The Fed Prepares to Dive

By John Mauldin


“No one will lend at a negative interest rate; potential creditors will simply choose to hold cash, which pays zero nominal interest.”

– Ben Bernanke, 2009

“I think negative rates are something the Fed will and probably should consider if the situation arises.”

– Ben Bernanke, December 2015

“In theory there is no difference between theory and practice. In practice there is.”

– Yogi Berra

Economists used to think below-zero interest rates were impossible. Necessity (as central banks see it) is the mother of invention, though; and multiple central banks now think negative rates are a necessary step to restore growth.

Are they right? Will negative rates pull the global economy out of its funk? Probably not; but for better or worse, several central banks are already below zero. The Federal Reserve just sent its clearest signal yet that it is headed that way, too. The Fed has warned banks to get ready. We had all better do the same.

This week’s letter has two parts. The first deals with some of the practical aspects of negative rates and what the Fed is really signaling. The second part, which is somewhat philosophical, deals with why the Fed will institute negative rates during the next recession. This letter is longer than usual, but I think it’s important to understand why we will see negative rates in the world’s reserve currency (and the currency in which most global trade is conducted). This policy trend is truly a foray into unexplored territory.
Be Careful What You Wish For

The idea of negative rates isn’t new; what’s new is the willingness to try them out. The Ben Bernanke quote above comes from a November 2, 2009, Foreign Policy article in which the Fed chairman wrestled with how to keep inflation at the “right” level in a weak economy.

Set aside the question of whether there is any “right” level of inflation. As of six years ago, the head of the world’s most important central bank thought no one would ever lend at a negative interest rate. We now know he was wrong, at least with regard to Japan and most of Europe. Central banks there have instituted negative rate policies, and people are still borrowing and lending.

The Fed staff has also speculated on the possibility. Earlier this month my good friend David Kotok sent around links to several academic and central bank negative-rate studies. One was a 2012 article by Kenneth Garbade and Jamie McAndrews of the Federal Reserve Bank of New York. Their title tells you what they thought at the time: “If Interest Rates Go Negative… Or, Be Careful What You Wish For.”

Their point was less about the theoretical wisdom of NIRP and more about the actual potential consequences. They believed we would see a variety of odd responses to a very odd policy situation. All kinds of incentives would reverse, for starters.

Under negative deposit rates, buyers would want to pay their invoices as soon as possible, while sellers would want to delay receiving cash as long as possible. Think about your credit card bill. If you normally spend $10,000 a month, your best move would be to send the bank that much money before you spend it, then draw down the resulting credit balance. The bank would no doubt try to discourage this practice.
Could they? We don’t know.

Garbade and McAndrews throw out another interesting idea: special-purpose banks:

If rates go negative, we should expect to see financial innovations that emulate cash in more convenient forms. One obvious candidate is a special-purpose bank that offers conventional checking accounts (for a fee) and pledges to hold no asset other than cash (which it immobilizes in a very large vault). Checks written on accounts in a special-purpose bank would be tantamount to negotiable warehouse receipts on the bank’s cash. Special-purpose banks would probably not be viable for small accounts or if interest rates are only slightly below zero, say -25 or -50 basis points (because break-even account fees are likely to be larger), but might start to become attractive if rates go much lower than that.

Ludwig von Mises fans will recognize that this approach is not far from the Austrian economics goal of 100% reserve banking. It isn’t quite there because the vault contains fiat currency instead of gold, but I think Mises would recognize it as a step in the right direction. (The fact that Fed economists see it only as an exotic theoretical possibility wouldn’t surprise him, either.)

The consequences of such banking would be more than theoretical. If enough people wanted to use these special-purpose banks, demand for physical cash would go through the roof. There simply wouldn’t be enough to go around if it just sat in vaults instead of circulating. Furthermore, if the vaulted cash in these banks reduced deposits in normal loan-making banks, the whole banking system might grind to a halt.

That being the case, I suspect the Fed would prohibit banks from operating this way – but they can’t stop people from hoarding cash under their mattresses. The one thing they could do is eliminate physical cash. Denmark, Sweden, and Norway are already considering ways to do so.

Even more ominously, Bloomberg reported on. Feb. 9 that a move is afoot for the European Central Bank to get rid of 500-euro notes, the Eurozone’s largest-denomination bills. They portray this move mainly as a crime-fighting measure, but it would clearly make cash hoarding much more difficult.

And if Larry Summers and a few other well-known economists like Ken Rogoff have their way, we will see the demise of the $100 bill in the US. You thought you were just carrying those Ben Franklins around for convenience, not realizing that they make you a potential drug dealer in some people’s eyes.

And of course, hoarding cash would undermine the Fed’s goal of fighting deflation.
Holding cash is by definition deflationary.

If Crazy Doesn’t Work, Try Crazier

All of the above is just speculation at the moment. We don’t know how deeply negative rates would have to go before people change their behavior. So far the negative rates in Europe and Japan apply mainly to interbank transactions, not to individual depositors or borrowers. Unless of course you are buying government bonds.

That said, we’ve seen a clear tendency on the part of central banks since 2008: if a crazy policy doesn’t produce the desired results, make it even crazier. I believe Yellen, Draghi, Kuroda, and all the others will push rates deep below zero if they see no better alternatives. And my best guess is they won’t.

Turns out negative rates aren’t exactly new. My good friend David Zervos, chief market strategist for Jefferies & Co., sent out a note this week pointing out that many “real,” inflation-adjusted rates have actually been negative for years. Such rates have thus far not produced the kind of reflation that central banks want to see. David thinks the ECB and BOJ should push nominal rates down to -1%, launch new quantitative easing bond purchases of at least $200 billion per month, and commit to do even more if their economies don’t respond.

Is Zervos losing his mind? No, he actually makes a pretty good case for such a policy – if you buy into his economic theories, which I discuss in the second part of this letter. (Over My Shoulder subscribers can read Zervos’s note here.) It is painfully clear to most of us that what the central banks have done thus far has not worked. I have a hard time imagining that a major NIRP campaign will help, but I’ve been wrong before.

Former Minneapolis Fed President Narayana Kocherlakota, who was for years the FOMC uber-dove, says going negative would be “daring but appropriate.” He has a number of reasons for this stance. In a note last week, he said the federal government is missing a chance to borrow gobs of money at super-attractive interest rates.

Kocherlakota would like to see the Treasury issue as much paper as it takes to drive real rates back above zero. He would use the borrowed money to repair our rickety infrastructure and to stimulate the economy.

It is an appealing idea – in theory. In reality, I have no faith that our political class would spend the cash wisely. More likely, Washington politicians would collude to distribute the money to their cronies, who would build useless highways and bridges to nowhere. The taxpayers would end up stuck with more debt, and our infrastructure would be little better than it is now.

The fact that this is a “monumentally” bad idea doesn’t mean it will never happen. There’s an excellent chance it will happen. Yellen and the Fed are clearly looking in that direction.

Yellen & the Spirit of Prudent Planning

Yellen might face one small problem on the road to NIRP: no one is completely sure if the Fed has legal authority to enact such a policy. An Aug. 5, 2010, staff memo says that the law authorizing the Fed to pay interest on excess reserves may not give it authority to charge interest.

This potential snag is interesting for a couple of reasons. With last month’s release of this memo, we now know the Fed was actively considering NIRP less than a year after Bernanke himself said publicly that “no one will lend at a negative interest rate.” Meanwhile, some at the Fed were clearly examining the possibility.

What else was happening at the time? The bond-buying program we now call QE1 had just wrapped up in June 2010. The Fed launched QE2 in November 2010. This memo came about because the Fed realized it needed to do more and was considering options. QE2 apparently beat out NIRP as the crazy policy du jour.

The question of the legality of negative rates came up again in congressional testimony a couple of weeks ago. Rep. Patrick McHenry (R-NC) directly asked Yellen if the Fed had authority to impose negative interest rates. According to press reports, she skirted a definitive answer:

In the spirit of prudent planning we always try to look at what options we would have available to us either if we needed to tighten policy more rapidly than we expect or the opposite. So we would take a look at [negative rates]. The legal issues I'm not prepared to tell you have been thoroughly examined at this point. I am not aware of anything that would prevent [the Fed from taking interest rates into negative territory]. But I am saying we have not fully investigated the legal issues.

We know the Fed was investigating the legal issues as long ago as 2010. I would be shocked to learn that they did not investigate those issues thoroughly in the six subsequent years. Various Fed officials – including Yellen – have openly speculated about NIRP. The Fed’s legal team should be disbarred for malpractice if it hasn’t fully investigated yet. I think Yellen’s testimony was a way to deflect the potential controversy as long as possible. I believe the Yellen Fed will telegraph the markets about negative rates prior to implementing them, but evidently Yellen feels it is too soon to send that signal now.

Of course, Yellen also says she is “not aware of anything that would prevent” a NIRP move. So she may do it and then blame her lawyers if someone cries foul. By then the policy would be in place and probably irreversible. In Washington, forgiveness comes easier than permission does.

In the same testimony, Yellen hinted that the previously forecast March rate hike is probably off the table now. We will get new “dot plot” forecasts, though. It will be interesting to see how dovish they are.

As I’ve said, I am firmly convinced that the Fed will not raise the federal funds rate even to 1% this year. December may well have been the last hike we will see for some time. I can see the Fed holding steady for several months. And they are clearly getting ready to introduce negative rates during the next recession. They are already telling banks to get ready for them, too.

Y2K All Over Again?

The Dodd-Frank Act requires the Fed to conduct yearly “stress tests” on major banks. They do this by giving the banks a set of hypothetical economic scenarios. They released this year’s scenarios on Jan. 28.

The “severely adverse” scenario instructs banks to test their systems for a deep recession, a 10-year Treasury yield as low as 0.2%, 5-year notes yielding 0%, and a -0.5% 3-month T-bill yield from Q2 2016 through 2019.

Is this “severely adverse?” It’s far less adverse than what Japan has already experienced. BOJ purchases have driven Japanese government bond yields negative 10 years out the curve. Rates are also negative far out the yield curve all over Europe, even in countries that don’t deserve such rates, let alone midterm rates with even a one or a two handle.

The stress test scenarios aren’t a forecast, per se, but they mean the Fed at least sees those conditions as possible. The whole exercise is pointless if the scenarios could never happen. I think this stress test scenario is the clearest sign yet that the Fed views NIRP as a legitimate alternative.

It doesn’t mean NIRP is guaranteed. I believe Yellen when she says their policy is “data-dependent.” They are no more prescient about the future than the rest of us are. All they can do is look at the data and try to respond appropriately. I don’t envy them that job.

I think the Fed is right now in a position much like the one that was portrayed in that 2010 staff memo. They see their last big move as not having had the desired effect and are considering a new set of options. NIRP is on their list.

Having decided to put NIRP on the list, the Fed has to make sure the banking system can handle it. Whether it can is far from clear right now. The technology issues alone could unleash chaos if the Fed went negative without warning. I think putting negative rates in the stress test scenarios is the Fed’s not-so-subtle message to Wall Street: “Get ready; this could really happen.”

If Europe’s experience means anything, it seems likely our banks aren’t ready yet. Consider this Mar. 4, 2015, Wall Street Journal story.

Widespread negative interest rates, once only a theoretical possibility, have become a real-life problem for Europe’s financial system.

From Sweden to Spain, banks, brokers and other financial firms are grappling with technical and legal glitches thrown up by negative rates, forcing them to redesign computer systems, tear up spreadsheets and redraft legal contracts.

The issue echoes the scrambles around the Year 2000 computer bug and the launch of the euro, when some bank systems couldn’t handle the introduction of a new currency, said Kevin Burrowes, head of U.K. financial services at PricewaterhouseCoopers. A handful of malfunctioning computer programs can cause “huge problems,” while working around problems manually makes more controls necessary and increases the risk that something could go wrong, Mr. Burrowes said.

Preparing for NIRP is a far smaller challenge than preparing for Y2K, which required years of reprogramming and hundreds of billions of dollars, but it is still a huge project. Some reports say European banks are still dealing with the programming issues. And technology is only part of the problem. Think of all the contracts and other legal documents that might need rewriting and renegotiation. If nothing else, the Fed just stimulated the securities and contract law businesses.

One small example from my personal experience: I have been involved in the management of several large commodity funds over the past 25 years. Back in the day, commodity funds had a significant advantage in that they could put 90% of their money into short-term government bonds to generate the capital for their futures contracts. This interest offset a lot of their fees in the ’80s and ’90s. Not so much today. I suspect that many of the organizational documents required still state that such funds will use short-term Treasuries as their cash base.

Requiring these funds to lose ½% would mean they start in the hole. Not what a fund manager wants to do. But it has to be short-term cash, as the money has to be available on very short notice since it’s the collateral for a futures contract. I’ve sat and thought about this and still haven’t come up with a way around this. I wonder how many other funds will have the same issue. (We will discuss this subject in further depth in a few paragraphs.)

Go Thou and Do Likewise

The Fed is specifically warning banks, but NIRP will affect the whole economy. If you own any kind of business or you are an active investor, I expect that NIRP will create significant headaches for you. Are you ready?

Most of us have no idea whether we’re ready, but we might be able to find out. Here’s a simple test. Go to whatever accounting software or spreadsheet program you use, find the interest rate setting and see if it will let you enter a negative number.

If it won’t accept a negative rate at all, now might be an excellent time to update your software.

If the program does let you show a negative rate, dig a little and see how that rate affects the rest of your bookkeeping. Most of us have created numerous Excel spreadsheets. You know that if you get your programming off a little bit, you end up with  ##### signs in some of the cells. When you enter negative interest rates into your software, you may find similarly weird things happening. They could be good-weird or bad-weird, but in either case you might want to consult your brokerage firms, investment advisors, accountants, and tax advisors about possible consequences.

While you’re at it, think about how the rest of the Fed’s “severely adverse” scenario might affect you. Here is the guidance the Fed gave the Banks:

(Yes, I know they spelled severely wrong. Clearly the Fed needs a new proofreader along with new policies. That said, you just can’t catch all the mistakes. There are at least three professional editors who read my letter prior to publication, and misteaks still happen.)

I didn’t even mention the Fed’s stock market scenario in the right column above. It shows the Dow dropping almost to 10,000 by the end of this year and recovering very slowly. In a world where anything is possible, I suppose it is prudent to ask what if questions. I do not see the Dow’s dropping 10,000 points this year, but in a deep recession? That plunge would not be out of the realm of historical precedent. If banks are planning for adverse scenarios, it would be a good idea for you to do so, too, even if you think there is no chance in hell those scenarios will play out. Contingency planning is simply prudent management. Don’t let a recession catch you without a plan.

The Religion of Economics

The problems posed by negative rates are mostly practical in nature, but they come with some deeply disturbing side effects. In the discussion above I didn’t venture into the theoretical problems of misallocation of capital, the negating of Schumpeter’s creative destruction cycle, the even more intense repression of savers and retirees, and the absolute devastation negative rates would wreak up on pension, endowment, and insurance company portfolios.

In a world of ultralow rates, pension funds that are targeting 7½% growth in order to meet their funding needs 20 years out will find those targets are impossible to attain (as they are today, only moreso). It is not yet obvious to the general public how deeply underfunded pensions are, because pension funds are still assuming that future returns will be in the 7½-8% range. That pension or annuity you are counting on for your retirement is most likely in serious trouble. And as people get older and have no practical way to go back to work, pension funds that are forced to reduce payments in 10 or 15 years (and some even sooner) will destroy the lifestyles of many of our elderly. You think there is a violent backlash among voters today? Just screw around with pensions…

So what would make central bankers around the world agree that negative rates are a solution to our current economic malaise? And that, with all their known negative consequences, not to mention their unknown unintended consequences, negative rates are better than the alternative?

I have been trying to devise an explanation of the negative rates proposition that most people can grasp by likening prevailing economic theories to a religion. Everyone understands that there is an element of faith in their own religious views, and I am going to suggest that a similar act of faith is required if one is believe in academic economics. Economics and religion are actually quite similar. They are belief systems that try to optimize outcomes. For the religious that outcome is getting to heaven, and for economists it is achieving robust economic growth – heaven on earth.

I fully recognize that I’m treading on delicate ground here, with the potential to offend pretty much everyone. My intention is to not to belittle either religion or economics, but to help you understand why central bankers take the actions they do.

This explanation will need a little set-up. I have noted before, in an effort to be humorous, that when you become a central banker you are taken into a back room and given gene therapy that makes you always and everywhere opposed to deflation. Actually, this visceral aversion is imparted during academic training in the generally elite schools from which central bankers are chosen.

This is our heritage; it’s learning derived not only from the Great Depression but from all of the other deflationary crashes in our history, too, not just in the US but globally. When you are sitting on the board of a central bank, your one overriding rule is never to allow deflation to occur on your watch. No one wants to be thought responsible for bringing about another Great Depression.

And let’s be clear, without the radical actions taken in 2008–09 to bail out the banks, drop rates to the zero bound, and institute quantitative easing, we would likely have been facing something similar to the Great Depression. While I don’t like the manner in which we chose to bail out the banks, some form of bailout was a necessary evil.

Think deflationary depressions can’t happen today? Clearly, they can. Greece, for all intents and purposes, has sunk into a massive deflationary depression. That reality is not necessarily reflected in the prices of their goods, which are denominated in euros. No, the deflationary depression in Greece is in their labor market.

Normally, when a sovereign country gets into financial trouble (generally because of too much debt), it will devalue its currency so that the prices of products it imports go up and labor costs and the prices of products it sells abroad go down. But since Greece could not devalue its currency (the euro), it was essentially forced to allow its labor costs to fall drastically. Since it is basically impossible to go to everyone in Greece and say, “You need to take a 25% cut in your pay, even though the prices of everything you’ll be buying will still be in euros,” the real world simply produced massive Greek unemployment – precisely what you would expect in a deflationary depression. Greece will likely continue to suffer for a very long time, whereas if the Greeks had left the euro, defaulted on their debts, and devalued their currency, they would likely be enjoying a quite robust recovery.

Greece’s present is a possible near future for other countries in Europe (Portugal is likely to be next, and Italy will surprise everyone with its severe banking problems), which is why the European Central Bank is so desperately fighting the deflationary impulse embedded in the very structure of the European Union.

Now, the United States is clearly not Greece. However, we are subject to the same laws of economics.

By definition, recessions are deflationary. Whenever we enter the next recession, we are going to do so with interest rates close to the zero bound. Most of the academic research both inside and outside the Fed suggests that quantitative easing, at least in the way the Fed did it the last time, is not all that effective. If you are sitting on the Federal Reserve Board, you do not want to allow deflation to happen on your watch. So what to do? You try to stimulate the economy. And the one tool you have at hand is the interest-rate lever. Since rates are already effectively at zero, the only thing left is to dip into negative-rate territory. Because, for you, allowing a deflationary malaise to set in is a far worse thing than all of the potential negative consequences of negative rates put together. It’s a Hobson’s choice; you see no other option.

Let’s do a little sidebar here. There’s lots of discussion in the media of the possible moves the Federal Reserve could make. Some people talk about the Fed’s buying the government’s infrastructure bonds, or buying equities or corporate bonds, or even doing the infamous “helicopter drop” of money into outstretched consumer hands. Those are not legal options for the Fed. The Fed is actually fairly restricted in what it can purchase. All of these outside-the-box transactions would require congressional approval and amendment of the Federal Reserve Act.

I can tell you that there is almost no stomach in the leadership of Congress or at the Fed to bring up the Federal Reserve Act for congressional action. Everyone is worried about potential mischief and political sideshows. Quite frankly, if the Federal Reserve decides that it wants to do more quantitative easing, I would much prefer that Congress authorize the Fed to purchase a few trillion dollars of 1% self-liquidating infrastructure bonds – or, as a last resort, to do an actual helicopter drop. The infrastructure bonds would create jobs and give our children something for their future, a much healthier outcome than the ephemeral boosting of stock and bond prices yielded by the last rounds of quantitative easing. In those instances, the benefits of QE went primarily to the well-off. But I digress.

The reigning academic orthodoxy for central bank believers is Keynesianism. Saint Keynes postulated that consumption is the fundamental driver of the economy. If the country is mired in recession or depression, then government and monetary policy should be geared toward increasing consumption in order to spur a recovery. Keynes argued that the government should be the consumer of last resort, running deficits as deep as necessary during recessions. (He also advocated paying down the debt during the good times, prudent advice roundly ignored.)

The current belief in vogue is that another way to increase consumption is to get businesses and consumers to borrow money and spend it. Hopefully, businesses will invest it and create new jobs, which will in turn enable more consumption. One way to stimulate more borrowing is to lower the cost of borrowing, which the Federal Reserve does by lowering interest rates. The opposite is also true: if inflation is a problem, the Fed raises rates, taking some of the inflationary steam out of the economy.

How would negative rates work? The Federal Reserve would charge a negative interest rate on the excess reserves that banks deposit at the Fed. Note this is not a negative interest rate on all deposits, just on “excess reserves” on deposit at the Fed. An excess reserve is a regulatory and political concept that is a necessary feature of the fractional reserve banking systems of the modern world. Banks are required to maintain a reserve of their assets against possible future losses from their loan portfolios. The riskier the assets the banks hold, the less those assets count towards the required level of reserves. Reserves are required to keep a bank solvent. Banks are closed and sold off when their reserves and capital are depleted below the allowed levels.

Any reserves in excess of the regulatory requirements are counted as “excess.” The theory is that if the central bank charges banks interest on their excess reserves, the banks will be more likely to lend that money out, even if at a lower rate, in order to at least make something on those reserves. Right now, banks are paid by the central bank for their excess reserves on deposit. Given the level of excess reserves at the Fed, these interest payments amount to multiple billions of dollars that are fed into the banking system each quarter; and that is one of the reasons why US banks have been able to get healthier in the wake of the Great Recession.

Consumers and businesses would borrow this cheaper money from the banks and presumably spend it or otherwise put it to use, thereby stimulating the economy and vanquishing the evil of deflation. In theory, as the economy recovers, interest rates are allowed to rise back above the zero bound.

Of course that was the theory when we went to zero rates some six years ago. At some point the economy would recover and the Fed would normalize rates. Except the economy never got to a place where the Fed felt comfortable raising rates even minimally – until last December. And now the high priests of the FOMC are signaling that it might be longer than they originally thought before they swing their incense orbs and raise rates again.

There are some (including me) who would argue that, rather than focusing on consumption, monetary and fiscal policy should focus on increasing production and income. By lowering (repressing) the amount of income savers get on their money, you push savers into riskier assets. That is generally not what you tell people to do with their retirement portfolios, (nor can we overlook the fact that the country is getting older). Thus if interest rates are artificially low because of Fed policy, that reduces the amount of money retirees have to spend. The Federal Reserve and central banks in general seems to think it’s better to have consumers borrow than save.

It’s a Keynesian conundrum. If nobody spends and everybody saves, the economy slows down. While it may be a good thing for you individually to save and prepare for your retirement, if everybody does so at the same time the economy plunges into recession.

Now let’s get back to the intersection of economics and religion. There are multiple competing economic theories on the government’s role in monetary policy making. The operative word is theories. Each is an attempt to describe how to manage a vastly complex modern economy. Some see too much debt as the cause of our current malaise. Others think that lowering taxes would allow consumers and businesses to keep more of their income and hopefully spend it.

In the not too distant human past, shamans and soothsayers conjured theories about how the world worked and how to predict the future. Some examined the entrails of sheep, while others read meaning into the positions of the stars (or whatever their prevailing theory dictated) and told leaders what policies they should pursue. An astute priest would pretty quickly figure out that the best route to priestly job security was to foretell success for the politician’s/king’s/tribal chief’s pet policy course.

In today’s world, economists serve exactly the same function. They skry their data sets – a latter-day version of throwing the bones – and then, based on the theory by which they believe the data should be interpreted, they confirm the orthodox policy choices of their political masters – and so their careers prosper.

This is not to disparage economists – not at all. They really do try to come up with the best possible policies – but the range of policy alternatives is constrained by the economists’ (and the general society’s) belief system. If you believe in a Keynesian world, then you will prescribe lower rates and more fiscal stimulus during times of recession.

If, however, you believe in a competing model, such as the Austrian theory postulated by Ludwig von Mises, then you believe that smaller government, far less fractional reserve banking (if any at all), and a gold standard are appropriate. A recession should be allowed to “clear,” permitting defaulting borrowers to reduce their debts and putting the assets that collateralized their loans back on the market at reduced prices, thereby encouraging businesses to employ those now-cheaper assets in income-producing activities. (This is a very simplified explanation.)

There are other competing theories, each with its own model of how the world works. There is convincing logic and a believable rationale behind each theory. If we had adopted an Austrian model in 2008–09, we would have had a much deeper recession and unemployment would have risen higher, but the recovery would theoretically have come more quickly as prices cleared and debt was resolved. However, that period of time before the recovery began would have been devastating to the millions of families who would have faced even more crippling unemployment than we saw. That is an experiment we did not conduct, so we will never truly know whether that path might have been less painful in the long run.

Austrians are willing to face a series of small recessions as part of the price of maintaining a free economy, rather than postponing recession and trying to fine-tune what is supposedly a free market economy by means of monetary and fiscal policy. An analogy would be the theory that allowing small and controllable forest fires today might prevent a large, utterly devastating forest fire in the future. Nassim Taleb’s important book Antifragile makes a strong case that businesses, markets, and whole societies are much better off if they allow relatively minor random events, errors, and volatility to correct as quickly as possible rather than continually patching them over to avoid short-term pain. Decentralized experimentation in the economy by numerous complex actors capable of taking risks works better than a directed economy that encourages the buildup of excessive risk throughout the entire economy.

The problem is, there really is no one clearly right answer as to which economics belief system is best. I know what I believe to be the correct answer, but that belief is based on the way I understand the world – and the world is vastly more complex than anyone’s theory can be. No theory allows for a perfect solution for all participants. Rather, each theory picks winners and losers, with the overall objective of creating an economy that has maximal potential to grow and prosper.

(Sidebar: Let me tell you where Bernie Sanders and I agree. He rails against the privileges of Wall Street, crony capitalists, corporate insiders, and lobbyists, and the political favors and laws they get passed that benefit them and not Main Street. The deck is stacked in their favor. In that he is right. But his and my solutions to the problem are not similar, as he wants to create even more regulation and taxation, and I would prefer to remove all of the tax preferences and greatly reduce the regulatory morass that favors large businesses over small. I don’t want the government involved in picking winners and losers; that’s the role of the marketplace.)

So this is what it comes down to: The reigning academic theory/belief system is Keynesianism. The head Keynesians are signaling that they are going to give us negative rates. In fact, according to their theory, it would be irresponsible not to do so. They believe that if they sit back and allow the economy to sort itself out, the outcome would be far worse than anything that could be wrought by the intended and unintended consequences of negative interest rates.

We can differ with those in charge, but the experiment with negative rates is going to happen, and we need to begin to adjust – to think through how to position our portfolios and our investment strategies, our businesses, and our lives.

The Fed is run by True Believers. Just as Christianity or Islam or any other religion has believers that range across a spectrum of faith and beliefs, so does Keynesianism. At the Fed, these are deeply held beliefs: our central bankers are well convinced that the facts demonstrate the validity of their belief system.

I am reminded of the apologetics courses that I took in seminary (yes I graduated from seminary in 1974 – go figure). Apologetics courses basically teach you reasoned arguments in justification of a particular view, typically a theory or religious doctrine. We would look for logic and evidence that our particular version of Christianity was the correct and true position. Apologetics gave us the techniques and facts that would back us up!

I am not really trying to equate religion and economics, but I am saying that both rely on belief systems about how the world works, and that the behavior of believers is modeled on those systems. Paul Krugman tells us that fiscal stimulus and quantitative easing didn’t give us enough of a recovery simply because we didn’t do enough. If we had just believed more, had more faith in the effectiveness of Keynesian doctrine, we would now be well on our way to the economic promised land!

The fact that neither Europe nor Japan nor the United States have seen a recovery – that much of Europe is either in recession or on the borderline of recession, that Japan is dealing with severe deflationary pressures, and that the US is visibly slowing down does not create a question in Keynesian minds with respect to the correctness and effectiveness of their policies. I believe that both Japan and Europe are going to double down on quantitative easing and negative rates in their respective countries, and the US will soon follow.

I am glad I am not a central banker. The pressure to “do something” in the midst of a crisis must be horrific. To feel a responsibility and not be able to respond would be emotionally draining. I do not envy any of them. I think my own current belief system would probably take us in the optimal direction over the long term, but I can assure you that in the short term quite a few of my fellow citizens would not be happy with the process. And whether it is I or the Keynesians selling a particular theory, promising people pie in the sky doesn’t help them much to deal with the problems they face here and now.

The fact is that all of these economic theories have at their core political views about how the economy should be organized and managed. Including mine. That doesn’t necessarily mean mine is right and theirs is wrong. To determine the “rightness” of a theory, you generally try to conduct controlled experiments that give reproducible results. That kind of gold-standard research is simply not possible in today’s world. So we actually are forced to rely upon our pet theories as to how the world works. I am certainly not a believer in moral equivalency, but until one operative theory is thoroughly discredited (as communism was) it can remain the controlling theory for a long time.

I have a lot more to say and will do so in the future, but this letter is getting overly long, and I need to close it. I leave you with one of my favorite Yogi Berra quotes: “In theory there is no difference between practice and theory. In practice there is.” In theory the economy should respond to stimulus, and an economy that is demonstrably overburdened with debt should be pushed to increase that debt. In practice, the outcome may not be quite as salutary as the theory suggests. Adjust your world accordingly.

Your meditating on belief systems analyst,

John Mauldin

Gold And Silver - February Heralding End Of Down Trend?

By: Michael Noonan


Applying market logic:

We often state that the market is replete with logic, even for those who do not know how or do not like to look at charts to explain the markets. Charts that explain developing market activity have been superior to all fundamental analysis over the last several years. For us, that statement would include for as long as charts have been maintained, starting with Japan's rice market, a few hundred years ago.

Most market participants have some [unrequited] need to have fundamentals be the driving force behind their market comprehension. [See the stock market top from 2008 and the ongoing follow-up by fundamentalists who were unable to comprehend how their world of value investing had just been turned upside down. As an aside, charts were flashing a major sell signal after the top but well before the collapse]. We digress...not really. The point is valid.

There have been many calls over the past few years for a bottom in gold and silver, yet none ever materialized. Just like in advertising, the same old products are repackaged as "new and improved," those so-called gold/silver pundits simply ignore their past and call for yet another bottom. People have short memories, except for when their accounts have suffered from believing and acting upon past false calls, and everyone is hungry to be among the first to participate in the final bottom that begins a trend reversal.

We are putting ourselves out as viewing February as perhaps signaling a potential turn in trend for gold and silver, and if true, it would mark December 2015 as a bottom. We leave the door open for the possibility of yet another new low, not as wiggle room or talking out of both side of our mouth, as it were, but regular readers of our commentaries know we like to see confirmation of any market call. Without confirmation, there can be no change, and to date, there has been nothing to confirm a bottom in PMs.

The significance of February is its decided change in market behavior on the monthly and weekly charts. The significance of the monthly and weekly charts is that both are more controlling for trend direction and, as a consequence, require more time to turn. Neither are used for market timing, the daily serves that purpose. If there is to be a change in trend, it will show up on the daily before the weekly and monthly.

While we have been reluctant to say the daily has identified a bottom for gold and silver, by the close of February, [this is Friday, the last trading day is Monday], both the monthly and weekly charts reveal a story that could not have been told prior to what has occurred this past month.

We have acknowledged that the fundamentals overwhelming support a bull market for gold and silver, beyond question. We have also stated that fundamentals do not apply, at least in terms of market timing, to reflect that overt bullish outlook. All fundamentals have taken a back seat to the elite's central bankers that have been actively manipulating and suppressing the price of gold and silver at least since the 1960s, and not just over the past several years. 

What has been a far more accurate barometer for gold and silver since the market peak in 2011 than charts?

Many presume we are technical analysts. We are not. You never see moving averages, RSI discussions, conventional trend lines that keep changing when they cease to work, MACD, whatever that is, Bollinger Bands, etc, etc, etc. All are based on past tense market activity and imposed onto present tense market activity as a means for "predicting" future tense market activity. Many, if not all, have a similar consistency of a stopped clock: right twice a day with pinpoint accuracy but no so reliable on other occasions.

We read and interpret the market based upon the market's own generated information using price and volume, over time, on the premise that there is no better an accurate source of information than that provided by the markets. Some, maybe most, see that as a distinction without a difference. If so, then why the total absence of standard tools for technical analysis, as just described?

The markets are full of logic. The objective is to read and perceive what that logic may be, for it is not always clear. For those times when it is not always clear, that is the market's logic to say, stand aside or use a lot of caution before proceeding. The most important piece of market logic is knowing and identifying the trend, for that is the prevailing direction of the market, and one can be more profitable by trading in harmony with the established trend.

A subsidiary aspect to knowing the trend is to realize that they take time to turn, as those who have been waiting for a turn over the past few years can recognize or appreciate. Here is our interpretation of the market's logic using the results from February's market activity.

For the past few years, we have mentioned bullish spacing as a characteristic trait of a trending market. We have identified it since 2013, and the spacing has slowly been getting smaller and smaller over time. You can see from the chart below that it has narrowed to a point of almost disappearing, but it is still there. The fact that the spacing was not eliminated speaks for its strength as a market measure: sellers were unable to erase it, at least up to this point. [Everything in the market is subject to change.]

When bullish spacing was nearly eliminated in December 2015, note how small the bar was and how volume declined. The fact that the bar was small is the market telling us that sellers did not have the ability to move the market any lower and at a point in time when sellers have been in total control. Then, note how volume diminished. It was the lowest sell volume [red bar], since 2009. That is a message from the market.

The logic is clear. Sellers could not close out the bullish spacing evident by a small range bar at a recent market low and when volume was not there to drive price lower. While the logic is clear, does that mean one should act upon it and be a buyer? Absolutely not. That apparent support could still fail, as it did in four preceding swing lows. Then what is the point for that information? Excellent question.

Confirmation is the point. The four preceding swing lows were not confirmed. They were not validated, and knowing that the trend, the prevailing market momentum is down, it is foolhardy to trade against the trend and increase one's risk exposure. The point of acknowledging February's activity is that is has an increased probability of confirming that the December low could be the bottom. What could increase that probability to a certainty?

Confirmation that the next correction holds above the December low.

Not a lot of people appreciate the value of knowing and heeding the trend. The next most important piece of information is knowing that one move confirms [validates] the prior move. It is the market's way of keeping yourself in the most advantageous position to profit from developing activity. See comments on monthly chart.

Monthly Gold Chart

Here is an important market message that has increased the probability that February could indicate a market in the process of turning direction. Not once in the prior months do you see a swing high higher than the previous swing high. This is again applying simple logic from the activity generated by the market that is sending a message for the first time in the past few years.

In order to determine if February is a valid indicator for change, it, in turn, has to be validated by developing market activity taken from the daily chart.

Weekly Gold Chart

While the daily chart has shown a short-term up trend, the higher monthly and weekly time frames did not support the message. We state that a change in trend will appear on the daily chart before the weekly and monthly charts. Prior to February, there has been no clear indication of a trend change on the daily. Now, after the fact, the recent rally on the daily takes on more significance due to the new and just completed market-generated information on the weekly/monthly time frames.

This is why we view the daily chart as pivotal, at this juncture, because the next reaction lower could confirm the read of February's developed activity on the higher time frames. If confirmed, one can then develop a trading strategy to be in harmony with what may be the beginning of higher prices to come.

What to look for?

Will the next reaction stay above a 50% retracement level, a general sign of strength? Will the reaction lower be comprised of smaller range bars [= less control by sellers], and less volume [= less pressure from sellers]? If yes, the market is telling us that sellers have lost control. Buyers will recognize that and start to become more aggressive. When that happens, the supply/demand equation kicks in, and higher prices result.

Daily Gold Chart

The gold:silver ratio has reached 81+:1, where it takes 81+ ounces of silver to buy one ounce of gold.

This is reflected in the slightly weaker chart structure for silver relative to gold. It is for this reason we have favored buying silver over gold because 80:1 gold over silver has not been self-sustaining for long periods of time. The ratio may continue to increase, just as the price for gold and silver continued to decline, despite the fundamentals, but the ratio does not have proven staying power above 80:1. The probability grows that, at some unknown point, the gold:silver ratio will turn in favor of silver.

Over time, we expect the ration to turn back to 40:1, perhaps even lower. At 40:1, it then only takes 40 ounces of silver to purchase one ounce of gold, down by half over the current ratio. At 80:1, 10 oz of gold buys 800 oz of silver. At 40:1. the 800 oz of silver can now buy 20 oz of gold. [Transaction costs not included for sake of example]. One can double one's gold holding over a period of time just by strategically switching one metal for the other, is the point.

Monthly Silver Chart

February's [red] volume bar is the highest since May 2013. Note how wide the range of the down bar was in May 2013 relative to how much narrower the range is for February. Here is a clear example, [applying logic] of sellers in total control in May 2013, but buyers are clearly present in February 2016, thus preventing the price range from extending lower, another example of a message from the market and why market-generated information is always more pertinent and present tense.

Weekly Silver Chart

There was a failed rally in October 2015. The failed climatic rally, which we identified as such, a few weeks ago when it occurred, was confirmation of the October failure. This is another example of how one move can confirm a prior one. [Markets are always testing and retesting past support/resistance and high volume areas.]

Silver being weaker relative to gold is evident where gold is holding above its current 50% retracement level, and silver has declined slightly below its half-way retracement, typical of a weaker market. In gold, we said to look for narrower bars down on any reaction and on declining volume.

What we see in silver is the exact opposite: a large wide-range bar on increased volume.

Reading developing market activity is more of an art form and not absolute. Appearances can be deceiving. Smart money [controlling influences] like to hide their intent to not have any competition. Because smart money moves [buys/sells] such large positions, at times, volume is a dead giveaway. Small traders do not create large volume increases; only large market movers do...this is axiomatic.

Large volume typifies a change from weak hands into strong. It is where you see small traders react to what conditions smart money are creating, especially at swing turns and changes in trends. This could be where the large volume is masking the intent of what the market is conveying. Where large ranges down with a poor close on increased volume portends continuation lower, at times, smart money can be creating the move lower but is buying every contract offered from weak-hand sellers and sell stops in order to facilitate their need to buy a market at/near lows. This is how they function.

We could always be wrong in trying to determine the logic of reading developing market activity, for it is an art and not pro forma. If wrong, the market activity will not confirm the potential December low and no harm done, [because one waits for confirmation before taking action.

This analysis applies more to the paper market, for we have been strong advocates of buying physical gold and silver at any price, and especially at these low levels. We cannot know when the downside manipulation will end, and when it does, the released pressure should have an equal and opposite reaction to the upside, the unintended consequences of the elite's desire to keep the public out of the gold/silver market.

Buy the physical without concern for price. One day, this price will be unavailable, and the possibility exists that any future physical gold/silver will be unattainable. It could happen.

Daily Silver Chart

Opec has failed to stop US shale revolution admits energy watchdog

By Ambrose Evans-Pritchard

Abdalla el-Badri, secretary-general of Opec

Abdalla el-Badri, secretary-general of Opec, says his group and US shale producers may not be able to 'live together' Credit: Warren Allott

The current crash in oil prices is sowing the seeds of a powerful rebound and a potential supply crunch by the end of the decade, but the prize may go to the US shale industry rather Opec, the world's energy watchdog has predicted.

America's shale oil producers and Canada's oil sands will come roaring back from late 2017 onwards once the current brutal purge is over, a cycle it described as the "rise, fall and rise again" of the fracking industry.

"Anybody who believes the US revolution has stalled should think again. We have been very surprised at how resilient it is," said Neil Atkinson, head of oil markets at the International Energy Agency.

The IEA forecasts in its "medium-term" outlook for the next five years that US production will fall by 600,000 barrels per day (b/d) this year and 200,000 next year as the so-called "fracklog" of drilled wells is finally cleared and the global market works off a surplus of 1m b/d.

But shale will come back to life within six months - far more quickly than conventional mega-projects and offshore wells - once crude rebounds to $60. Shale output is expected to reach new highs of 5m b/d by 2021.

This will boost total US production of oil and liquids by 1.3m b/d to the once unthinkable level 14.4m b/d, widening the US lead over Saudi Arabia and Russia.

Fatih Birol, the IEA's executive director, said this alone will not be enough to avert the risk of a strategic oil crisis later in the decade, given the exhaustion of existing wells and the dangerously low levels of spare capacity in the world.

"Even if there were zero growth in demand, we would have to produce 3m b/d just to stand still," he said, speaking at the IHS CERAWeek summit of energy leaders in Texas.

Mr Birol said investment in oil exploration and production across the world has been cut to the bone, falling 24pc last year and an estimated 17pc this year. This is a drop from $520bn to $320bn a year, far below the minimum levels needed to keep up with future demand.

A table showing oil capex by region
"It's not good news for oil security. Over the past 30 years we have never seen oil investment dropping two years in a row," he said.

"It is easy for consumers to be lulled into complacency by ample stocks and low prices today, but they should heed the writing on the wall: the historic investment cuts raise the odds of unpleasant oil security surprises in the not too distant future," he said.

The warnings were echoed by Opec's secretary-general, Abdalla El-Badri, who said the current slump will lead to serious trouble when the cycle turns. "It sows the seed for a very high price in the future," he said at the CERAWeek forum.

Mr El-Badri said he had lived through six oil cycles over his career but the surge of shale oil supply from the US has made this one of the most vicious. "It is a supply bubble. This cycle is very nasty," he said.

The Opec chief admitted that the cartel has been caught badly off guard by crash, blaming the wild moves on speculative forces with control over 5m "paper barrels" on the derivatives markets. "The fundamentals have not changed that much," he said.

But Mr El-Badri sent mixed signals about the real problem in the crude markets, letting slip that Opec and the US shale industry may not be able to "live together" and that frackers will take advantage of output cuts intended to stabilize the market. "If there is any increase in price, shale will come back immediately," he said.

Contrary to widespread assumptions, the IEA report said Saudi Arabia and the Opec club will lose market share, treading water as North America and Brazil's "pre-salt" basin in the Atlantic account for most of the growth in global output by the early 2020s. Algeria, Venezuela, Nigeria and Indonesia are all going into decline.

Iran's grand plan to reach 5m b/d and regain its place as the cartel's number two is dismissed as "aspirational". It will struggle to add much once it has recaptured its pre-sanctions level of 3.6m b/d.

Iran's major fields are 70 years old and need sophisticated technology, yet foreign investors are wary of taking the plunge.

Outside Opec, there will be a steady erosion of output in China, Mexico, Colombia, Egypt, Oman and the North Sea, all chipping away at global supply and leaving the world vulnerable as demand rises by an average of 1.2m b/d each year - hitting 100m b/d by 2020.

China's demand will ratchet upwards by an accumulated 2.5m b/d even as its own output slips, a scissor effect likely to tighten the global market relentlessly from 2017 onwards.
A table showing selected sources of non-Opec supply changes
The IEA report implicitly calls into question Opec's strategy of flooding the market in order to cripple of the US shale industry. Asked if the policy had failed, Mr Birol deflected the question diplomatically.

"I wouldn't could call it failure of this group or that group, but there is a new fact of life: we can produce oil at $50-$60. It is the success of oil industry," he said.

While the Opec strategy is finally forcing frackers to shut down, it has taken far longer than expected and may prove fleeting since private equity groups armed with a $60bn war chest are waiting to buy up the assets of failed shale companies.

The strategy has been prohibitively costly for Opec itself. Annual revenues have dropped from a peak of $1.2 trillion to around $400bn at today's prices, and a large part of this is a result of Opec's own actions.
A graph showing US oil production
The IEA said US frackers have been able to cut costs by 25pc-30pc and even more in the Permian Basin of West Texas. "A year ago it was widely believed that this would happen by the end of 2015 but that view has proved to be very wide of the mark. In 2014 and again in 2015 supply exceeded demand by massive margins," it said.

Much of the confusion is over the US "rig-count", which has dropped from 1,500 to 440. "Oil production has not fallen nearly as quickly as the rig-count alone would suggest," it said.

Russia is perhaps the biggest casualty, given that it is trying to fund a superpower military status and cover half its budget comes from oil and gas revenues. Its output will fall by 275,000 b/d as the old Soviet fields in western Siberia go into decline.

The Vankor, Uvat and Verkhnechonsk fields all boosted growth last year but there is little else new on the horizon. "Russia is expected to see the steepest output declines," said Mr Birol.
A table showing the Chinese oil demand
Ultimately, a fresh oil price spike or just a return to prices of $80 sows the seeds of its own destruction for the industry. It is likely to accelerate the shift to electric cars as the technology comes of age, and the COP21 climate accords start to bite.

That is a story for the 2020s. Mr Birol said it is a "heroic task" to interest anybody in the Houston oil fraternity in climate change

Emerging market bonds hit as foreign investors dump debt

©Getty Images; Reuters; EPA; Bloomberg

Twenty years ago, a dangerous cocktail of debt accumulated in foreign money and deteriorating exchange rates led emerging markets into financial meltdown.

In the aftermath, countries vowed to repent of the “original sin” of borrowing huge sums in non-domestic currencies. Major emerging markets went from having more than three-quarters of their debt in foreign currencies to around half. Finance ministers were applauded for better protecting economies from swings in global market sentiment.
Yet as the world recoils from risky assets amid a slowdown in China and collapsing oil prices, emerging market bonds are once again being dragged into the fray.

Unable to resist strengthening currencies and double-digit yields at a time when returns in developed markets were falling, the share of local-market government debt owned by foreigners more than doubled between 2009 and 2015. Now they want out.

Funds invested in emerging market debt issued in domestic currencies have experienced five consecutive weeks of outflows, according to funds tracked by EPFR, taking net outflows over the past 12 months to $12bn.
The move means debt markets promoted as a means to insulate developing countries from sudden swings in international market sentiment are instead amplifying it.
For governments, the inflow of international capital was initially a blessing. Foreign money in local bond markets raises the profile of the country, suggesting international investors trust the government’s ability to manage its economy. Higher demand also boosts prices, reducing borrowing costs.

Foreign investors hold more than a quarter of the outstanding total of emerging market bonds issued in local currencies, up from 9 per cent a decade ago, according to the World Bank.

In Mexico, Indonesia, Poland and Peru, ownership of local currency debt markets by foreigners exceeds 35 per cent.

But as the share of international investors in domestic bond markets increased, the IMF began to point out that emerging markets should regard local currency debt held by foreigners in the same way as external debt, given the potential for foreign investors to sell their holdings.

Last year, that withdrawal began. Emerging markets suffered a net outflow of capital for the first time since the 1980s, according to the Institute of International Finance.
Currencies across emerging markets have plummeted. Brazil’s currency hit its lowest level against the dollar in two decades last year, while South Africa’s rand and the Russian rouble reached a record low earlier this year.

“It has been a disaster for local currency investors,” said Jim Barrineau, co-head of emerging markets debt at Schroders.

“The currency volatility means investors are unwilling to stomach these bonds. And as growth slows in the countries and the bond yields go higher, the cost of servicing debt is getting more difficult for the countries.”

Sergio Trigo Paz, co-manager of Blackrock’s emerging market flexible dynamic fund, one of the few in the sector to post a positive return last year, said the fund had slashed its exposure to local currency debt.

“Last year we saw there was no opportunity in going long in emerging market FX,” he said.

“So we use FX to decrease the volatility of the fund — as a hedging instrument. The first weeks of this year tell us something we were already worried about which is that we are entering a world without QE, and markets are now going to be far more volatile.”

As currencies fall and concerns about solvency grow, investors are demanding more to hold local currency bonds. Yields in 10-year Turkish lira bonds, for example, have increased over the past 12 months from 7.79 per cent to 10.52 per cent. Brazil’s benchmark 10-year cost of borrowing in real has jumped from 10.7 per cent one year ago to 16.02 per cent.
“There has been a noticeable increase in foreign ownership of local currency bonds in emerging markets and as they liquidate their holdings emerging market governments are left facing some unappetising choices,” said William Jackson, emerging markets economist at Capital Economics. “Do they intervene or not.

There are some exceptions. Emerging market borrowers close to Europe have benefited from the European Central Bank’s monetary easing and yields in debt issued by countries including Czech Republic and Latvia are falling.

The rest face a difficult choice between raising interest rates and implementing capital controls to keep foreign money in the country or allowing their currency to fall and accepting the risk of higher inflation.

“I don’t think we are facing an impending collapse in emerging markets,” says Neil Shearing, chief emerging markets economist at Capital Economics. “But I think there is a growing awareness that the damage being done right now means any recovery will be extremely fragile.”