Dangerous Games of Chicken

Doug Nolan

Friday, January 30, 2015

It’s difficult to imagine more challenging analysis.  The global nature of the current Credit Bubble creates dynamics and complexities dissimilar to previous Bubble cycles.  There are extraordinary uncertainties – in hyper-speculative global markets, in experimental policymaking, in unsettled societies and unstable geopolitics.  Never have market perceptions mattered as much.  And never before has global activist monetary management so impacted market sentiment and prices – well, at least going back to the late-twenties.

I have written that I am these days more worried than in 2007, and back then I was quite apprehensive.  And while today’s global risks dwarf those of 2007, complacency and faith in central bankers have become so deeply embedded in securities and derivative prices.  Never has there been such extreme divergence between inflating securities markets and deflating future prospects.  As an analyst of Bubbles, I contend with the inevitable “chicken little” issue.

This week offered important confirmation of my global macro thesis.  Greece, a eurozone member, has a democratically elected radical party now controlling parliament and a leftist government led by a charismatic radical prime minister.  A deeply disillusioned people have spoken, and they’re fed up with Greek affairs being dictated from Brussels and Berlin.  Post-Bubble dislocation and ongoing policy-induced wealth redistribution finally reached the breaking point.  Sunday’s Greek election has left wing, right wing, anti-euro and antiestablishment parties throughout Europe further emboldened.  Greece is now moving rapidly toward a conflict with the EU, with potentially profound consequences for global markets.  A “Game of Chicken” has officially commenced.

January 30 – Bloomberg (Nikolaos ChrysolorasMarcus BensassonEleni Chrepa): “Finance Minister Yanis Varoufakis said Greece won’t seek an extension of its bailout agreement, setting the government on course to enter March without a financial backstop for the first time in five years. Greece won’t engage with officials from the troika of official creditors who have been policing the conditions of its rescue since 2010. It’s five-day-old government wants a new deal with the European Union that allows for more spending, Varoufakis said at a joint press conference with Eurogroup Chief Jeroen Dijsselbloem in Athens, Friday. ‘We don’t plan to cooperate with that committee,’ Varoufakis said. ‘The Greek state has a future, but what we won’t accept has a future is the self-perpetuating crisis of deflation and unsustainable debt.’ The standoff could see Greek banks effectively excluded from European Central Bank liquidity operations and the government with no source of funding, having rejected EU aid while still shut out of international markets.”
It’s worth noting that Putin and the Russian government have courted Syriza as well as anti-euro parties throughout Europe.  As strange as it sounds here in the U.S., Putin is idolized by many of Europe’s so-called “fringe” politicians – leading political movements that are rapidly gaining power and influence across the continent.

Thursday’s headline from the FT (Sam Jones, Kerin Hope and Courtney Weaver):  “Alarm Bells Ring Over Syriza’s Russian Links: Soon after Syriza, the Greek radical leftwing party swept to power this week, alarm bells began ringing in the capitals of Europe. But it was not finance officials who were rattled but Europe’s defence and security chiefs. The day after his election as Greece’s new prime minister, Alexis Tsipras threw a grenade in the direction of Brussels: he objected to calls for fresh sanctions against Russia as a result of rising violence in Ukraine. On Wednesday, Athens went further: ‘We are against the embargo that has been imposed against Russia,’ said Panagiotis Lafazanis, the energy minister and leader of Syriza’s far left faction… ‘We have no differences with Russia and the Russian people.’ The Greek rebuff has elicited an angry — and, behind closed doors, indignant — response. EU powers led by the UK, Germany and France, have lately trodden a careful path in trying to keep the EU’s 28 member states unified on the need to impose a financial and economic cost on Russia for its destabilising actions inside Ukrainian territory. While some diplomats and analysts see Mr Tsipras’ intervention against more sanctions as an opening gambit in forthcoming negotiations over Greece’s international bailout and debt burden, others point to it as another example of spreading Russian influence in southeastern Europe.”
I am again reminded of Adam Fergusson’s classic, “When Money Dies: The Nightmare of Deficit Spending, Devaluation, and Hyperinflation in Weimar Germany.”  In reading a brilliant account of the German monetary breakdown, it was incredible how German central bankers remained oblivious to the reality that their printing operations were at the root of an unfolding catastrophe. Like today’s central banks, German bankers at the time believed their actions were a necessary response to outside forces.

These days it goes unappreciated that crises - ongoing and unfolding alike - emanate from an unprecedented period of unsound global money and Credit.  To be sure, financial, economic, social and political turmoil in Greece has been a direct consequence of years of unsound finance.  The euro monetary experiment, hatched during a period of optimism, integration and cohesion, is now a slow motion train wreck in today’s backdrop of growing discontent, disenchantment, hostility and disintegration. Greece, of course, must shoulder much of the responsibility.  Yet the euro currency coupled with unfettered global finance provided the noose for the Greeks to hang themselves.  Runaway global monetary inflation has ensured an abundance of nooses.

“Greek” and “Ukraine” crises this week seemed to merge into a potential geopolitical quagmire, with Russia supplying the muck.  It’s been my view that Russia’s invasion of Ukraine likely marked a historic inflection point.  The optimistic consensus view has been that Putin misjudged Western reaction to his Ukraine gambit – and that punishing sanctions would spur his retreat.  The disconcerting view, one I subscribe to, holds that the U.S. and the “West” on various fronts crossed Putin’s red line, provoking a fundamental change in the geopolitical landscape.  Not only would Western sanctions fail to alter Putin’s course, they would ensure a tit-for-tat escalation with the potential to spiral out of control.  The Ukraine conflict has again escalated.  Putin will not miss an opportunity to fracture Europe and split the “West” more generally.

For the week, Greek five-year yields surged an astounding 598 bps (to 15.00%), the high since the 2012 crisis.  Greek bank stocks collapsed.  As the markets prepare again for default, Greek CDS jump 560 bps this week to 1,732. The Russian ruble was slammed for 8.3% this week.  Russian 10-year dollar yields jumped 60 bps to 7.42%, the high since mid-December.

Greece now provides a clear and present danger to already weakened global markets.  From a more general market analysis framework, I’m watching for burst Bubble EM contagion.  To begin the year, EM has generally benefited from the perception of ongoing (“do whatever it takes”) liquidity abundance.  Yet the short-squeeze rally faltered this week.  I'm monitoring Brazil and Turkey closely.

On the back of the Brazilian real’s 2.9% Friday decline, the real fell 3.8% for the week.  Brazilian (real) yields jumped 24 bps this week (to 11.96%) with dollar yields up 28 bps to a four-week high 4.30%.  Petrobras bonds dropped a record 5% in Friday trade after a Moody’s downgrade.  Brazil these days faces an ugly mix of inflation, corruption investigations, government deficits and financial fragility.  They’ve had way too much government-directed lending and similar amounts of dollar-denominated borrowing.  Their central bank has written a huge amount of currency swaps.

The Turkish lira was slammed 3.8% this week to a new record low against the dollar.  Turkey certainly has its own corruption issues.  The Turkish central bank is now under intense pressure from the Erdogan government to aggressively slash interest rates.  Loose financial conditions have to this point sustained rapid Credit growth in Turkey, with attendant trade deficits and imbalances.  Similar to many EM economies, Turkey has issued significant amounts of dollar-denominated debt (government, corporate and financial).

On the EM currency front, this week saw the Mexican peso hit for 2.1%, the South African rand 2.1%, the Colombian peso 2.1%, the Indonesian rupiah 1.7%, the Peruvian sol 1.3%, the Chilean peso 1.4%, the South Korean won 0.9% and the Malaysian ringgit 0.8%.  It’s worth mentioning that the (offshore) Chinese renminbi lost 50 bps, trading to its lowest level versus the dollar since 2012.

Key EM equities markets were also under pressure.  Stocks in Brazil and Mexico were both down about 4%.  China’s Shanghai Composite fell 4.2%.  Turkish stocks were hit for 2.0%.

Let’s get back to Europe.  From my perspective, European crisis risk has elevated to the highest level since the summer of 2012.  Yet we’re at the phase of the cycle where disregarding risk comes naturally.  Complacency has been repeatedly well rewarded, especially back in 2012.  The bullish assumption is that the EU will flinch – that the Germans will back down as they’ve repeatedly done.  Surely Tsipras and Syriza don’t have a death wish - thus will eventually fall in line to remain in the euro.

Yet this is not 2012 – and Alexis Tsipras is a different character.  I don’t see Merkel and Schaeuble offering concessions to the firebrand Greek PM.  The German public stance against further
accommodations for Greece has hardened significantly.  Germany now has its own anti-euro movement enjoying solid momentum.  German and EU leadership will be tougher negotiators now than in 2012, wary to not further invigorate rising anti-euro parties and sentiments throughout the eurozone.  At the same time, Tsipras is a man with a mandate and clearly on a mission.  He’ll relish a Game of Chicken with major global ramifications.  “Grexit” – and all the havoc that would entail - would be blamed on the EU and Germans.

And there’s that other Game of Chicken.  Putin is a real wild card here.  Do hostilities continue to ratchet up in Ukraine?  Does Putin see the Greece situation as an opportunity to stick the EU in the eye?  Does he relish the opportunity to destabilize “Western” financial markets – payback time for the sanctions and collapse in crude prices?  Could the Russians see the current backdrop as an opportune time to ratchet up the new “Cold War”?

There is a potentially quite important downside to “do whatever it takes” “money” printing and market manipulation.  At this point, Draghi has ensured that European markets would be especially vulnerable to a destabilizing shift in market perceptions and/or crisis of confidence.  European equities have begun the year with strong gains, while historic bond market mispricing runs unabated.  To this point, mounting risks – financial, economic, geopolitical and the like – have been viewed as guaranteeing only greater injections of central bank liquidity.    

The euro closed Friday trading at about 1.13 to the dollar.  The euro traded below 1.22 only briefly during the tumultuous summer of 2012.  Draghi has successfully collapsed sovereign yields.  He has also taken a battering ram to confidence in the euro currency.  The expectation is that a weak euro will help grease the inflationary wheels.  But if the markets begin to fear a Greece euro exit, the wheels could come off the weakened euro currency.  King dollar wasn’t an issue in 2012.  And if the reality begins to sink in that the ECB and others are sitting on near-worthless Greek debt, the public outrage over further ECB bond purchases in Germany and elsewhere could be further inflamed.  At this point, “money” must be flying out of the Greek banking system.  The ECB’s job just became even
more difficult.  It’s that age-old illiquidity vs. insolvency issue – throwing good “money” after bad.

At this point, U.S. equity bulls aren’t losing any sleep over Greece.  Not with U.S. economic growth the envy of the world.  The consensus bullish view holds that the system is sound – now six years into a healing recovery.  To the bulls, the strong dollar and buoyant securities markets confirms their optimistic view.

I’ll provide a counter argument.  The global Credit “system” is quite vulnerable – and king dollar is increasingly destabilizing.  “Hot money” is on the move - out of EM, Europe and, increasingly, China.  Global currencies are unstable - making "carry trade" leverage problematic.  The ongoing collapse in commodities and EM currencies is creating enormous amounts of impaired global Credit.  China remains a Credit accident in the making.  The global leveraged speculating community is susceptible to de-risking/de-leveraging.

This week at home, market participants were awakened to the reality that American multinationals have major earnings exposure to both dollar strength and global economic weakness.   And the significant tightening in Credit Availability in the energy sector this week manifested into meaningful reductions in capital expenditure budgets (and job cuts).  The U.S. economy is not immune to global forces.  Yet the greatest exposure is within the financial markets.  There were certainly indications this week that contagion at the “periphery” gained important momentum.  There were as well signs that the deflating Bubble at the “periphery” is increasingly impinging the “core.”  For inflated and over-confident markets, it’s an inopportune time for Games of Chicken with really high stakes.

The Wreck Of The Monetary Hesperus

by David Stockman

January 28, 2015

For 73 months running the Fed has lashed the money markets to the gross financial anomaly of ZIRP. Never before in the history of the world has any central bank or other monetary authority decreed that overnight money shall be indefinitely free to gamblers or that liquid savers should have their hard earned wealth chronically confiscated by negative returns after inflation and taxes. And, needless to say, never have savers and borrowers in a free market struck a bargain night after night after  night at 0% for six years running, either.

Yet now comes another Fed meeting and announcement that our monetary overlords will be “patient” with zero cost money for several more meetings. Indeed, there are even hints that the era of ZIRP could extend beyond mid-summer—that is, for more than 80 months.

So an urgent question screams out. Don’t these obstinate zealots realize that zero cost overnight money has only one use, and that is to fund the carry trades of Wall Street gamblers?

Accordingly, are they not even more culpable than Longfellow’s skipper, who perished along with the fair daughter he lashed to his ship’s mast because he insouciantly belittled a ferocious storm made by nature?  By contrast, these benighted folks at the Fed are actually fueling their own hellish financial storm, thereby leaving in mortal danger the main street economy which they, too,  have foolishly nailed to the mast of ZIRP.

The reason that ZIRP is of exclusive benefit to financial gamblers is straight forward. No businessman in his right mind would fund equipment, inventories or even receivables with borrowings under a one-day or even one-week tenor. The risk of fatal business disruption resulting from the need to precipitously liquidate working assets if funding can not be rolled-over at or near the existing interest rates is self-evident.

Likewise, no sane householder would buy a home, automobile or even toaster on overnight borrowings, either. And, yes, financial institutions experiencing the daily ebb and flow of cash excesses and deficiencies do use the money market. But managing fluctuating cash balances does not require ZIRP—-especially when most banks alternate between being suppliers and users of funds on practically an odd/even day basis. Cash balances in the financial system can be cleared at 0.2%, 2% or 5% with equal aplomb.

So ZIRP is nothing more than free COGS (cost of good sold) for Wall Street gamblers. It is they who harvest the “arb”. That is, the spread between the free funding dispensed by the Fed and any financial asset with a yield or prospect of short-term gain. And, yes, if push comes to shove, these same fast money gamblers can ordinarily liquidate their assets, repay their borrowings and start with a clean book the next morning—unlike business and household borrowers in the main street economy.

Stated differently, the Fed’s ZIRP policy is a giant subsidy to speculators. Owing to the utter foolishness of its “transparent” communications policy, embodied in such gems as the fact the term “patient” is now the well understood code word for no rate increases for the next two meetings, traders don’t even have to worry about one single dime of unexpected change in their carry cost, or the losses that can result from needing to suddenly dump less than fully liquid assets in order to repay their overnight borrowings (or liquidate options and other similar “structured finance” positions).

The truth is, in an honest free market traders can not earn windfall returns arbing the yield curve. The vigorish gets competed away. And the independent movement of asset prices and funding costs compress returns toward the time value of money and the risk differentials embedded in each trader’s specific book of assets and liabilities.

By contrast, the ZIRP market is completely dishonest and therefore deeply subsidized. And every Econ 101 student knows that when you deeply subsidize something, you get more and more of it. In essence, by clinging obstinately and mindlessly to ZIRP the Fed is just systematically juicing the gamblers, and thereby inflating ever greater mispricing of financial assets and ever more dangerous and explosive financial bubbles.

In fact, after 73 months of ZIRP how can rational adults obsess over whether the first smidgeon of a rate increase should occur in June or September and whether the economy can tolerate a rise in the funds rate from 12 bps today to 25 bps sometime down the road?

The difference is utterly irrelevant noise to the main street economy; it can’t possibly impact the economic calculus of a single household or business.

Having pinned the money market rate at the zero bound for so long and with such an unending stream of ever-changing and fatuous excuses, the occupants of the Eccles Building do not even know that they are engaging in a word splitting exercise that is no more meaningful than counting angels on the head of a pin. Indeed, if they weren’t mesmerized by their own ritual incantation they would not presume for a moment that a fractional variance of the money market rate away from ZIRP would have any impact on main street borrowing, spending, investing and growth.

So why does the Fed persist in this farcical minuet around ZIRP? For two reasons that are not at all hard to discern.

In the first instance, the Fed is caught in a time warp and fails to comprehend that the game of bicycling interest rates to heat and cool the macro-economy is over and done. The credit channel of monetary transmission has fallen victim to “peak debt”. The main street economy no longer gets a temporary pick-me-up from cheap interest rates because balance sheets have been tapped out.

The only actual increases in household debt since the financial crisis has been for student loans, which are guaranteed by Uncle Sam’s balance sheet, and auto loans which are collateralized by over-valued vehicles. Stated differently, home equity was tapped out last time; wage and salary incomes have been fully leveraged for years and households have nothing else left to hock.

So households now only spend what they earn, meaning that the Fed’s interest rate manipulations—-which had potency 40 years ago—-have no impact at all today. Keynesian monetary policy through the crude tool of money market rate pegging was always a one-time parlor trick.

Likewise, the Fed’s interest rate machinations have not induced business to acquire incremental productive assets financed with borrowed capital. Instead, virtually the entire increase in business debt outstanding—- and it is considerable, having rising from $11 trillion on the eve of the financial crisis to nearly $14 trillion today—-has gone into financial engineering. But stock buybacks, LBOs and cash M&A deals do not cause output to expand or productivity to increase whatsoever. They just bid up the price of existing financial assets, thereby further rewarding the ZIRP-enabled gamblers who inhabit the casino.

Given the utter blockage of the credit channel of monetary transmission to households and businesses, then, why on earth do our monetary central planners cling so desperately to ZIRP? The apparent answer is that it even if the credit channel of transmission is badly diluted, cheap money might still do a smidgeon of good. Besides, it hasn’t caused any consumer price inflation so, they contend, what’s the harm?

Yes, and doing a rain dance neither causes harm nor rain, either. But there is a huge difference.

Zero interest rates are not even remotely harmless. They amount to a colossal economic battering ram because they transform capital markets into gambling casinos.

So doing, they cause risk and long-term capital to be mispriced, meaning an accumulating level of malinvestment and excess production capacity; and this is a worldwide condition because all central banks are engaging in the same game of financial repression.

As is now evident in the case of oil, iron ore, copper, consumer electronics and much more, massive excess capacity ultimately results in the collapse of boom time prices. Soon there is in motion a withering cycle of deflationary adjustment, profit collapse and a plunge in new capital spending.

So our monetary central planners are trapped in a dangerous feedback loop. Having fueled the boom with cheap money, they now justify the prolongation of ZIRP on the grounds that they must use the same tool to ward off the deflation they caused in the first place.

At the end of the day, there is nothing behind the curtain at the Eccles Building except for the specious doctrine of wealth effects. Fractional changes in the money market rate are of relevance only to the day traders and robo machines which occupy the casino. Today’s words clouds in the Fed’s 529 word statement, and tomorrow’s potential hairline changes in the money market interest rate, are all about speculator confidence.

Fed policy is designed to keep them dancing. It rests on the delusional hope that the drug of ZIRP or near-ZIRP can keep the stock market averages rising and a trickle down of extra spending by the wealthy flowing into the reported GDP and job numbers.

History proves beyond a shadow of doubt that bubbles fueled by bad money ultimately splatter into a world of harm. So now comes the Wreck of the Monetary Hesperus. And unlike Longfellow’s foolish captain, the Fed is not only ignoring the coming storm, but is actually fueling its intensity with malice of forethought.

2015 Investment Themes

John Mauldin

Jan 28, 2015


“If it ain’t broke, don’t fix it,” says my friend Gary Shilling as he kicks off today’s Outside the Box. He’s referring to his investment themes for 2015. He first gives us 11 reasons to continue favoring long Treasury bonds. That’s an obvious play for him if you know his view, but it’s nevertheless a compelling one this year and one that you should think through, given the specter of deflation about in the world, the firing up of QE in Japan and Europe (which gives folks money to buy … Treasurys), and the safe-haven status of the US dollar.

Gary’s reason #9 for buying Treasurys is that “The odds of a near-term Fed rate hike are receding. He sees any Fed rate increase being pushed out “as the deflationary effects of the oil price plunge sink in and investors – and the Fed – realize that foreign central bank stimuli amount to Fed tightening [in relative terms].”

Gary’s remaining themes for 2015 include some other clear winners like the US dollar and Japanese equities (no surprise there), but also some interesting defensive plays like consumer staples and foods and what Gary calls “small luxuries.”

This has been an extremely busy week, as the entire Mauldin Economics team has been in my home for the past three days, sharing ideas, shooting videos, making plans. That means I get a little behind on some things, but being with smart, creative people really gets my juices flowing.

Tonight is sushi with even more guests (and Neil Howe is in town). More planning and meetings and more things that get added to my to-do list.  But it is all fun and exciting.

You have a great week, and now let’s look at Gary’s investing themes for 2015.

Your overwhelmed with ideas analyst,

John Mauldin, Editor

2015 Investment Themes

(Excerpted from the January 2015 edition of A. Gary Shilling's INSIGHT)

Our 2015 investment themes are quite similar to our 2014 list that worked well for us. If it ain’t broke, don’t fix it.
The Treasury “bond rally of a lifetime” still seems intact. The “risk on” investment climate for U.S. equities persists, but as in 2014, we approach it with trepidation and with a defensive portfolio position. The U.S. economy is continuing to grow but at subpar rates (Chart 1) while growth in China is slowing, is very sluggish in the eurozone and negative in Japan.

The dollar is reigning supreme (Chart 2)—and 2015 may turn out to be the year of the greenback as almost every other currency declines against the buck, especially the euro and yen.

Commodity prices may drop much further, especially petroleum, while financial problems in Russia, Venezuela and elsewhere escalate severely. Deflation is spreading worldwide and may expand beyond the energy sector to prices in general. And low-quality bonds here and abroad are likely to keep declining as are emerging market stocks.

Here are our 13 investment themes for 2015.

1. Treasury bonds. There are many reasons why we continue to favor long Treasury bonds. Here are 10:

1. Safe haven. Like the U.S. dollar, Treasurys are a safe haven in times of global turmoil and uncertainty, of which there are plenty today.

2. Deflation, extant in many countries (Chart 3) and looming in many others including the eurozone, makes current Treasury note and bond yields attractive.

3. Quantitative Ease, underway in Japan and likely soon in the eurozone, provides money to invest in U.S. Treasurys.

4. Treasury yields are attractive relative to those abroad. The 2.17% yield on the 10-year Treasury note vastly exceeds the 0.54% yield on 10-year German bunds, 0.33% for 10-year Japanese governments (Chart 4) and almost every other developed country 10-year sovereign (Chart 5). With the new round of QE in Japan and impending QE in the eurozone, the BOJ and ECB will be buying more government securities, sending yields even lower. The U.S. government obligation is probably at least as high quality as any of these others, and the rising dollar against the euro and yen enhances the appeal to foreigners of buying U.S. debt. What are we missing?

5. Foreigners are buying Treasurys. In the December sale of $13 billion in 30-year Treasurys, indirect bids, a measure of foreign demand, took 50%. The Fed is no longer adding to its Treasury portfolio but foreigners, as well as domestic investors, are more than replacing Fed purchases. With half of Treasurys owned abroad, it is truly a global market.

6. U.S. banks are buying Treasurys as they move away from lower-quality assets, in part to comply with new rules requiring the biggest banks to hold more liquid assets and 60% of these must be backed by the federal government. Also, in counting towards liquid assets, corporate obligations get a 50% haircut but those backed by the full faith and credit of the federal government get 100% credit.

7. Long Treasurys continue to be attractive to pension funds and life insurance that want to match their long-maturity liabilities with similar duration assets.

8. Junk and corporate bonds are losing favor vs. Treasurys. The spreads between junk vs. Treasurys are widening as Treasurys rally while junk bonds sell off under the weight of heavy issues and investor worries about defaults, especially on weak energy company issues. At the same time, the spreads between Treasury and investment-grade yields are widening. Note that energy bonds represent about 20% of most fixed-income benchmarks. Companies are issuing debt at the fastest rate on record, often to fund dividends and share buybacks. Meanwhile, the issuance of Treasurys is shrinking as the federal deficit falls (Chart 6). Unlike the ECB, which is likely to buy corporate debt, the Fed is highly unlikely to do so. This pushes money from U.S. corporates to those in Europe.

9. The odds of a near-term Fed rate hike are receding. Early last year, the futures markets assigned a high probability to an increase by year’s end. Now these markets indicate that the odds are receding, with a 24% probability of an initial Fed rate increase by June and 51% by July. And these numbers will no doubt be pushed out further as the deflationary effects of the oil price plunge sink in and investors—and the Fed—realize that foreign central bank stimuli amount to Fed tightening, relatively.

After its December policy meeting, the Fed said it would be “patient” before raising interest rates, adding that the overall outlook hadn’t changed much from earlier assurances that its policy rates would stay at essentially zero for a “considerable time.” Fifteen of the 17 policy committee members expect rates to rise this year and their median forecast was for 1.125% in 12 months through December, 2.5% in 2016 and 3.625% in 2017. As we’ve noted in past Insights, however, in recent years they’ve consistently forecast stronger economic growth and quicker rises in interest rates than have materialized.

Of course, the Fed is right in step with private forecasters. The Wall Street Journal’s poll of 49 forecasters (not including us) back in January 2014 found that 48 expected yields in the 10-year Treasury note to rise from 2.9% at that time to an average forecast of 3.5% by year's end. It moved in the opposite direction and ended 2014 at 2.17%, as noted earlier.

We continue to believe it will be years before the Age of Deleveraging ends and, with it, slow growth, and the Fed shifting to selling securities and raising rates. The recent nosedive in commodity prices and deflationary implications will probably stretch out the central bank’s time line.

But what if, contrary to our forecast, the Fed raises its benchmark rate before the Age of Deleveraging is completed? When it hinted at tapering its then-$85 billion in monthly asset purchases in May and June of 2013, Treasury note and bond yields leaped. Nevertheless, these moves were out of keeping with history. Interest rates rose in the post-World War II era up until 1981 as inflation rates climbed, but have fallen since then with receding inflation. After removing these trends, first up and then down, we examined the relationship between the Fed benchmark, the federal funds rate, and the yields on both 10-year Treasury notes and 30-year bonds.

On average, the spillover from federal funds was small, with a one percentage-point rise pushing up the 10-year note yield by 0.35 percentage points and the 30-year bond yield by just 0.23 points. So, we don’t expect a nosedive in Treasury note and bond prices even if the Fed tightens credit earlier than we forecast—unless the 2013 Taper Tantrum marked the beginning of a new relationship. Recall, however, the sage words of Sir John Templeton: "The most dangerous words in the English language are, this time it's different."

10. Postwar babies are aging and this favors Treasurys as older people reduce the riskiness of their portfolios and favor high-quality bonds, despite low yields.

11. Speculators are increasingly short the benchmark 10-year Treasury note in the futures market. If the rally in Treasury prices persists, sooner or later they will be forced to buy back their shorts, adding to demand.

More Treasury Rally Ahead

We expect a further rally in Treasury prices with the 30-year yield dropping from the current 2.75% to 2.0%, perhaps by the end of 2015. If so, the Long Bond would provide a total return of 18.8% and the 30-year zero coupon bond, 24.6%. If the 10-year note yield drops from the current 2.17% to 1.0%, as we forecast, the total return would be 12.4%. These may seem like big gains for yield declines of only about one percentage point, but that’s what happens when yields are low. In any event, we believe that “the bond rally of a lifetime” marches on.

2. Selected income-producing securities, including investment-grade corporate and municipal bonds as well as utilities and other stable high dividend-paying stocks, remain attractive. In fact, with municipal bonds on average yielding more than Treasurys, they are very attractive to bond buyers who concentrate on yields, especially on an after-tax basis (Chart 7). Furthermore, the yields on investment-grade corporates and munis are almost the same, after adjusting corporate yields for the minimum 39% individual income tax rate, and even higher in many states.

U.S. stocks are expensive. The Fed’s largess, which we believe was behind the rally that started in March 2009, is no longer there with the end of QE (Chart 8). The leap in the price-earnings ratio that accounted for 67% of the 29.6% rise in the S&P 500 in 2013 is no longer present, and at 19 at present, it is well above the long-term average of 15.5.

3. Consumer staples and foods. We favor these stocks, but defensively, advocating things that people buy regardless of economic circumstances—utilities, consumer staples and health care—in sectors that also tend to have attractive dividend yields.

4. Selected healthcare providers benefit from the increasing health care needs of aging postwar babies as well as the newly insured under Obamacare. Medical office buildings continue to be attractive as physicians migrate to hospitals from stand-alone practices in view of increasing regulatory costs.

5. Low P/E stocks with meaningful dividends also fit into our defensive category.

6. Small luxuries, things that financially-stressed consumers buy to get the best of what they can afford, also is defensive and benefits from the many Americans and people abroad who still have compressed incomes, including in developing countries. Global consumer products companies like Unilever and Proctor & Gamble are finding that poor people in countries like India with static or even declining wages and little discretionary income will still pay more for fancier soap, shampoo, razors and mouthwash.

7. Productivity enhancers should continue to thrive as slow sales growth and lack of market acceptance of higher raise prices keep businesses focused on cost-cutting and productivity improvement.

8. Japanese stocks remain attractive as the Abe government strives to stimulate economic growth while trashing the yen.

9. The dollar continues to look profitable vs. the loonie, kiwi, Aussie (Chart 9) and other commodity currencies as commodity prices, led by oil, keep dropping along with the deliberately-trashed yen and euro. Virtually all currencies are being devalued against the dollar, which, as the world’s reserve and major trading currency, can’t really be devalued. It’s a matter of other currencies falling against the greenback, the established norm, not the buck rising against them.

The euro looks especially vulnerable as the chasm between the Teutonic North, led by Germany, and the Club Med South, spearheaded by France, continues to widen. Labor reform efforts and other measures to improve efficiency in the Italian government and private sectors continue to meet huge resistance, and the Italian economy is back in recession. Meanwhile, economic growth is trivial and government debt levels huge (Chart 10). Greece is facing another national election with the anti-eurozone Syriza Party showing strength.

We seldom make explicit forecasts for investment themes because we seldom know how far investments moving in our favor will go. In the case of the euro, however, it’s interesting to note that it started out in 1999 with the dollar worth about 1.10 euros (Chart 11). It dropped to 0.85 in May 2001 before climbing to 1.58 in March 2008. Since then, it’s been on a downward trend. With all the problems in the eurozone and ECB President Draghi’s determination to devalue the currency, the euro might well drop back to 1.00, or parity with the greenback this year.

Similarly, the yen could drop substantially from here. Note in Chart 12 that in November 1982, it hit 278 per dollar. That’s a long way from the current 120, and a collapse to 278 would be a disaster for Japan and the whole world. Still, given the newly-re-elected Abe’s determination to trash the yen, it’s reasonable to see the yen dropping to 150 or 200 per greenback. Notice that Abe used his re-election momentum recently to recommend a corporate tax cut from 34.6% to 32.1% in the fiscal year starting in April and to 31.3% in the following fiscal year.

Unattractive Themes

Our unattractive themes list includes 10. Industrial commodities, especially copper (Chart 13), which we love to short. As in 2014, we’re refraining from shorting crude oil because of uncertainty over OPEC actions and the outcome of the Saudis’ game of chicken with weak OPEC producers as well as American frackers.

We do, however, continue to list 11. Natural gas as a short because of the spillover from oil and the abundance created by U.S. fracturing—at least until LNG exports become substantial. It goes without saying that we’ve dropped our North American energy theme on the attractive side.

12. Emerging country stocks and bonds continue to be unattractive, in our view. With developing countries that depend on oil exports in deep trouble and other commodity exporters such as Brazil in doubtful positions, this whole investment sector is under pressure with both stock and government bond prices falling on average of late (Chart 14).

13. Junk bonds (Chart 15) continue to be interesting on the short side, especially those issued by energy-related companies. The rest may well be dragged down as investors flee to safe havens.

A Shock

In past Insights, we’ve explored the Grand Disconnect between slowly-growing major economies and soaring equity markets, propelled by central bank money and, in the U.S., by unsustainable corporate cost-cutting as well.

This gap will get closed sooner or later, either by Fed tightening and the recession that has followed in 11 of 12 similar incidences in the post-World War II era, or a substantial shock that will have the same effect. The resulting recession will no doubt become global, given the already weak state of many foreign economies and financial structures.

We also stated that it will be years before the Age of Deleveraging and slow economic growth are concluded, and the Fed then begins to raise interest rates and shrink or sterilize the $2.3 trillion in excess member bank reserves that have accumulated with QE. So a major shock may occur before the Fed shifts gears toward credit restraint. The obvious current possibility, of course, is the financial fallout from the ongoing weakness in commodity prices, especially crude oil, and the soaring greenback.

In “Past External Financial Shocks and Their Effects” (also in our January 2015 Insight report), we examine the effects of past shocks on the U.S. economy, going back to the 1973 Arab oil embargo.

The dollar was up over 7% last year against emerging economy currencies, and about $1 trillion in their corporate bonds were issued before the buck surged. So the cost of servicing those dollar debts is climbing, much as in the late 1990s when a similar problem with government dollar issues precipitated the Asian financial crisis that led to defaults in many Far Eastern economies as well as Russia, Brazil and Argentina.

Last year, companies in emerging markets issued almost $280 billion in dollar-denominated bonds to take advantage of low interest costs. Governments have joined this parade but not as extensively as in the late 1990s. Still, total company and sovereign debt issuers had $6 trillion in outstanding bonds at the end of 2014, up four times since the 2008 financial crisis.

As investors retreat from these emerging markets to dollars, local currencies will fall even further. The Indonesian rupeah, Chilean peso, Brazilian real and Turkish lira are near multi-year lows and the Mexican central bank recently spent $200 million to support its peso. The IMF and Bank for International Settlements worry that exchange rate problems could sire corporate defaults and asset price busts worldwide.

In any event, a major shock and resulting recession would shift the investment climate from the current “risk on” to “risk off,” emphasizing what we call the Quartet—Treasurys and the dollar would be attractive as safe havens while equities of all types, be they in developed, developing or frontier markets, would be dumped along with commodities. Interestingly, three of the four members of the Quartet are already on the stage and beginning to play. Treasurys are leaping in price. The dollar is soaring against almost every foreign currency. And commodity prices are plummeting. Only stocks are yet to enter the stage and tune down.

01/28/2015 11:08 AM

Draghi's Dangerous Bet

The Perils of a Weak Euro


The European Central Bank's current headquarters in Frankfurt. Last week's decision to weaken the common currency could have long-lasting effects.        REUTERS The European Central Bank's current headquarters in Frankfurt. Last week's decision to weaken the common currency could have long-lasting effects.

The recent decision by the European Central Bank to open the monetary floodgates has weakened the euro and is boosting the German economy. But the move increases the threat of turbulence on the financial markets and could trigger a currency war.

The concern could be felt everywhere at this year's World Economic Forum in Davis, the annual meeting of the rich and powerful. Would the major central banks in the United States, Europe and Asia succeed in stabilizing the wobbling global economy? Or have the central bankers long since become risk factors themselves? The question was everywhere at the forum, being addressed by experts at the lecturns and by participants in the hallways.

Central banks, said Harvard University economics professor Kenneth Rogoff, are surely the greatest source of uncertainty in the eyes of the financial markets, a statement that was not disputed by others on the panel. The fact that monetary policies at central banks in the US, Europe, Japan and elsewhere are drifting apart poses a major risk for the stability of financial markets, he said.

"It's important for the international community to work together to avoid currency wars which no one can win," Min Zhu, deputy managing director of the IMF, told the conference.

Yet last Thursday's decision by the European Central Bank to purchase €60 billion ($68 billion) a month in government bonds through September 2015 has increased the threat of exactly that kind of monetary conflict. It will further flood the markets with liquidity and will continue to apply downward pressure on the value of the common currency.

A weak euro, of course, is precisely what ECB President Mario Draghi wants. It makes exports to other currency areas cheaper, thereby increasing the competitiveness of euro-zone countries. At the same time, it increases the price of imports, thus reducing the threat of deflation.

Parity with Dollar?

Viewed in those terms, Draghi's policy has been thus far successful. The euro has fallen in value by 10 percent compared to the dollar since September, and many observers expect that the euro may soon achieve parity with the dollar.

But Draghi's policy also has inherent perils. By intervening in the exchange rate mechanisms, the EU is creating unfair advantages for itself globally at the expense of other countries. Those countries surely won't be pleased and are likely to respond by devaluating their own currencies.

Ultimately, there can only be losers in such a contest. It will be "interesting to see how the Japanese follow up at this point" -- as well as the US -- Gary Cohn, president of investment bank Goldman Sachs, said at Davos.

It's a development that worries Anton Börner. "A currency war would be devastating for everyone," said Börner, the president of the Federation of German Wholesale, Foreign Trade and Services (BGA). He argues that one of the reasons Germany has become so economically competitive is that companies here have been forced to contend with a strong currency. It forced them to make a greater effort and to be more creative. "Investments are made in places where the currency is strong," the BGA boss says.

Börner's line of argumentation sounds a lot like the hallmark of the monetary policy of pre-unification West Germany. It is rare that a currency becomes such an important part of the national identity as the deutsche mark was to Germans prior to the euro's introduction. Many considered the deutsche mark to be guarantor of prosperity and the Bundesbank a venerable institution that both embodied that promise and commanded international acceptance for the young country.

The job became even easier the more the mark gained ground against the dollar, the British pound and the Italian lira. It slowly came to be seen as a hard currency and ultimately became the world's second most popular reserve currency behind the US dollar. The strong deutsche mark also turned Germany into a nation of travelers.

Now, though, Germans are having to adapt to a new reality. Rather than fighting for a strong currency as the Bundesbank used to do, the ECB is weaking the euro.

In a currency block, of course, the disadvantages of a weaker currency are not immediately felt.

Most Europeans tend to vacation in Europe, thus limiting their exposure to stronger currencies abroad. And goods from abroad have not yet become more costly despite the euro devaluation because the price of oil has plunged as well.

Pros Outweigh Cons -- For Now

For the German economy, the advantages associated with a weaker currency outweigh the disadvantages. Coupled with the low oil price, the current euro exchange rate is like an "unexpected economic stimulus," government sources say. When he releases his current forecast as part of his ministry's annual economic report on Wednesday, Economy Minister Sigmar Gabriel is expected to issue an upward correction. The Economics Ministry is expected to forecast growth of 1.5 percent for 2015, up from the 1.3 percent forecast last autumn.

Yet even though that new figure is just now being released, it is already obsolete. Government economists believe that the euro's downward trend coupled with low oil prices mean that the German economy is more likely to grow by 2 percent this year, assuming there are no major geopolitical upheavals. Officially, Berlin doesn't want to sound too optimistic, preferring to be pleasantly surprised with potentially positive developments later this year.

Nevertheless, the downward trend in the euro's value and oil prices has the potential to create new problems for the German government in the foreseeable future, particularly in its relations with partner countries and with international organizations like the International Monetary Fund. They've long complained about Germany's growing current account surpluses. The imbalance threatens the recovery of euro-zone crisis countries and the global economy because Germany imports too little.

Trade Imbalance

Relative to economic output, no other European country exports as many goods and services as Germany. The country had a current account balance surplus in 2013 equivalent to 7 percent of gross domestic product. The figure for 2014 is not much lower.

The surplus could get even bigger in the future. Experts in Wolfgang Schäuble's Finance Ministry have calculated that the combination of the weak euro and declining oil prices could increase the surplus by 0.5 percent.

Experts believe the weak euro may help spur economic growth in crisis countries on the short term. A current analysis by the European Commission suggests that a falling euro exchange rate will result in an increase in exports, particularly for Italy, Portugal, Spain and France. It will also make it more attractive for non-Europeans to take vacations in the euro zone.

At the same time, it is unlikely that the measures announced last week will restore inflation to the ECB's target rate of 2 percent. "Studies show that a low euro exchange rate has little influence on inflation," says Ansgar Belke, an economics professor at the University of Duisburg-Essen.

For the time being, the focus remains primarily on advantages the weak euro has for the economy.

The general rule of thumb is that a devaluation of 5 percent will translate to additional growth of 0.3 percentage points in the euro zone. But what side effects will it have? And at what point might it get dangerous?

"At the moment, the situation is still relaxed," says Carl Martin Welcker, the CEO of the Kölner Schütte, the global market leader in grinding machines and multi-spindle automatic lathes and one of the medium-sized businesses that make up the backbone of the German economy. In light of the political situation, Welcker said he considers the depreciation of the euro to be an appropriate move, but says people need to keep an eye on developments. "If the euro were to lose another 15 percent in value, then things would be quite different," he said.

When Weakness Becomes a Problem

At that point, the euro would reach parity with the dollar -- a level at which the disadvantages of a weak euro could no longer be overlooked. Everything that is traded in dollars would then become palpably more expensive, especially commodities. If oil prices hadn't declined so dramatically in recent months, the cost per liter of diesel would be €1.50 today due to the weaker European currency. But at the moment, it costs €1.10 on average.

Investments made by German companies in the dollar zone also get more expensive when the euro's value slips. German chemicals giant BASF is currently planning to spend €5 billion to expand its North American business between 2014 and 2018. The chemical company says it still intends to stick with its plans. "Short-term currency fluctuations have no influence on our investment decisions," BASF officials state. The question is how long the euro will remain weak.

Potentially even more important is the psychological effect devaluation has. A weak euro can give companies a false sense of security. "This kind of thing only provides a temporary boost," warns BGA President Börner. "You can't create any prosperity through devaluation," he says. "It's window dressing."

Thomas Mayer, Deutsche Bank's former chief economist, views the situation similarly. "In addition to reducing the pressure to reform in countries, an artificially depressed euro exchange rate could also stifle innovation in industry," the economist said. With a devalued euro, products practically sell themselves and, experience has shown, companies tend to hold on to older products as well as inefficient manufacturing processes.

But there's an even greater danger that is far more decisive. "If the downward trend in the euro accelerates, in the worst case scenario, investors could lose trust in the durability of the euro zone," warned Clemens Fuest, the head of the Center for European Economic Research in Mannheim. "Then the opposite of what the ECB is trying to achieve would happen."

Is It Contagious?

Last week's decision by the Swiss central bank to unpeg the franc from the euro illustrated just how dangerous markets can be for banks and investors alike. Swiss stock prices dropped sharply and banks, funds and currency traders around the world -- but also many private individuals and German municipalities -- who had invested in Swiss francs suffered painful losses. The move even drove one major US hedge fund out of business.

Still, Axel Weber, the former president of Germany's central bank, the Bundesbank, and currently chairman of the Swiss bank UBS, praised the ECB's decision even though it could ultimately be a burden for his institution. "It has always been clear that pegging the franc to the euro was a temporary thing," he said. "The Swiss National Bank made the right move. It's better to make a painful break than to draw out the agony."

Officials within Germany's Finance Ministry are already concerned that the currency turbulence could prove contagious and hit countries neighboring the euro zone. Like Switzerland, a few other countries have pegged their currencies to the euro exchange rate, and they too may now feel the pinch of appreciation pressures.

This is especially true of Denmark and Poland, which could become the next focus of speculators. The Danish crown and the Polish zloty are more or less pegged to the euro exchange rate. Central bank officials in both countries almost slavishly follow each move made by the ECB in order to ensure their currency values remain stable. But it's an arrangement that will be thrown into jeopardy if the ECB now starts purchasing large quantities of government bonds. In order to prevent speculation against the crown, the Danish central bank recently lowered its key interest rate by 0.15 percent to 0.5 percent.

Upheaval Inevitable

Still, further upheaval appears inevitable. It's possible that both countries will ultimately have to establish a new exchange rate in relation to the euro or that they will have to unpeg from the common currency completely.

Germany's Finance Ministry has also registered with concern that the euro's role as a reserve currency is suffering as a result of monetary policy decisions made by the ECB. Around one-fifth of global currency reserves are currently held in euros, but that share used to be considerably larger. If the ECB opens up the floodgates for additional quantitative easing, they fear that share could fall even further.

Central banks normally sell their reserves in a weak currency in order to limit their losses. But if they push their euros onto the market, it will further weaken the common currency, triggering a self-perpetuating downward spiral.

For months, the Americans and the IMF have been calling on the Europeans to implement precisely the monetary policy that is now making the euro weaker. They will now have to accept the increasing trade imbalance as the logical consequence of this move. "You can't have both -- a loose monetary policy and at the same time a reduction in imbalances," one government expert in Berlin said.

It's for the same reasons that Schäuble and Economics Minister Gabriel don't believe that the latest developments will lead to competitive devaluations or currency wars. The Europeans are now following precisely the monetary policy Washington has been requesting for years. Now Washington will have to be able to cope with the risks and the side-effects that come with it.

Are Europe and America Trapped?

Efforts by the Federal Reserve to become the first major central bank to reverse its quantitative easing illustrated just how risky the flood of money can be. A year and a half ago, the Fed began suggesting that it would end its loose monetary little by little. The statements led to a reverse in capital flows in large parts of the world, with investors pulling money out of developing nations and investing it in the US. In countries like India, the markets fell sharply and currencies were strained.

Quiet has since returned to the markets, but the Fed still hasn't raised its interest rates.
Worry about the possibility of new turbulence may even prevent the Fed from taking that step this year. Conditions for raising the interest rate are actually favorable given that the US economy is currently undergoing its first upswing in many years. But higher interest rates would also attract more capital to the US, leading the dollar to continue its ascent. Developing nations would fall into difficulties and the euro exchange rate would fall even further.
That's why a return to normal monetary policies is unlikely for the time being. Central banks on both sides of the Atlantic appear to be trapped.

If the value of the dollar relative to the euro continues to increase, the Fed may feel forced to take countermeasures. "As long as things are going decently with the US economy, people will accept appreciation of the dollar," says economist Mayer. "But if the mood shifts at some point, the exchange rate will become a political issue." Accusations of currency manipulation, he says, would quickly follow.
In that event, the US Congress has the means of imposing punitive measures against countries or entities deemed guilty of such manipulations. And, as the case of China has shown, US lawmakers aren't afraid of threatening to use those powers.

By Sven Böll, Martin Hesse, Alexander Jung, Armin Mahler and Christian Reiermann

The Swiss Franc Will Collapse

By: Keith Weiner

Wed, Jan 28, 2015

I have worked to keep this piece readable, and as brief as possible. My grave diagnosis demands the evidence and reasoning to support it. One cannot explain the collapse of this currency with the conventional view. "They will print money to infinity," may be popular but it's not accurate. The coming destruction has nothing to do with the quantity of money. It is a story of what happens when interest rates fall into a black hole.

Yields Have Fallen Beyond Zero

The Swiss yield curve looks like nothing so much as a sinking ship. All but the 20- and 30-year bonds are now below the water line.

Sinking Interest Rates in Switzerland

Look at how much it's submerged in just one week. The top line (yellow) is January 16, and the one below it was taken just a week later on January 23. It's terrifying how fast the whole interest rate structure sank. Here is a graph of the 10-year bond since September. For comparison, the 10-year Treasury bond would not fit on this chart. The US bond currently pays 1.8%.

Swiss 10-Year Bond

The Swiss 10-year yield was as high as 37 basis points on Friday January 2. By the next Monday, it had plunged to 28, or -25%. By January 15 -- the day the Swiss National Bank (SNB) announced it was removing the peg to the euro -- the yield had plunged to just 7 basis points. It has been nonstop freefall since then, currently to -26 basis points.

What can explain this epic collapse? Why is the entire Swiss bond market drowning?

Drowning is a fitting metaphor. In my dissertation, I describe several harbingers of financial and monetary collapse. The first is when the interest interest rate on the long bond goes to zero.

I discuss the fact that a falling rate destroys capital, and that lower rates mean a higher burden of debt. If the long bond rate is zero then the net present value of all debt (which is effectively perpetual) is infinite. Debtors cannot carry an infinite burden. As we'll see, any monetary system that depends on debtors servicing their debt must collapse when the rate goes to zero.

I think the franc has reached the end. With negative rates out to 15 years, and a scant 33 basis points on the 30-year, it is all over but the shouting.

Not Printing, Borrowing

Let's take a step back for a moment, and look at how the recent chapter unfolded. It began with the SNB borrowing mass quantities of francs. Most people say printed, but it's impossible to understand this unprecedented disaster with such an approximate understanding. It's not printing, but borrowing.

Think of a homebuyer borrowing $100,000 to buy a house. He never gets the cash in his bank account. He signs a bunch of paperwork, and then at the end of the day he has a debt obligation to repay, plus the title to the house. The former owner has the cash.

It works the same with any central bank that wants to buy an asset. At the end of the day, the bank owns the asset, and the former owner of the asset now holds the cash. This cash is the debt of the central bank. It is on the bank's balance sheet as a liability. The bank owes it.

This is vitally important to understand, and it can be quite counterintuitive. If one thinks of the franc (or dollar, euro, etc.) as money, and if one thinks that the central banks print money, then one will come to precisely the wrong conclusion: that there is nothing owed, and indeed there is no debtor. In this view, the holder of francs has cash, which is a current asset. End of story.
This conclusion could not be more wrong.

Certainly, the idea of the central bank repaying its debt is absurd. By law, payment is deemed made when the debtor pays in currency -- i.e. francs in Switzerland. However, the franc is the very liability of the SNB that we're discussing. How can the SNB pay off its franc liabilities using its own franc liabilities as means of payment?

It can't. This is a contradiction in terms. Thus it's critical to understand that there is no extinguisher of debt in the regime of irredeemable paper currency. You may get yourself out of the debt loop by paying in currency, but that merely shifts the debt. The debt does not go out of existence, because paying a debt with an IOU cannot extinguish it. Unlike you, the central bank cannot get itself out of debt.

However, it can service its debt. For example, the Federal Reserve in the U.S. pays interest on reserves. Indeed, the bank must service its debts. It would be a calamity if a payment is missed, if the central bank ever defaulted.

The central bank must also maintain its liabilities, which is what it uses to fund its assets. If the commercial banks withdraw their deposits -- and they do generally have a choice -- the central bank would be forced to sell its assets. That would be contrary to its policy intent, not to mention quite a shock to brittle economies.

Make no mistake, a central bank can go bankrupt. This may seem tricky to understand, as the law makes its liability legal tender for all debts public and private. A central bank is also allowed to commit acts of accounting (and leverage) that would not be tolerated in a private company.

Regardless, it can present misleading financial statements, but even if the law lets it get away with that, reality will have its revenge in the end. The emperor may claim to be wearing magnificent royal robes, but he's still naked.

If liabilities exceed assets, then a bank -- even a central bank -- is insolvent and the consequences will come soon enough. The cash flow from the assets will sooner or later become insufficient to pay the interest on the liabilities. No central bank wants to be in a position where it is obliged to borrow, not to purchase asset but to service a negative cash flow. That is a rapid death spiral. It must somehow push down the interest rate on its liabilities (which are typically short term) to keep the cost of financing its portfolio below the revenue generated on the assets.

This becomes increasingly tricky when two things happen. One, the yield on the asset goes negative. Thus, the even-more-negative (and even more absurd) one-day rate of -400 basis points in Switzerland. Two, the issuance of more currency drives down yields even further (described in detail, below).

Events force the hand of the central bank. It goes down a path where it has fewer and fewer choices. That brings us back to negative interest rates out to the 15-year bond so far.

The Visible Hand of the Swiss National Bank

So the SNB issued francs to fund its purchase of euros. Next, it spent the euros on whatever Eurozone assets it wished to buy, such as German bunds.

It's well known that the SNB put on a lot of this trade to keep the franc down to €0.83 (the inverse of keeping the euro down to CHF1.2) l. It also helped push down interest rates in Europe. The SNB was a relentless buyer of European bonds.

That leads to the question of what it did in Switzerland. The SNB was trading new francs for euros. That means the former owner of those euros then owned francs. These francs have to stay in the franc-denominated domain. What asset will this new franc owner buy?

I frame the question this way deliberately. If you have a 100-franc note, you can put it in your pocket. If you have CHF100,000, you can deposit it in a bank. If you have CHF100,000,000 (or billions) then you are going to buy a bond or other asset (depositing cash in a bank just pushes it to the bank, who buys the asset).

The seller of the asset is selling on an uptick. He gives up the bond, because at its higher price (and hence lower yield) he now finds another asset more attractive on a risk-adjusted basis.

Risk includes his own liquidity risk (which of course rises as his leverage increases).

As the SNB (and many others) relentlessly push up the bond price, and hence push down the yield, the sellers of the ever-lower yielding bonds have fresh new franc cash balances.

The Quantity Theory of Money holds that the demand for money falls as the quantity rises. If demand for money falls, then by this definition the prices of all other things -- including consumer goods -- rises. It is commonly held that people tradeoff between saving money vs. spending money (i.e. consumption). The prediction is rising consumer prices.

I emphatically disagree. A wealthy investor does unload his assets to go on an extra vacation if he doesn't like the bond yield. A bank with a trillion dollar balance sheet does not dole out bigger salaries if its margins are compressed.

So what does trade off with government bonds? If an investor doesn't want to own a government bond, what else might he want to own? He buys corporate bonds, stocks, or rental real estate, thus pushing up their prices and yields down.

And then, in a dysfunctional monetary system, you can add antique cars, paintings, a second and third home, etc. These things serve as surrogates for investment. When investing cannot produce an adequate yield, people turn to non-yielding non-investment assets.

The addition of a new franc at the margin perturbs the previous equilibrium of risk-adjusted yields across all asset classes. Every time the bond price goes up, every owner of every franc-denominated asset must recalculate his preferences.

The problem is that the SNB does not create any more productive investment opportunities when it spills more francs into the Swiss financial system. Those new francs have to chase after the existing assets.

Yields are falling. They necessarily had to fall.

An Increasing Money Supply and Decreasing Interest Rate

The above discussion describes the picture in every developed economy. Interest rates have been falling for 34 years in the U.S., for example.

In a free market, the expansion of credit would be driven by a market spread: available yield - cost of borrowing. If that spread is too small (or negative) there will be no more borrowing to buy assets. If it gets wider, then banks can spring into action.

However, central banks distort this. Instead of the cost of borrowing being a market-determined price, it is fixed by the central bank. This perverts the business model of a bank into what is euphemistically known as maturity transformation -- borrowing short to lend long.

It's not possible for a bank to borrow money from depositors with 5-year time deposit accounts in order to buy 5-year bonds. The bank has to borrow a shorter duration and buy a longer, in order to make a reasonable profit margin.

If the central bank sets the borrowing cost lower and lower, then the banks can bid up the price of government bonds higher and higher (which causes a lower and lower yield on the long bond). This is not capitalism at all, but a centrally planned kabuki theater. All of the rules are set by a non-market actor, who can change them for political expediency.

The net result is issuance of credit far beyond what could ever happen in a free market. This problem is compounded by the fact that the central bank cannot control what assets get bought when it buys bonds. It hands the cash over to the former bond holders. It's trying to accomplish something -- such as keeping the franc down in the case of the SNB, or preventing bankruptcies, in the case of the Fed -- and it has no choice but to keep flooding the market until it achieves its goal. In the US, the rising tide eventually lifted all ships, even the leaky old tubs.

The result is a steeper credit gradient, and the bank can eventually force liquidity out to its target debtors.

The situation in Switzerland makes the Fed's problems look small by comparison. Unlike the Fed, which had a relatively well-defined goal, the SNB put itself at the mercy of the currency market. It had no particular goal, and therefore no particular budget or cost. The SNB was fighting to hold a line against the world. While it kept the franc peg, the SNB put pressure on both Swiss and European interest rates.

Something changed with the start of the year. We can understand it in light of the arbitrage between the Swiss bond, and other Swiss assets. The risk-adjusted rate of return on other assets always has to be greater than that of the Swiss government bond (except perhaps at the peak of a bubble).

Otherwise why would anyone own the higher-risk and lower-yield asset?

Therefore, there are three possible causes for the utter collapse in interest rates in Switzerland beginning 10 days prior to the abandonment of the peg:

  1. the rate of return of other assets has been leading the drop in yields
  2. buying pressure on the franc obliged the SNB to borrow more francs into existence, fueling more bond buying
  3. the risk of other assets has been rising (including liquidity risk to their leveraged owners)
#1 is doubtful. It's surely the other way around. It's not falling yields on real estate driving falling yields on bonds. Bond holders are induced to part with their bonds on a SNB-subsidized uptick. Then they use the proceeds to buy something else, and drive its yield down.

One fact supports conclusion #2. Something forced the SNB to remove the peg. Buying pressure is the only thing that makes any sense. The SNB hit its stop-loss.

The rate of interest continued to fall even after the SNB abandoned its peg. Why? Reason #3, rising risks. Think of a bank which borrowed in Swiss francs to buy Eurozone assets. This trade seemed safe with the franc pegged to the euro. When the peg was lifted, suddenly the firm was faced with a staggering loss incurred in a very short time.

The overreaction of the franc in the minutes following the SNB's policy change had to be the urgent closing of Eurozone positions by many of these players. The franc went from €0.83 to €1.15 in 10 minutes, before settling down near €0.96. For those balance sheets denominated in francs, this looked like the euro moved from CHF1.20 to CHF0.87, a loss of 28%. What would you do, if your positions instantly lost so much? Most people would try to close their positions.

Closing means selling Eurozone assets to get francs. Then you need to buy a franc-denominated asset, such as the Swiss government bond. That clearly happened big-time, as we see in the incredible drop in the interest rate in Switzerland. Francs which had formerly been used to fund Eurozone assets must now be used to fund assets exclusively in the much-smaller Swiss realm.

In other words, a great deal of franc credit was used to finance Eurozone assets. This is a big world, and hence the franc carry trade didn't dominate it. When those francs had to go home and finance Swiss assets only, it capsized the market.

And the entire yield curve is now sinking into a sea of negative rates.

The Consequences of Falling Interest

Meanwhile, unnaturally low interest is offering perverse incentives to corporations who can issue franc-denominated liabilities. They are being forced-fed with credit, like ducks being fatted for foie gras. This surely must be fueling all manner of malinvestment, including overbuilding of unnecessary capacity. The hurdle to build a business case has never been lower, because the cost of borrowing has never been lower. The consequence is to push down the rate of profit, as competitors expand production to chase smaller returns. All thanks to ever-cheaper credit.

Artificially low interest in Switzerland is causing rising risk and, at the same time, falling returns.

The Swiss situation is truly amazing. One has to go out to 20 years to see a positive number for yield -- if one can call 21 basis points much of a yield.

It's not only pathological, but terminal. This is the end.

In Switzerland, there is hardly any incentive remaining to do the right things, such as save and invest for the long term. However, there's no lack of perverse incentives to borrow more and speculate on asset prices detaching even further from reality.

Speculation is in its own class of perversity. Speculation is a process that converts one man's capital into another man's income. The owner of capital, as I noted earlier, does not want to squander it. The recipient of income, on the other hand, is happy to spend some of it.

We should think of a falling interest rate (i.e. rising bond market and hence rising asset markets) as sucking the juice (capital) out of the system. While the juice is flowing, asset owners can spend, and lots of people are employed (especially in the service sector).

For example, picture a homeowner in a housing bubble. Every year, the market price of his house is up 20%. Many homeowners might consider borrowing money against their houses.

They spend this money freely. Suppose a house goes up in price from $100,000 to $1,000,000 in a little over a decade. Unfortunately, the debt owed on the house goes up proportionally.

With financial assets, they typically change hands many times on the way up. In each case, the sellers may spend some of their gains. Certainly, the brokers, advisors, custodians, and other professionals all get a cut -- and the tax man too. At the end of the day, you have higher prices but not higher equity. In other words, the capital ratio in the market collapses.

To understand the devastating significance of this, consider two business owners. Both have small print shops. Both have $1,000,000 worth of presses, cutters, binding machines, etc. One owns everything outright; he paid cash when he bought it. The other used every penny of financing he could get, and has a monthly payment of about $18,000. Both shops have the same cost of doing business, say $6,000. If sales revenues are $27,000 then both owners may feel they are doing well.

What happens if revenues drop by $3,500? The all-equity owner is fine. He can reduce the dividend a bit. The leveraged owner is forced to default. The more your leverage, the more vulnerable you are to a drop in revenues or asset values.

Falling interest, and its attendant rising asset prices, juices up the economy. People feel richer (especially if their estimation of their wealth is portfolio value divided by consumer prices) and spend freely. Unfortunately, it becomes harder and harder to extract smaller and smaller drops of juice. The marginal productivity of debt falls.

Think about it from the other side, the borrower. The very capacity to pay interest has been falling for decades. A declining rate of profit goes hand-in-hand with a falling rate of interest.

Lower profit is both caused by lower interest, and also the cause of it. A business with less profit is less able to pay interest expense. Who could afford to pay rates that were considered to be normal just a few decades ago? It is capital that makes profit, and hence capacity to pay interest, possible. And it is capital that's eroded by falling rates.

The stream of endless bubbles is just the flip side of the endless consumption of capital. Except, there is an end. There is no way of avoiding it now, for Switzerland.

How About Just Shrinking the Money Supply?

Monetarists often tell us that the central bank can shrink the money supply as well as grow it, and the reason why it's never happened is, well... the wrong people were in charge.

I disagree.

To see why, let's look at the mechanism for how a central bank expands the money supply. It issues cash to an asset owner, and the asset changes hands. Now the bank owns the asset and the seller owns the cash (which he will promptly use to buy the next best asset). A relentlessly rising bond price is lots of fun. It's called a bull market, and everyone is making profits as they reckon them (actually consuming capital, as we said above).

How would a contraction of the money supply work? It seems simple, at first. The central bank just sells an asset and gets back the cash. The cash is actually its own liability, so it can just retire it. And voila. The money supply shrinks.

Not so fast.

There is an old saying among traders. Markets take the escalator up, but the elevator down. Central bank buying slowly but relentlessly bid up the price of bonds. Tick by tick, the bank forced it up. What would central bank selling do? What would even a rumor of massive central bank selling do?

Bond prices would fall sharply.

The problem is that few can tolerate falling bond prices, because everyone is leveraged. Think about what it means for everyone to borrow and buy assets, for sellers to consume some profits and reinvest the proceeds into other assets. There is increasingly scant capital base supporting an increasingly inflated -- as in puffed-up with air, without much substance -- asset market. A small decline in prices across all asset classes would wipe out the financial system.

Market participants have to be leveraged. Dirt cheap credit not only makes leverage possible, but also necessary. How else to keep the doors open, without using leverage? Spreads are too thin to support anyone, unlevered.

Banks are also maturity mismatched, borrowing short to lend long. The consequences of a rate hike will be devastating, crushing banks on both sides of the balance sheet. On the liabilities side, the cost of funding rises with each uptick in the interest rate. On the asset side, long bonds fall in value at the same time. If short-term rates rise enough, banks will have a negative cash flow.

For example, imagine owning a 10-year bond that pays 250 basis points. To finance it, you borrow at 25 basis points. Well, now imagine your financing cost rises to 400 basis points. For every dollar worth of bonds you own, you lose 1.5 cents per year. This problem can also afflict the central bank itself.

You have a cash flow problem. You are also bust.

The Bottom Line

The problem of falling rates is crushing everyone, but raising the rate cannot fix the problem. It should not be surprising that, after decades of capital destruction -- caused by falling rates -- the ruins of a once-great accumulation of wealth cannot be repaired by raising the interest rate.

I do not see any way out for the Swiss National Bank and the franc, within the system of irredeemable paper money. However, unless the SNB can get out of this jam, the franc is doomed. I can't predict the timing, but I believe the fuse is lit and the powder keg could go off at any time.

One day, a bankruptcy will happen. Soothing voices will assure us it was unexpected. Then another will happen, perhaps triggered by the first or perhaps not. Then the cascading begins.

One party's liabilities are another's assets. ABC's bankruptcy wipes out DEF's asset. Since DEF is leveraged, it cannot absorb much loss until it, too, is dragged under.

Somewhere in the midst of this, people will turn against the franc. Today, it's arguably the most loved paper currency. However, I don't think it will take too many capital losses in Switzerland, before there is a selling stampede. The currency will fall to zero, in a repeat of a pattern that the world has seen many times before.

People will call it hyperinflation (I don't prefer that term). Call it what you will, it will be the death of the franc. It will have nothing to do with the quantity of money.

Two factors can delay the inevitable. One, the SNB may unwind its euro position. As this will involve selling euros to buy francs, the result will be to put a firm bid under the franc. Two, speculators will of course know this is happening and eagerly front-run the SNB. After all, the SNB is not an arbitrager buying when it can make a spread. It is a buyer by mandate (in this scenario) and must pay the ask price. Even if the SNB does not unwind, speculators may buy the franc and wait for it to happen. And of course, they could also buy based on a poor understanding of what's happening, or due to other perverse incentives in their own countries.

Bankruptcies aside, the franc is already set on a hair-trigger. Something else could trip it and begin the process of collapse. There is little reason for holding Swiss francs in preference to dollars. The interest rate differential is huge. The 10-year US Treasury pays 1.8%. Compare that to the Swiss bond which charges you 26 basis points, and the difference is over 208 points in favor of the US Treasury. Once the risk of a rising franc is taken out of the market (by time or price action) this trade will commence. A falling franc against the dollar will add further kick to this trade. A trickle could become a torrent very quickly.

I would not be surprised if the process of collapse of the franc began next week, nor if it lingered all year. This kind of event is not susceptible to a precise prediction of when.

What is clear is that, once the process begins in earnest, it will be explosive, highly non-linear, and over quickly (I would guess a matter weeks).