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Why a bear market will lead to a dollar collapse
Why a bear market will lead to a dollar collapse
Falling equity markets this week are likely to signal the onset of a bear market, responding to a combination of the coronavirus spreading beyond China and persistent indications of a developing recession.
This has provoked a flight into US Treasuries, with the ten-year yield falling to an all-time low of 1.31%. This will prove to be a mistake, given US price inflation which on independent estimates is running close to ten per cent, exposing US Treasuries as badly overpriced.
After this short-term response, much higher US Treasury yields are inevitable. Foreigners, who possess more dollars and dollar investments than the entire US GDP will almost certainly sell, driving bond yields up and the dollar down, leaving the Fed the only real buyer of US Treasuries.
This article goes through the sequence of events likely to destroy value in US financial assets and the dollar as well. And what goes for the US goes for all other fiat-currencies and their financial markets.
Introduction
In my last article I pointed out that the cumulative effect of central bank intervention has led to bond prices that have come badly adrift from reality. Taking a more realistic estimate of the dollar’s purchasing power than that implied in goal-sought CPI numbers, plus an estimated amount for the time preference involved, ten-year US Treasuries should yield closer to 10% to maturity, not the 1.31% implied today. If a ten-year bond has a coupon such that it is currently priced at par, the price should halve.
Those who put our monetary misfortunes down to the coronavirus have missed the point. Yes, it will be fatal, both economically and unfortunately for some of us as individuals as well. It is early days in what is definitely becoming a pandemic, that is to say an epidemic that is not restricted to national boundaries.
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Coronavirus and credit – a perfect storm
Coronavirus and credit – a perfect storm
This article posits that the spread of the coronavirus coincides with the downturn in the global credit cycle, with potentially catastrophic results. At the time of writing, analysts are still trying to get to grips with the virus’s economic impact and they commonly express the hope that after a month or two everything will return to normal. This seems too optimistic.
The credit crisis was already likely to be severe, given the combination of the end of a prolonged expansionary phase of the credit cycle and trade protectionism. These were the conditions that led to the Wall Street crash of 1929-32. Given similar credit cycle and trade dynamics today, the question to be resolved is how an overvaluation of bonds and equities coupled with escalating monetary inflation will play out.
This article sees worrying parallels with the collapse of John Law’s Mississippi scheme exactly 300 years ago. By tying in the purchasing power of his livres to the value of his Mississippi venture, Law ensured they both collapsed together in the space of only six months.
The similarities with our Keynesian experiment are too great to ignore. Could a simultaneous collapse of fiat currencies and financial assets happen again? If so both the money bubble and financial asset bubble could be fully deflated into worthlessness by this year’s end.
The epidemic
“Ring-a-ring o’ roses / A pocket full of posies / A-tishoo! A-tishoo! / We all fall down.”
Some folk attribute this old nursery rhyme to the plague in England of 1665. But it seems singularly appropriate for coronavirus or COVID-19, about which, as yet, we know little. Its origin is, allegedly, a mutation of a virus from a snake, bat or pangolin. Alternatively, one school of thought believes it escaped from a biological warfare laboratory in Hunan.
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Gold’s outlook for 2020
Gold’s outlook for 2020
This article is an overview of the economic conditions that will drive the gold price in 2020 and beyond. The turn of the credit cycle, the effect on government deficits and how they are to be financed are addressed.
In the absence of foreign demand for new US Treasuries and of a rise in the savings rate the US budget deficit can only be financed by monetary inflation. This is bound to lead to higher bond yields as the dollar’s falling purchasing power accelerates due to the sheer quantity of new dollars entering circulation. The relationship between rising bond yields and the gold price is also discussed.
It may turn out that the recent extraordinary events on Comex, with the expansion of open interest failing to suppress the gold price, are an early recognition in some quarters of the US Government’s debt trap.
The strains leading to a crisis for fiat currencies are emerging into plain sight.
Introduction
In 2019, priced in dollars gold rose 18.3% and silver by 15.1%. Or rather, and this is the more relevant way of putting it, priced in gold the dollar fell 15.5% and in silver 13%. This is because the story of 2019, as it will be in 2020, was of the re-emergence of fiat currency debasement. Particularly in the last quarter, the Fed began aggressively injecting new money into a surprisingly illiquid banking system through repurchase agreements, whereby banks’ reserves at the Fed are credited with cash loaned in return for T-bills and coupon-bearing Treasuries as collateral. Furthermore, the ECB restarted quantitative easing in November, and the Bank of Japan stands ready to ease policy further “if the momentum towards its 2% inflation target comes under threat” (Kuroda – 26 December).
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A History of Inflationary Money: From 1844 to Nixon
A History of Inflationary Money: From 1844 to Nixon
So that we can understand the financial and banking challenges ahead of us, this article provides an historical and technical background. But we must first get an important definition right, and that is the cause of the periodic cycle of boom and bust. The cycle of economic activity is not a trade or business cycle, but a credit cycle. It is caused by fractional reserve banking and by banks loaning money into existence. The effect on business is then observed but is not the underlying cause.
Modern banking has its roots in England’s Bank Charter Act of 1844, which led to the practice of loaning money into existence, commonly described as fractional reserve banking. Fractional reserve banking is defined as making loans and taking in customer deposits in quantities that are multiples of the bank’s own capital. Case law in the wake of the 1844 act, having more regard for the status quo as established precedent than for the fundamentals of property law, ruled that irregular deposits (deposits for safekeeping) were no different from a loan. Judge Lord Cottenham’s ruling in Foley v. Hill (1848) 2 HLC 28 is a judicial decision relating to the fundamental nature of a bank which held in effect that
The money placed in the custody of the banker is to all intents and purposes, the money of the banker, to do with it as he pleases. He is guilty of no breach of trust in employing it. He is not answerable to the principal if he puts it into jeopardy, if he engages in haphazardous speculation.
This was undoubtedly the most important ruling of the last two centuries on money. Today, we know of nothing else other than legally confirmed fractional reserve banking. However, sound or honest banking, with banks acting as custodians, had existed in the centuries before the 1844 act and any corruption of the custody status was regarded as fraudulent.
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America’s trade policy will end up destroying the dollar
America’s trade policy will end up destroying the dollar
America’s tariffs against China are already showing signs of undermining the global economy and will create a funding crisis for the Federal Government when it leads to foreigners no longer buying US Treasury debt and selling down their existing dollar holdings. A subversive attempt by America to divert global portfolio investment from China by destabilising Hong Kong will force China into a Plan B to fund its infrastructure plans, which could involve actively selling down her dollar reserves and hastening the introduction of a new crypto-based trade settlement currency.
The US budget deficit will then be financed entirely by monetary inflation. Furthermore, the turn of the credit cycle, made more destructive by trade tariffs, is driving the global and US economy into a slump, further accelerating all indebted governments’ dependency on inflationary financing. The end result is America’s trade policies have been instrumental in hastening the end of the dollar as the world’s reserve currency, ultimately leading to its destruction.
Introduction
For almost two years President Trump has imposed various tariffs on imported Chinese goods. He advertised his tactics as hardball from a tough president who knows the art of the deal, taking his business acumen and applying it to foreign affairs. He even proudly described himself as a tariff man.
His opening gambit was to impose tariffs on some goods to get leverage over the Chinese, with the threat that if they didn’t cooperate, then further tariffs would be introduced. The Chinese declined to be cowed by threats, introducing tariffs themselves on US imports, particularly agricultural products, to bring pressure to bear in turn on President Trump.
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Plans for a global Dystopia
Plans for a global Dystopia
Global policy planners intend to deliver replacements for both dollar hegemony and fossil fuels. Plans may appear uncoordinated and in their early stages, but these issues are becoming increasingly linked.
A monetary reset incorporating state-sponsored cryptocurrencies will enable exchange controls to be introduced between nations by separating cross-border trade payments from domestic money circulation. The purpose will be to gain greater control over money and to direct its investment into green projects.
The OECD will build on current tax disclosures to make everyone’s income and capital known to governments and therefore readily taxable, money destined to kick-start economic growth. Under the guidance of supranational organisations, governments will redirect investment into green technology. The objective, particularly for Europeans, is to neutralise Russia’s increasing dominance of the global energy market by becoming carbon neutral by 2030.
But perhaps as Robert Burns put it, “the best-laid schemes o’ mice an’ men gang aft agley”. They are based on Keynesian fallacies, but cannot be ignored.
Introduction
There appear to be policy areas being driven by statist responses to events, encouraging global institutions to take on a coordinating role. It means deeper levels of centralised planning by unaccountable bureaucrats. Assuming their plans continue to gain credence, we could end up with a dystopian world where supranational bodies direct individual governments to conform. We are already on this road to perdition. The OECD has coordinated attempts by governments to restrict the freedom of their citizens to avoid taxes by forcing over a hundred jurisdictions to automatically supply information on the financial affairs of every citizen, irrespective of nationality and where they reside.
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The monetary lessons from Germany
The monetary lessons from Germany
Germany suffered two currency collapses in the last century, in 1920-23 and1945-48. The architect of the recovery from the former, Hjalmar Schacht, chose to cooperate with the Nazi successors to the Weimar Republic, and failed. In that of the second, Ludwig Erhard remained true to his free market credentials and succeeded. While they were in different circumstances, comparisons between the two events might give some guidance to politicians faced with similar destructions of their state currencies, which is a growing possibility.
Introduction
Let us assume the next credit crisis is on its way. Given enhanced levels of government debt, it is likely to be more serious than the last one in 2008. Let us also note that it is happening despite the supposed stimulus of low and negative interest rates, when we would expect them to be at their maximum in the credit cycle, and that some $17 trillion of bonds are negative yielding, an unnatural distortion of markets. Let us further assume that McKinsey in their annual banking survey of 2019 are correct when they effectively say that 60% of the world’s banks are consuming their capital before a credit crisis. Add to this a developing recession in Germany that will almost certainly lead to both Deutsche Bank and Commerzbank having to be rescued by the German government. And note the IMF recently warned that $19 trillion in corporate debt is a systemic timebomb, and that collateralised loan obligations and direct exposure to junk held by the US commercial banks is approximately equal to the sum of their equity.
Then we can say with some confidence that a major credit crisis is developing, and that it will almost certainly be far greater than Lehman.
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Central Bank “Stimulus” is Really a Huge Redistribution Scheme
Central Bank “Stimulus” is Really a Huge Redistribution Scheme
When an economy turns from expansion to contraction there is an order of events. The first signs are an unexpected increase in inventories of unsold goods, both accompanied with and followed by business surveys indicating a general softening in demand. For monetarists, this is often confirmed by an inverting yield curve, which tells them that at the margin the short-term rates set by the central bank are becoming too high for business conditions.
That was the position for the US 10-year bond less the 2-year bond very briefly at the end of August, since when this measure, which is often taken to predict recessions, has turned mildly positive again. A generally negative sentiment, fueled mainly by the escalating tariff war between America and China, had earlier alerted investors to an international trade slowdown, expected to undermine the American economy in due course along with all the others. It stands to reason that backward-looking statistics have yet to reflect the global slowdown on the US economy, which is still buoyed up by consumer credit. The German economy, which is driven by production rather than consumption is perhaps a better guide and is already in recession.
After an initial hit, a small recovery in investor sentiment is understandable, with the negative outlook perhaps having got ahead of itself. But we must look beyond that. History shows the combination of a peak in the credit cycle and tariffs can be economically lethal. A brief return to a positive yield curve achieves little more than a sucker rally. It may be enough to put further monetary expansion on pause. But when that is over, and jobs begin to be threatened, there can be no doubt that central banks will ramp up the printing presses.
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Monetary failure is becoming inevitable
Monetary failure is becoming inevitable
This article posits that there is an unpleasant conjunction of events beginning to undermine government finances in advanced nations. They combine the arrival of a long-term trend of rising welfare commitments with an increasing certainty of a global-scale credit crisis, in turn the outcome of a combination of the peak of the credit cycle and increasing trade protectionism. We see the latter already undermining the global economy, catching both governments and investors unexpectedly.
Few observers seem aware that an economic and systemic crisis will occur at a time when government finances are already precarious. However, the consequences are unthinkable for the authorities, and for this reason it is certain such a downturn will lead to a substantial increase in monetary inflation. The scale of the problem needs to be grasped in order to assess how destructive it will be for government finances and ultimately state-issued currencies.
Introduction
Listening to recent commentaries about the repo failures in New York leads one to suppose there is insufficient money in the system. This is not the real issue, as the chart below of the fiat money quantity for the dollar clearly shows.
The fiat money quantity is the amount of fiat money (in this case US dollars) both in circulation and held in reserve on the central bank’s balance sheet. Before the Lehman crisis, it grew at a fairly constant compound growth rate of 5.86%. Since the Lehman crisis, it has grown at an average of 9.45%, even after the slowdown in its rate of growth that started in January 2017. FMQ is still $5 trillion above where it would have been today if the massive monetary expansion in the wake of the Lehman crisis had not happened. If there is a shortage of money, it is because the process of debt creation to fund current expenditure is spiralling out of control.
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An Inflationary Depression
An Inflationary Depression
Financial markets are ignoring bearish developments in international trade, which coincide with the end of a long expansionary phase for credit. Both empirical evidence from the one occasion these conditions existed in the past and reasoned theory suggest the consequences of this collective folly will be enormous, undermining both financial asset values and fiat currencies.
The last time this coincidence occurred was 1929-32, leading into the great depression, when prices for commodities and output prices for consumer goods fell heavily. With unsound money and a central banking determination to maintain prices, depression conditions will be concealed by monetary expansion, but still exist, nonetheless.
Introduction
The unfortunate souls who are beholden to macroeconomics will read this article’s headline as a contradiction, because they regard inflation as a stimulant and a depression as the consequence of deflation, the opposite of inflation.
An economic depression does not require deflation, if by that term is meant a contraction of the money in circulation. More correctly, it is the collective impoverishment of the people, which is most easily achieved by debasement of the currency: in other words, monetary inflation. Fundamental to the myth that an inflation of the money supply is the path to economic recovery are the forecasts by the economic establishment that the world, or its smaller national units, will suffer no more than a mild recession before economic growth resumes. It is not only complacent central bank and government economists that say this, but their followers in the private sector as well.
It is for this reason that the S&P 500 Index is still only a few per cent below its all-time high. If there was the slightest hint that Corporate America risks being destabilised by a depression, this would not be the case.
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The Ghost of Failed Banks Returns
THE GHOST OF FAILED BANKS RETURNS
Last week’s failure in the US repo market might have had something to do with Deutsche Bank’s disposal of its prime brokerage to BNP, bringing an unwelcome spotlight to the troubled bank and other foreign banks with prime brokerages in America. There are also worrying similarities between Germany’s Deutsche Bank today and Austria’s Credit-Anstalt in 1931, only the scale is far larger and additionally includes derivatives with a gross value of $50 trillion.
If the repo problem spreads, it could also raise questions over the synthetic ETF industry, whose cash and deposits may face escalating counterparty risks in some of the large banks and their prime brokerages. Managers of synthetic ETFs should be urgently re-evaluating their contractual relationships.
Whoever the repo failure involved, it is likely to prove a watershed moment, causing US bankers to more widely consider their exposure to counterparty risk and risky loans, particularly leveraged loans and their collateralised form in CLOs. The deterioration in global trade prospects, as well as the US economic outlook and the likelihood that reducing dollar interest rates to the zero bound will prove insufficient to reverse a decline, will take on a new relevance to their decisions.
Problems under the surface
Last week, something unusual happened: instead of the more normal reverse repurchase agreements, the Fed escalated its repurchase agreements (repos). For the avoidance of doubt, a reverse repo by the Fed involves the Fed borrowing money from commercial banks, secured by collateral held on its balance sheet, typically US Treasury bills. Reverse repos withdraw liquidity from the banking system. With a repo, the opposite happens: the Fed takes in collateral from the banking system and lends money against the collateral, injecting liquidity into the system. The use of reverse repos can be regarded as the Fed’s principal liquidity management tool when the banks have substantial reserves parked with the Fed, which is the case today.
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