China’s ‘helicopter money’ is blowing up a bubble

Investment implications go far beyond the mainland’s markets

Arthur Budaghyan

An air show in Tianjin, China. Helicopter money discourages innovation and breeds capital misallocation, which reduces productivity growth © VCG via Getty Images

The escalation of the trade conflict between the US and China has raised the likelihood of greater stimulus by Beijing to prop up the economy. While China’s excessive debt isn’t news, investors must wake up to the reality of “helicopter money” — enormous money creation by Chinese banks “out of thin air”.

While this sugar rush may provide short and medium-term cover for investors, the long-term effects will exacerbate China’s credit bubble. China, like any nation, faces constraints on frequent and large stimulus, and its vast and still rapidly expanding money supply will produce growing devaluation pressures on the renminbi.

When a bubble emerges we are often told that this bubble is different. Many economists justify China’s credit and money bubble and continuing stimulus by pointing to the nation’s high savings rate. But this narrative is false. At its root is the idea that banks are channelling or intermediating deposits into loans. This is not how banks operate.

When a bank expands its balance sheet, it simultaneously creates an asset (say, a loan) and a liability (a deposit, or money supply). No one needs to save for this loan and money to be originated. The bank does not transfer someone else’s deposits to the borrower; it creates a new deposit when it lends.

In all economies, neither the amount of deposits nor the money supply hinge on national or household savings. When households and companies save, they do not alter the money supply.

Banks also create deposits/money out of thin air when they buy securities from non-banks. As banks in China buy more than 80 per cent of government bonds, fiscal stimulus also leads to substantial money creation. In short, when banks engage in too much credit origination — as they have done in China — they generate a money bubble.

Over the past 10 years, Chinese banks have been on a credit and money creation binge. They have created Rmb144tn ($21tn) of new money since 2009, more than twice the amount of money supply created in the US, the eurozone and Japan combined over the same period. In total, China’s money supply stands at Rmb192tn, equivalent to $28tn. It equals the size of broad money supply in the US and the eurozone put together, yet China’s nominal GDP is only two-thirds that of the US.

In a market-based economy constraints are in place, such as the scrutiny of bank shareholders and regulators, which prevent this sort of excess. In a socialist system, such constraints do not exist. Apparently, the Chinese banking system still operates in the latter.

There are clear downsides. Helicopter money discourages innovation and breeds capital misallocation, which reduces productivity growth. Slowing productivity and strong money growth ultimately lead to rising inflation — the dynamics inherent to socialist systems.

In the long run, more stimulus in China will entail more money creation and will heighten devaluation pressures on the renminbi. As we all know, when the supply of something surges, its price typically drops. In this case, the drop will take the form of currency devaluation.

As it stands, China’s money bubble is like a sword of Damocles over the nation’s exchange rate. Chinese households and businesses have become reluctant to hold this ballooning amount of local currency. Continuous helicopter money will increase their desire to diversify their renminbi deposits into foreign currencies and assets. Yet, there is no sufficient supply of foreign currency to accommodate this conversion. China’s current account surplus has almost vanished.

As to the central bank’s foreign exchange reserves, at $3tn they are less than a ninth of the amount of renminbi deposits and cash in circulation. It is inconceivable that China can open its capital account in the foreseeable future.

If China chooses the path of unrelenting stimulus, investors should recognise the long-term negative outlook for the renminbi. Continuous stimulus will beef up investment returns in local currency terms, but currency depreciation will substantially erode returns in US dollars or euros in the long run.

The investment implications go beyond Chinese markets. Market volatility over the past few months as the talk of stimulus picked up has given us a peek into the future. As the renminbi has depreciated by 12 per cent since early 2018, the pain has reverberated across Asian and other emerging markets. The MSCI Asia and MSCI EM equities indices have each fallen 24 per cent in dollar terms since their peak in January 2018. Long-term pressures could play out even more dramatically.

Fortunately, Chinese authorities recognise these issues. Yet they face an immense task of stabilising growth while containing credit and money expansion. This will be hard to achieve in an economy that has become addicted to credit creation.

Arthur Budaghyan is chief emerging market strategist at BCA Research.

Areas of concern

Parts of America may already be facing recession

Slowdowns in housing construction and manufacturing are ominous

IT CAN BE hard to know when isolated announcements become something more. Since last November General Motors has cut several thousand factory jobs at plants across the Midwest.

In early August US Steel said it would lay off 200 workers in Michigan. Sales of camper vans dropped by 23% in the 12 months ending in July, threatening the livelihoods of thousands of workers in Indiana, where many are made. Factory workers are not the only ones on edge.

Lowes, a retailer, recently said it would slash thousands of jobs. Halliburton, an oil-services firm, is cutting too.

In any given month, even at the height of a boom, more than 5m Americans leave a job; nearly 2m are laid off. Most of the time, however, overall employment grows. But not all the time.

America may or may not be lurching towards a recession now. For the time being employment and output continue to grow. But in the corners of the economy where trouble often rears its head earliest, there are disconcerting portents.

Recessions are synchronised declines in economic activity; weak demand typically shows up in nearly every sector in an economy. But some parts of the economic landscape are more cyclical than others—that is, they have bigger booms and deeper slumps. Certain bits tend to crash in the earliest stages of a downturn whereas others weaken later. Every downturn is different.

Those caused by a spike in oil prices, for example, progress through an economy in a different way from those precipitated by financial crises or tax increases.

But most recessions follow a cycle of tightening monetary policy, during which the Federal Reserve raises interest rates in order to prevent inflation from running too high. The first rumblings of downturns usually appear in areas in which growth depends heavily on the availability of affordable credit. Housing is often among the first sectors to wobble; as rates on mortgages go up, this chokes off new housing demand. In a paper published in 2007 Edward Leamer, an economist at the University of California, Los Angeles, declared simply that “housing is the business cycle”. Recent history agrees.

Residential investment in America began to drop two years before the start of the Great Recession, and employment in the industry peaked in April 2006. Conditions in housing markets were rather exceptional at the time. But in the downturn before that, typically associated with the implosion of the dotcom boom, housing also sounded an early alarm.

Employment in residential construction peaked precisely a year before the start of the downturn. And now? Residential investment has been shrinking since the beginning of 2018.

Employment in the housing sector has fallen since March.

Things may yet turn around. The Fed reduced its main interest rate in July and could cut again in September. If buyers respond quickly it could give builders and the economy a lift. But housing is not the only warning sign. Manufacturing activity also tends to falter before other parts of an economy. When interest-rate increases push up the value of the dollar, exporters’ competitiveness in foreign markets suffers. Durable goods like cars or appliances pile up when credit is costlier.

In the previous cycle, employment in durable-goods manufacturing peaked in June 2006, about a year and a half before the onset of recession. This year has been another brutal one for industry. An index of purchasing managers’ activity registered a decline in August. Since last December manufacturing output has fallen by 1.5%. Rather ominously, hours worked—considered to be a leading economic indicator—are declining. Some of this is linked to President Donald Trump’s trade wars, which have hurt manufacturers worldwide. But not all. Domestic vehicle sales have fallen in recent months, suggesting that Americans are getting more nervous about making big purchases.

In some sectors, technological change makes it difficult to interpret the data. Soaring employment in oil industries used to be a bad sign for the American economy, since hiring in the sector tended to accompany consumer-crushing spikes in oil prices. But America now produces almost as much oil as it consumes, thanks to the shale-oil revolution. A recent fall in employment and hours in oil extraction may be a bad omen rather than a good one. By contrast, a fall in retail employment was once unambiguously bad news. But retail work in America has been in decline for two and a half years; ongoing shrinkage may not signal recession, but the structural economic shift towards e-commerce.

Other signals are less ambiguous. In recent decades employment in “temporary help services”—mostly staffing agencies—has reliably peaked about a year before the onset of recession. The turnaround in temporary employment in 2009 was among the “green shoots” taken to augur a long-awaited labour-market recovery. Since December it has fallen by 30,000 jobs.

Even if America avoids a recession, the present slowdown may prove politically consequential. Weakness in some sectors, like retail, is spread fairly evenly across the country. But in others, like construction or, especially, manufacturing, the nagging pain of the moment is more concentrated (see map). Indiana lost over 100,000 manufacturing jobs in the last downturn, equal to nearly 4% of statewide employment. It is now among a modest but growing number of states experiencing falling employment: a list which also includes Ohio, Pennsylvania and Michigan.

Those four states, part of America’s manufacturing heartland, suffered both early and deeply during the Great Recession. In 2016 all delivered their electoral-college votes to Mr Trump, handing him the presidency. The president’s trade war might have been expected to play well in such places. But if the economic woe continues, voters’ faith in Mr Trump is anything but assured. Choked states might well turn Democrat-blue.

It’s Official: The World’s Third Oil Shock Is Underway…

By Nick Giambruno, chief analyst, The Casey Report

The world’s next oil shock is playing out exactly as I predicted…

On Saturday morning, tensions in the Middle East escalated after drones attacked two major oil facilities in Saudi Arabia.

The strikes knocked out more than half of Saudi Arabia’s crude oil output… and 5% of the world’s oil supply. The Houthi movement in Yemen, which is at war with Saudi Arabia, claimed responsibility. The U.S. government, however, has blamed Iran.

In any case, this attack is unprecedented and makes escalating actions almost inevitable. I think it’s only the beginning.

If you thought this attack was disruptive, understand that it’s only a tiny example of what could really happen in the case of a full-fledged war with Iran, which grows more likely by the hour.

If you’ve been reading the Dispatch, this shouldn’t come as a surprise at all. I’ve been saying that the chances of war with Iran are higher than ever…

And when it happens, it will have tremendous consequences for the price of oil.

We’re seeing this play out just as I predicted. The attacks sent the global oil markets into chaos… and crude oil prices are up 14% today as I write.

And I saw it coming a mile away. Today, I’ll show you everything you need to know about the rising tensions with Iran – including what Iran could do next…

Tensions Flaring

You see, about a year ago, I warned readers of my newsletter, The Casey Report, that the next big war in the Middle East was coming. And I showed them why it would focus on Iran.

But let me give you a quick refresher of what’s going on…

Tensions in the Persian Gulf region were already near a boiling point as U.S. sanctions choked Iran’s economy. But Iran hasn’t taken this economic strangulation lying down. It has a few cards to play, too.

Let me explain…

Things have been heating up around a key waterway in the Middle East – the Strait of Hormuz.

Six oil tankers were attacked near the Strait and the Persian Gulf, and the U.S. government blamed Iran.

Iran then shot down a $120 million U.S. drone. It claims the drone was flying in its airspace.

In response, Trump approved airstrikes against Iranian targets. It would have started a full-scale war… but Trump pulled back at the last minute.

And those are just a few of the skirmishes that are now making headlines. In short, tensions between the U.S. and Iran are flaring.

But Iran holds a powerful card… because it controls the Strait.

Oil’s Most Important Chokepoint

The Strait is a narrow strip of water that links the Persian Gulf to the rest of the world. It’s the most important oil chokepoint in the world.

Five of the world’s top 10 oil-producing countries – Saudi Arabia, Iran, Iraq, the United Arab Emirates, and Kuwait – border the Persian Gulf. The Strait of Hormuz is their only sea route to the open ocean… and world markets.

Every day, nearly 19 million barrels of oil pass through the Strait of Hormuz. That translates into roughly 33% of the world’s oil traded by sea. It’s over $1.2 billion in value every single day.

That’s part of the reason why big Middle East wars are often catastrophic for global oil supplies.

After all, almost 40% of global oil exports comes from the Middle East. Take a look:


As you can see, shutting down the Strait is Iran’s next powerful option in this conflict. And the investment implications are huge…

The Next Oil Shock

If Iran shuts down the Strait of Hormuz, it would cause the largest oil supply shock the world has ever seen.

And that will cause a huge price shock.

A “price shock” is when the price of something rises so quickly that businesses cannot react.

Two classic examples are the First and Second Oil Shocks.

The First Oil Shock happened in 1973.

A regional war in the Middle East caused the price of oil to nearly triple. It triggered a massive gas shortage in the U.S.… and a lot of panic.

Drivers sat in lines stretching for blocks, waiting to fill up their gas tanks. Some gas stations closed.

Others operated by appointment only. Rationing was introduced.

The Second Oil Shock came in 1979. Crude prices nearly tripled again… also caused by conflict in the Middle East.

You can see what happened to the oil price during both oil shocks in the next chart.


I would expect the Third Oil Shock’s effect on the oil price to be at least as severe as the first two shocks. Recall that oil prices nearly tripled both times.

In today’s prices, that would likely mean oil shooting to around $200 a barrel…

A Golden Opportunity

However, the market doesn’t appreciate how close we are to a war yet.

Yes, the price of oil is rising, but this is just the beginning.

In this environment, you want to own the highest-quality oil stocks. That means two things:

1) Companies that have done well during turbulent times in the past.

2) Companies that aren’t heavily exposed to trouble in the Middle East.

As Middle East supply disruptions cause oil prices to skyrocket around the world, companies that fulfill these criteria will be your ticket to profits.

So if you haven’t yet, now’s the time to get in.

Three JPMorgan metals traders charged with market manipulation

US prosecutors allege ‘massive, multiyear scheme’ to defraud customers

Henry Sanderson and Neil Hume in London

US prosecutors have charged three JPMorgan metal traders with a “massive, multiyear scheme” to manipulate markets and warned they were continuing to probe higher echelons at the largest US bank.

Michael Nowak, head of precious metals trading, was charged on Monday along with two colleagues, Gregg Smith and Christopher Jordan, on federal racketeering charges normally used to take down organised crime syndicates.

The indictment alleged that the three traders engaged in “widespread spoofing, market manipulation and fraud” while working at JPMorgan, which along with HSBC dominates global flows of gold and silver trading.

They placed orders they intended to cancel before execution in an effort to “create liquidity and drive prices toward orders they wanted to execute on the opposite side of the market”, it said.

The case will increase scrutiny over global precious metals markets and the dominance of large banks such as JPMorgan, with prosecutors indicating more senior executives and other banks are under investigation.

“We’re going to follow the facts wherever they lead,” said Brian Benczkowski, assistant attorney-general. “Whether it’s across desks or upwards into the financial system.”

The Dodd-Frank financial reform law of 2010 imposed criminal penalties for spoofing, the practice of duping other market participants by entering and rapidly cancelling large orders.

This was the first time that federal racketeering charges have been applied in a spoofing case, a derivatives lawyer said.

Mr Nowak, who joined JPMorgan in 1996, is on leave from the bank, according to a person familiar with the matter, as is Mr Smith, a precious metals trader. JPMorgan declined to comment. Mr Nowak’s lawyers at Skadden, Arps, Slate, Meagher & Flom said Mr Nowak had “done nothing wrong” and they expected “him to be fully exonerated”. Mr Smith and Mr Jordan could not immediately be reached for comment.

Between 2008 and 2016, the traders sought to take advantage of algorithmic traders by placing genuine orders to buy or sell futures, some of them so-called “iceberg orders”, that concealed the true order size, the indictment alleged.

At the same time they placed one or more orders that they intended to cancel before executing, so-called “deceptive orders”, on the opposite side, which were fully visible to the market, the indictment alleged.

“By placing deceptive orders, the defendants and their co-conspirators intended to inject false and misleading information about the genuine supply and demand for precious metals futures contracts into the markets,” the DoJ said.

The DoJ alleged the three men named in the indictment placed deceptive orders for gold, silver, platinum and palladium futures contracts on exchanges run by the CME Group, including the Nymex and Comex exchanges.

In addition, the men also allegedly defrauded JPMorgan’s own clients who had bought so-called “barrier options” by trading precious metals futures contracts “in a way that sought to push the price towards a level at which the bank would make money”, Mr Benczkowski said.

Barrier options are contracts that pay out if the underlying asset breaches a pre-determined price level.

A former JPMorgan trader, Jonathan Edmonds, pleaded guilty to charges of spoofing last November. Another former JPMorgan precious metals trader, Christian Trunz, pleaded guilty in August.

A third trader, Corey Flaum, who worked with Gregg Smith at Bear Stearns before it was acquired by JPMorgan, also pleaded guilty in July, Mr Benczkowski said.

Gold bugs and retail investors have fixated for years on JPMorgan’s precious metals business and its influence over gold and silver markets. “It’s no surprise to me,” said Ted Butler, an independent analyst and persistent critic of the bank’s role in metal markets.

Additional reporting by Gregory Meyer in New York

The Real Loser From the Oil Price Jump Is China

Nation is already dealing with an inflation spike and weak manufacturing margins

By Nathaniel Taplin

Higher oil prices are no longer an unalloyed negative for the U.S., but they are for the world’s largest crude importer: China.

The country is already dealing with a vicious outbreak of African Swine Fever that has pushed the price of pork, its staple meat, up over 40% on the year. Inflation is running at its hottest since 2013, excluding the volatile Chinese New Year holiday period. And amid the ongoing trade war with the U.S., August data released Monday showed investment, retail sales and industrial growth all slowing further—the latter to its weakest in 17 years.

For much of the past year, cheap oil has eased the pain for beleaguered Chinese consumers and businesses. Following Saturday’s attacks on Saudi Arabia, though, the Brent benchmark on Monday has risen about 10% to $65 a barrel. And it could stay elevated for a while, even as Saudi Arabia brings some production back online—in part because investors are now reevaluating the risk of more disturbances in the Middle East. Brent futures show investors betting that oil prices won’t fully move back down to where they were on Friday until next summer, even with the global economy widely expected to weaken further.
All of this will make shoring up sagging Chinese growth even more difficult. China has managed to dull the impact of U.S. tariffs with a cheaper currency. Pricier oil, on top of out-of-control food prices, makes devaluing the yuan even riskier than it already was. Beijing’s recent move to exempt new purchases of U.S. pork and other agricultural products from tariffs should be viewed primarily in the context of China’s increasingly alarming domestic food prices rather than softening trade tensions.

Expensive oil makes looser monetary policy riskier too. Analysts widely expect an imminent cut to rates on a key central bank lending facility that underpins China’s new benchmark lending rate. But policymakers remain trapped between a weakening economy and too-pricey food and housing. House prices are still up over 10% on the year, and growth in housing investment actually accelerated to a four-month high in August.

The outlook for Chinese growth is weaker than ever. Given the constraints, though, modest rather than overwhelming 2015-style policy stimulus is probably the best investors can hope for.

A gas station in north China's Hebei

Gold And Backwardation, A Dangerous Mix

by: Austrolib
- Backwardation is a phenomenon in the futures market where spot prices are higher than for future delivery. Usually futures are in contango, where futures sell at a premium to spot.

- Backwardation happens when there is a shortage of a commodity, usually from seasonal factors like prior to a harvest. It is quickly resolved through arbitrage or an increase in supply.

- But what if backwardation happens not because of higher demand to hold a commodity now, but because of lower demand to hold dollars into the future?

- This could theoretically happen if and when dollar interest rates go negative, cheapening futures relative to spot because dollars are taxed.

- Only much higher rates across the yield curve can pull commodities futures out of backwardation in that case.

The mechanics of an eventual crack-up boom continue to be put into place. Last week, Alasdair MacLeod at Goldmoney made the case from a futures market perspective. What does a crack-up boom look like numerically in the futures market? His answer: It looks like permanent backwardation across all commodities. How does this theoretically happen? His answer: Negative dollar interest rates. Here I’d like to go into how this actually works, conceptually.
First of all, let's define terms. Backwardation is when the spot price for a commodity is more expensive than for delivery of that commodity in the future. The closer to the present, the more expensive the contract. Contango is the opposite, when spot is cheaper than a futures contract and the farther out in time you go, the more expensive the contract. Contango is normal.
Backwardation is abnormal, and is corrected by an increase of supply, or price increases by people playing futures arbitrage.
Why is contango normal? Because a supplier delivering a commodity in the future allows that supplier to keep his dollars in the present and earn interest on those dollars. That interest is reflected in the higher price for a futures contract the farther into the future you go.
Backwardation is abnormal because it means that the demand for a commodity at a certain time is high enough to counteract interest earned on dollars held. Those with a supply would gladly sell in the present to buy that cheaper futures contract and earn the difference. If supplies are short though, backwardation persists until supplies are replenished.
Backwardation from the Commodity Side
Seasonal backwardation is normal in consumable commodities. It is always a temporary phenomenon where a premium for spot is caused by a physical shortage of a given commodity at a certain time as explained above, for example, immediately before the seasonal grain harvest. This is resolved by the harvest, because then there are present supplies for futures traders to sell while buying the futures contract and profiting on the spread, lowering present prices and raising future prices.
This returns the market to contango, where it usually stays until another temporary shortage may arise for whatever reason. There is nothing troubling about this and it happens in cycles.

Backwardation from the Dollar Side
Here's where Macleod adds his critical twist. He asks, what if backwardation is coming not from the commodity side of the equation like a wheat shortage before harvest, but rather from the dollar side of the equation? In other words, not from a positive desire to hold wheat now, but from a negative desire to hold dollars into the future? These are mirror images of the same phenomenon numerically at least, but the latter is in an "evil twin financial universe" if we can call it that. Here's why.
Contango, the normal situation in commodities markets, is generally caused by the logical desire to hold dollars for as long as possible. For, say, gold delivered in 2025, the seller gets to hold on to the dollars paid for that contract for 5 years. The interest he can earn on those dollars is reflected in the premium usually demanded for later deliveries.
But when we suddenly introduce negative interest rates, there is an unnatural disincentive to hold dollars for longer created by central banks trying to pump asset prices. The longer you hold dollars when rates are negative, the more money you lose. The premium turns into a discount against shorter deliveries, with the highest-priced contract being the most immediate delivery available. And voila, backwardation.
Here is the crux of it. Macleod says the following in his latest piece, and this is the paragraph I want to focus on:
If the Fed introduces negative dollar rates, then distortions of time preference will take a catastrophic turn. All financial markets will move into backwardation, reflecting negative rates imposed on dollars. Remember, the only conditions where backwardation can theoretically exist in free markets are when there is a shortage of a commodity for earlier settlement than for a later one. Yet here are backwardation conditions being imposed from the money side.
Let’s work this out step by step. We will use gold here, but it applies for any commodity, because they are all traded in dollars. Let us assume that in order to counter the next recession, the Federal Reserve pushes the fed funds rate to -4%. Let’s now make two assumptions and see what happens logically. First, let’s assume a negative yield curve between the 5Y and the fed funds rate, which is what we have now. The 5Y yield is at 1.39%, and the fed funds rate is at 2.12% currently. That’s a negative spread of 73 basis points.
So assuming the same spread, fed funds rate of -4% puts the 5Y at -4.73%. The COMEX offers gold delivery currently out to 2025, about 5 years, so if 5Y yields are –4.73% and overnight is -4%, if you are a seller of gold futures for 2025 you lose 4.73% a year multiplied by 5 for that contract. That’s a total loss of 23.65% over the 5-year period due to the negative interest rates imposed on dollars.
However, if you sell a contract for delivery in one month (let's use 1M rates as a proxy for the fed funds rate) you lose only 4/12, or 0.33%. Obviously, in that case, gold for delivery in 2025 would be about 24% cheaper than gold deliverable in one month.
Can arbitrage be made over this spread to return the market to contango? Let's consider. Can a speculator make a profit buying gold deliverable in 5 years and selling gold deliverable in 1 month?
No, because he's going to lose 24% on gold deliverable in 5 years with negative interest rates.
He can only speculate about making money on this move if he is betting on higher interest rates down the road. There is no risk-free arbitrage here as there is with wheat once the harvest comes in and backwardation becomes contango. Plus, there is no such thing as a gold shortage because gold does not get consumed like, say, wheat does. More gold supply does not alleviate the backwardation. Only higher dollar interest rates can possibly do that.
Therefore, in a negative yield curve situation with overnight rates at -4%, everyone tries to buy gold now, raising the dollar price across deliveries and locking the market in backwardation from the dollar side - NOT the gold side. Other commodities fall in terms of gold and rise in terms of dollars.
The result when enough traders realize what's going on, is the crack-up boom across the entire commodity complex as the entire commodities futures market warps into backwardation due to negative dollar interest rates.
But what if the yield curve is positive? Let’s say the fed funds rate is -4% again. The highest the spread between the 5Y and overnight rates has gone is about 300bps, so let’s assume rates on the 5Y of -1%. What happens then? That means for gold delivered in 5 years, the seller of that contract loses 5% (1% a year multiplied by 5). The seller of 1-month gold loses -4%/12, or .33%. Gold is locked in backwardation whether the yield spread is positive or negative.
What could even theoretically stop this process to put gold back in contango? The only possible answer is higher dollar interest rates across the board. How much higher? Let’s say yields on overnight rates are still -4%, and yields on the 5Y move up to 1%. What would be the highest spread between them in history, but let's stick with this. Then sellers can earn 5% on 5Y gold (1% a year), lose 0.33% selling one-month gold. That's a spread of 5.33% down the delivery line, theoretically putting 5Y gold at a 5.33% premium. Unless, of course, the price inflation rate is higher than 5.33%. In that case, a seller of 5Y gold would still lose money in real terms and the premium for 1-month gold remains. Still backwardation persists.
The only thing that can take the gold market out of backwardation from negative rates is much higher interest rates across the board with a yield spread substantially higher than the price inflation rate. If, say, rates on the 5Y were 20% like they used to be in 1980, and one-month rates at 0%, then we have a 100% gain waiting 5 years for gold, and no loss for buying it in a month. That could do it, depending on the rate of price inflation and if the loop hasn’t spun out of control by that point. Price inflation would have to be below 20% a year for the market to return to contango in that case.
The big problem is, once the futures market gets locked into backwardation from negative rates, the fear Macleod expresses is that at that point, everyone starts plowing into commodities fast and price inflation explodes, making it much harder to reverse the backwardations. The Fed will not have much time to reverse the situation once it starts, if doing so is even possible without destroying the incredibly leveraged global economy.
Negative dollar interest rates are an absolute disaster waiting to happen. If it ever does happen, once we start to see nominally negative rates in the United States, the danger of a crack-up boom becomes very real. The only cure would be to jack up dollar interest rates very quickly to rates higher than the inflation rate. This was possible in the late 1970s and early 1980s when rates actually did go to 20%.
Debt was so much smaller back then. But this time, the wave of bankruptcies across corporate and sovereigns would break records.
The entire German and Swiss yield curves are already below zero. It’s not causing backwardations in commodity markets though because commodities are priced internationally and settled in dollars, the reserve currency, not euros or Swiss francs. But a systemic shock to Europe could lead the Fed to introduce negative rates in the world’s reserve currency if the European Central Bank and Swiss National Bank go there first. If that happens, duck and cover.
You can either hope this doesn’t happen and assume the Fed understands the threat of backwardation from the dollar side, and therefore won’t introduce negative rates under any circumstances. Or you can prepare for it, assuming they will.

martes, septiembre 17, 2019


Brexit, the Novel

If UK Prime Minister Boris Johnson had to worry about the value of the pound or the fragility of the British economy, he would need to be much more careful. But the British are resilient, the Bank of England will take the necessary actions, and the value of the pound does not matter much – all of which means that Johnson could win.

Simon Johnson

johnson119_David M. BenettGetty Images_boris johnson book

WASHINGTON, DC – The best way to think about the United Kingdom’s political predicament and presumed imminent exit from the European Union is to read the Slough House spy novel series by Mick Herron (the sixth installment, Joe Country, just appeared). Herron writes about the modern MI5 intelligence agency and the machinery of government in general – not directly about economic policy. But he perfectly captures how bureaucracies function, as well as what political “leadership” really means in a complex world where illusion and misdirection prevail in democratic systems.

The contrast with classic spy novels, such as the early work of John le Carré, is readily apparent and part of the fun for readers. During the Cold War, the so-called Moscow Rules guided how spies could survive in hostile environments: “watch your back” was the guiding idea. Today, according to Herron, a set of London Rules prevails, the most important of which is “cover your ass” and protect your career.

Britain has had many economic difficulties and some serious crises over the past century, and it is tempting sometimes to draw parallels – for example, to difficulties associated with the gold standard between the world wars or the Suez Crisis in 1956. But the international system is now quite different, Britain’s role in the global economy is much diminished, and the pound floats freely against major currencies.

In 1956, as well as in other prominent historical episodes, preserving the value of the pound was viewed by policymakers as important, if not essential. Through at least the early 1990s, there was an ever-present fear that devaluation (relative to the dollar and other currencies, including the Deutsche Mark) would fuel inflation, which would necessitate higher interest rates and overall economic contraction.

Today, the world is quite different. Fixed exchange rates in the developed economies disappeared in the 1970s, first with a bang (the devaluation of the dollar under US President Richard Nixon) and then with a whimper (as leading central banks focused on bringing down inflation). An even bigger shift came with disinflation almost everywhere, along with what appears to be an extremely resilient anchor for long-term inflation expectations around 2% per year in places like the UK, the eurozone, and the United States.

The good news from this shift is that a country like the UK is now more resilient to shocks. The Bank of England is well run and communicates its policy clearly. Rather than destabilizing the economy, a depreciation of the pound most likely could help boost the economy, including by making exports more competitive.

Britain also has a strong (though not perfect) education system, producing well-qualified scientists, engineers, and executives. If, for example, the London-based financial sector suffers a downturn because of reduced access to European opportunities after Brexit, other sectors such as pharmaceuticals or autos or software will find it easier over time to attract talent.

Unfortunately, not all the news is good – which brings us back to Herron’s Slough House novels. Herron’s older heroes worked during the Cold War, when the stakes seemed existential and the tactics were brutal. Modern Britain, seen through Herron’s lens, faces no such severe threats, yet the tactics of intelligence operatives (and their handlers) are no less ruthless (though often also more humorous). Herron’s acerbic but undeniable contention that many modern politicians believe in little except their own survival and potential career advancement or glory is also relevant to Brexit.

The Suez Crisis was precipitated by then-Prime Minister Anthony Eden’s belief that he was standing up to an authoritarian ruler (Egyptian President Gamal Abdel Nasser), in contrast to Neville Chamberlain’s policy of appeasement of Adolf Hitler in the 1930s. British military action, supported by France and Israel, was based on a presumption of Britain’s continuing imperial power, and it failed when there was a run on the pound – ultimately due to lack of support from the United States.

Today the constraints on developed-country politicians are greatly reduced. The irony of a strong independent central bank is that it is much more able to offset the effects of other irresponsible policies. If UK Prime Minister Boris Johnson had to worry about the value of the pound or the fragility of the British economy, he would now need to be much more careful. But the British are resilient, the Bank of England will take the necessary actions, and the value of the pound does not matter much.

What would Herron’s characters and plot lines produce in this scenario? It’s hard to say, because politics and bureaucratic skulduggery are doubtless just as prevalent in the EU as they are in the UK.

My suggestion: a “hard” Brexit that, when it plays out, is really no such thing. There will be a pragmatic relationship with Europe, disguised as confrontation, and slower medium-term growth will be blamed on the outside world. By generating enough populist anger, partly owing to his own irresponsible actions, Johnson could even win a general election.

As a novel, it might seem ridiculous. As a potential real-life scenario, it seems quite plausible.

Simon Johnson, a former chief economist of the IMF, is a professor at MIT Sloan, a senior fellow at the Peterson Institute for International Economics, and co-founder of a leading economics blog, The Baseline Scenario. He is the co-author, with Jonathan Gruber, of Jump-Starting America: How Breakthrough Science Can Revive Economic Growth and the American Dream.