cut corporate income tax rates from 35 to 15 percent in the recent days. In accordance with the previous rhetoric of Trump’s campaign and presidency, the measure is also aimed to support international competitiveness and improve external balances by lowering the tax content of American production. After the first hearing, it doesn’t seem to be a bad idea, as the US has the highest official tax rate among OECD member countries. However, if someone would take a look behind the headline numbers the picture would change significantly. On the one hand, when compared to GDP numbers the American corporate tax burden is much lower than in most OECD economies, representing a smaller burden for the overall supply chain. On the other hand, the effective corporate tax rate is 11 percentage point below what the official numbers would suggest.

The differences between official and technical measures originate from various factors. Firstly, American corporation producing for export markets may not bring the profits home, hence spare a round for the taxman, and increase the profit for themselves. Secondly, the share of profits and margins within the headline GDP numbers may differ from country to country, thus examining plain vanilla tax rates does not result an apple-to-apple comparison in the system’s competitiveness. Thirdly, and maybe most importantly, rules of taxation may once again differ between OECD member states. There are several factors, such as accounting for amortization and write-downs, or deferred payments, which can effectively change the base or the temporal flows of public funds.

American corporations already exploiting deduction policies to get a leverage against Uncle Sam. For instance, the companies of S&P 500 are eligible for future deductions around 200 billion dollars, which also appear on their books. Altering the tax rate would change the valuation of such assets, hence create an immediate loss for the firms. However, this loss might be dwarfed by the amount of lower tax obligations in the future. According to the first round calculations, the new tax regime would create a 2-billion-dollar gap on the government account in the next ten years, creating federal debt equal to roughly 12 percent of current economic output. Even though nominal numbers are set to increase, the economy does not have to effectively pay it back in order to build down its debt burden. The other way is to grow it out.

Increasing government deficit would have the same monetary effects as credit expansions created by commercial banks. As in any kind of accounting, the economy also needs a corresponding ‘savings’, or asset side. This may come from the saved tax money, which effectively means that a unilateral social transfer would be replaced by a bilateral agreement (government bond) which would create a ‘tangible’ and marketable asset. The other way is to finance the deficit by involving foreign investors into the equation. However, this would result in deteriorating external balances, exactly the opposite what the current administration is trying to achieve. (Financial and capital accounts = current account)

The two solutions are not mutually exclusive, nor make a difference regarding following policy implications. By issuing new bonds (either financed internally or externally) the quasi-money supply increases, along with money velocity. Given that capacity constraints apply, it would be surprising if the real economy could keep up with this monetary expansion without inflationary pressures. This may help the government finances, however, the Fed would need to tolerate higher inflation.

As a result, if the Fed doesn’t raise rates the dollar would weaken due to low real rates, international investors my demand higher interest rates and sell their treasury holding off. The other way, if the Fed decides to raise the rates to fight inflation, primary fiscal deficit may prevail. Either way, the Treasury department faces a hard time in the long-term for a short-term gain on the peak of the recovery.

Currency of Mordor

More than a year ago the Fed had its first rate hike in more than a decade. The event will definitely be remembered as a milestone, however, it is yet hard to tell if it will mark the start of a firm recovery or something worse. Just remember the example of ’36; it was premature then, and given the still negative output gap, underemployment, and demographic changes this might be proved to be wrong too.

The monetary tightening started a bit before December of 2015 though. Prior to the historical hike, the Securities Exchange Commission (SEC) announced its planned reform regarding the operation of money market mutual funds, the USD 2.7 trillion sector, which is responsible for both internal and external interbank lending. According to the new regulations, money market mutual funds investing in non-government issued securities must change to floating NAV accounting (making it a bit more volatile to investors), and can use liquidity fees and redemption gates to prevent fund-runs.

The legal changes came into effect last October, however, markets always price in advance. Exactly a year before the implementation of the reform, preparing for tightening and for the reform, investors headed to the exit, and started to stockpile funds with T-bills. This raised borrowing costs on the interbank market (USD Libor), made currency swaps (Eurodollar, yen) costly, and widened the TED spread, sending small, but significant shockwaves through the markets. If you were preparing for the rate hike with floating instruments linked to Libor you could beat the market for 14 month now.

But why did Libor rates rise? If I buy the T-bill from an other investor know he will have to hold the liquidity, or buy something else, in which case his new partner will hold the money. It cannot disappear from the system this way.

Similarly to the One Ring in Tolkein’s epic tale, modern currencies can only be destroyed were they were born. In the depth of Mount Doom, in this case also known as the Fed’s vaults (or accounts, to be more precise). Given the role of dollar in international finance, I believe it is not inappropriate to say that this little change made many markets’ life harder, especially when the dollar was already increasing financing costs due to its appreciation.

One Ring to rule them all, One Ring to find them,
One Ring to bring them all and in the darkness bind them…

As this little story foreshadowed it, if you are interested in the where the money went you have to dig up the Fed’s balance sheet. In this period, when Libor started rising, and money flew from prime money funds, you will find two factors behind the tightening of liquidity. Firstly, banks entered into reverse repo agreements, obtaining government bonds from the Fed’s stock. Secondly, the government account drained bank liquidity (high powered money). Although, the latter doesn’t necessarily imply that the banks were given bonds in exchange, the effect is nonetheless the same. Interbank liquidity dries up.