Germany hides the awkward truth about the euro

The benefits of integration carry a price tag. German voters have never been required to understand this bargain

Philip Stephens

web_Germany and the Euro

Last weekend European policymakers gathered on the glistening shores of Lake Como for the Ambrosetti business forum. I heard three things. The downturn in the eurozone economy looks perilously like the prelude to recession. The European Central Bank’s monetary easing will serve as a vital, but insufficient corrective. And Germany will wait until it is too late before providing a measurable fiscal stimulus. Brexit is a sideshow, albeit an unwelcome one given the darkening economic clouds.

Mario Draghi, the departing president of the ECB, has already earned his place in the pantheon of great Europeans. His willingness to remake the monetary rules saved the euro in the aftermath of the 2008 crash. Had the single currency collapsed, much of the architecture of postwar European integration would have gone with it. National politicians, frozen in the headlights of the crisis, have a lot for which to thank Mr Draghi.

His strategy was embedded in a single sentence during the summer of 2012. “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” Mr Draghi’s steely conviction did indeed prove enough.

There are limits, however, to the reach of even a courageous central banker. The ECB, as with its latest volley of expansionary measures, can push back against deflationary pressures. But, at Germany’s insistence, the euro is a project still only half-made. Fiscal policy remains firmly in the hands of national governments. The eurozone budget sanctioned by Berlin under pressure from Paris is so small as to be invisible.

Jean-Claude Juncker, the outgoing president of the European Commission, is credited with the observation about Europe’s political leaders that: “We all know what to do, we just don’t know how to get re-elected after we’ve done it.” Speaking when he was still prime minister of Luxembourg, Mr Juncker was talking about structural reforms — often disturbing traditional employment rights — to raise productivity. The lag between such politically painful measures and higher living standards often overruns the electoral cycle.

His maxim, however, can equally be applied to policymakers in the eurozone’s creditor states. Former German chancellor Helmut Kohl backed the single currency as both a fair price for reunification and as a mechanism to fix the new Germany into Europe. The euro would mark the route to a European Germany and provide a roadblock against a German Europe.

Mr Kohl’s offence — the original sin, I would say, at the launch of the single currency — was to shy away from spelling out to German voters the inescapable meaning of the bargain. It still goes unsaid. In short, Germany is the biggest beneficiary of European integration. The EU supplies the democratic stability and economic certainty on which its prosperity has been built. No country has more to lose from a break-up.

These benefits, understandably, carry a price tag. As the EU’s most powerful economy, Germany bears a proportionate responsibility for the stability of the enterprise.

The mantra in Berlin continues to obfuscate. Germany, it says, will never accept a “transfer union”. In real life, of course, that horse has already bolted. The true choice is between the shadow transfer union represented by the mountain of national central bank liabilities that have built up at the ECB — so-called Target balances — and the creation of an economic union that admits the role of fiscal policy in managing economic demand.

The present catch-22 is that those with room to operate the fiscal levers — Germany and its northern neighbours — refuse to do so. Those pressing for a more expansionary stance — led by France — lack the budgetary headroom.

Among my German friends, the most frequent riposte centres on moral hazard. The eurozone needs strong incentives for politicians in debtor states to take the unpopular measures needed to improve competitiveness. The flawed assumption is that there is a straight either/or choice. Why not structural modernisation and fiscal support for growth-enhancing investment?

There has rarely been a better time for Europe to invest in its future. Inflation has disappeared. Germany is awash with fiscal surpluses, federal, state and municipal. The cost of borrowing is zero. In Emmanuel Macron’s France, Berlin has a partner that has shown it will take tough supply side decisions.

Fiscal support for the eurozone economy is not about digging-holes-and-filling-them-in demand management, though even that would be better than nothing. The continent faces a yawning investment gap. Communications networks need replacing (check your WiFi speed or cellular telephone connection in Germany). The decarbonisation required to meet climate targets demands the re-engineering of the continent’s economy. Europe is way behind the US and China in advanced computing and machine learning.

German leaders know this as well as anyone. Still, they fear saying anything that might alarm the good burghers of Munich, Hamburg and Frankfurt. Were recession to provoke a full-blown eurozone crisis, Berlin would of course act. In those circumstances the politics would be much easier to manage. But do not expect Germany to dispatch the fire brigade before the flames have fully taken hold. What a waste.

Bond Markets Might Be Worried About Japan, but U.S. Manufacturing Is the Real Trouble Spot

By Randall W. Forsyth 

Photograph by Nathan Boadle 

The thing to worry about in global bond markets isn’t what the Bank of Japan is doing, but what’s happening to U.S. manufacturing.

U.S. bond yields plunged Tuesday morning after the Institute for Supply Management’s closely watched manufacturing index was reported to have plunged in September, to 47.8 from 49.2 in August. The gauge had been forecast to have recovered to above 50, the dividing line between expansion and contraction in the manufacturing sector.

Japanese bond yields jumped Tuesday after a weak auction of new securities, resulting from a change in the Bank of Japan’s bond-purchase operations. The sharp rise in Japanese government bond yields rippled through global sovereign debt markets. U.S. Treasury note yields surged more than five basis points (0.05 percentage points) for the benchmark 10-year maturity, to an intraday peak of 1.75%.

But then the 10-year yield plunged to 1.644%, down 2.3 basis points on the session. Even more worrying were components of the ISM report, which showed continued weakness in new orders, especially export orders, all of which reflect the continuing trade war.

What investors shouldn’t worry about is the uptick in Japanese government bond yields. Steven Ricchiuto, U.S. chief economist for Mizuho Securities, says the adjustment in the BoJ’s purchases was technical, but a sign of the central bank’s sensitivity to the plight of Japanese banks’ difficulties of operating in a negative interest-rate environment. The shift wasn’t a fundamental change by the central bank—it isn’t backing away from its longstanding policy of monetary stimulus, he emphasized.

But Ricchiuto expects Japanese investors to resume their “grab for yield” globally as they recognize Japan’s economy “isn’t getting any better.” With the increase in that nation’s value-added tax that took effect Tuesday—adding to the drag on the economy—he looks for investors to resume their bond buying.

In the U.S., attention turns to the rest of this week’s slate of economic data releases and how they may affect Federal Reserve policy. After the ISM report was released midmorning, the probability of a 25-basis-point cut in the federal funds target rate at the Oct. 30 policy meeting jumped to 58.3% from 39.6% as of Monday, according to the CMEFedWatch Tool.

Friday’s employment report will be the key report for the markets. Estimates for nonfarm payrolls have a median rise of 140,000, with average hourly earnings expected to be up 0.3% from a year earlier. Those projections are in line with recent trends. But surprise on the weak side, as seen in the ISM report, could further boost expectations for Fed rate cuts coming sooner.

Fed wrestles with role of regulation in repo squeeze

Breakdown in overnight lending exacerbated by banks’ preference for reserves

Brendan Greeley in Washington and Laura Noonan, Joe Rennison, Robert Armstrong and Colby Smith in New York

The Fed is trying to work out why banks with sufficient cash reserves did not lend them out when short-term interest rates began to spike last month
The Fed is trying to work out why banks with sufficient cash reserves did not lend them out when short-term interest rates began to spike last month

The Federal Reserve is looking at whether regulation played a role in the sudden rise in short-term interest rates that rocked markets last month, when the largest US banks, despite being flush with cash reserves, did not lend them out overnight as expected.

The central bank has indicated that it is focused on the concentration of reserves among a few banks and said it will consider the question at its next monetary policy meeting on October 29-30.

According to policymakers, traders and bank executives, that concentration contributed to the rise in two ways. Larger banks have to meet higher regulatory standards for cash, particularly for same-day liquidity that only reserves can provide. And larger banks have different strategies for their own reserve holdings, which may not include lending them out overnight.

In a speech on Friday, Patrick Harker, president of the Philadelphia Fed, said that some pipes in financial markets “might be rusty — or clogged”, and added that it was “worth asking if regulation might be contributing to any erosion or blockage that might exist”.

Fed data show large banks are keeping a disproportionate amount in reserves, relative to their assets. The 25 largest US banks held an average of 8 per cent of their total assets in reserves at the end of the second quarter, versus 6 per cent for all other banks.

Meanwhile, the four largest US banks — JPMorgan Chase, Bank of America, Citigroup and Wells Fargo — together held $377bn in cash reserves at the end of the second quarter this year, far more than the remaining 21 banks in the top 25.

Since the financial crisis, large banks have been obliged to meet a liquidity coverage ratio (LCR) — a portion of high-quality assets such as cash reserves and Treasuries that can be sold quickly to keep the lights on for a month in a crisis. But regulations also require them to track intraday liquidity — cash they can immediately access — which does not include Treasuries.

This additional requirement can vary depending on their business models, which in turn inform supervisors’ and examiners’ bank-specific demands.

Executives at several large banks say this puts a de facto premium on reserves that varies by bank.

“The [one-day] liquidity requirement is massive,” said a managing director at a bank on Wall Street. “There is no way banks can hold anything but cash for that.”

The Federal Open Market Committee has been working for several years to define “ample” reserves — enough so that banks will lend them overnight as a release valve to prevent rates from going too high.

Banks currently hold $1.3tn in reserves at the Fed. In surveys, most recently in February, bank officers had shared their own “lowest comfortable level” of reserves. Using their responses, the New York Fed estimated a system-wide lowest comfortable level of between $800bn and $900bn.

But that estimate came with a warning. In a speech this year, Lorie Logan, interim manager of the Fed’s securities portfolio and a senior vice-president at the New York Fed, flagged the possibility that if reserves are not distributed efficiently among banks, that lowest comfortable level could be higher than the survey estimates.

Mary Daly, president of the San Francisco Fed, suggested bank officer surveys might have limitations as predictors. “People tell you what they’re willing to do,” she told the Financial Times, “but then when it really comes to it, they want to do something different.”

Reserves at large banks have varied over time, suggesting that reserve levels — and willingness to lend them — reflect not just regulatory compliance, but also business decisions.

“We have plenty of liquidity,” said the chief financial officer of a top-10 US bank. “We are just choosing not to lend it out overnight to hedge funds.”

A graphic with no description

A 2019 paper from economists at the Fed found that more cautious banks held more reserves, but holdings also differed according to “differing business models, products and services, and unobservable, internal operating procedures”.

“If you had a simple model and you could predict that every institution would behave exactly the same, it’d be much easier to pick a number of ample reserves,” said Ms Daly. “But when institutions have different strategies for different reasons, you have to uncover what those strategies are, and how responsive those strategies are to demand.”

Second-quarter data from the four largest reserve holders show Wells Fargo held 39 per cent of its high-quality liquid assets in reserves. JPMorgan held 22 per cent, Bank of America held 15 per cent and Citigroup 14 per cent.

“If you have a very large concentration in a few institutions and you lose one or two on any day, then you are losing a major portion of your funding,” said Jim Tabacchi, chief executive at South Street Securities, a broker dealer active in short-term debt markets. “Rates have to skyrocket. It’s simple math.”

I'm Still Loading Up On Gold And Gold Stocks. Here's Why

by: Lyn Alden Schwartzer


- People have worried about federal deficits for decades, but recent catalysts are making the problem more acute.

- Domestic institutions are being fed excess government debt, and it's becoming an increasingly acute liquidity problema.

- Two potential outcomes analyzed.


I've written a couple articles this year here on Seeking Alpha about why, in addition to investing in a variety of normal equities, I began allocating a portion of my portfolio into gold and gold stocks starting in the autumn of 2018.
And in my most recent article, Recession Obsession, I examined how these gold stocks have been the best-performing asset class within my portfolio since they were added, with some ups and downs along the way.
During the past couple months, after the quick rise of gold and the rather meteoric rise of high-quality gold stocks (many of them up 30-50% or more within the year), I have naturally started to receive emails about whether I think precious metals are still worth having exposure to.
My short answer is yes, I'm still buying gold stocks for multi-year exposure. I'm a bit more cautious at these levels than I was earlier this year, focusing on dip-buying and dollar-cost averaging, but I still think we are well within the bounds of an attractive risk/reward profile for long-term investors. We could easily see further dips and corrections, but I would be a buyer of those.
However, I'm also long cash and cash-equivalents like very short-term T-bills, but I don't have any exposure to long-term Treasury notes or bonds. There are two potential outcomes that I see as coming down the path, and this cash/gold split prepares for both.
Updated Gold Charts
Back in February, I wrote an article here about how I approach the topic of gold valuation. As many people readily point out, gold doesn't produce cash flows, so in order to have a frame of reference for what it's worth, it helps to understand the main demand drivers.
Gold often gets confused as an inflation hedge, an inversely-correlated asset, or other things, but the price history is a bit more nuanced than that.

First of all, over very long periods of time, the gold price generally keeps up with the growth rate of money supply per-capita, because the amount of gold per person is relatively fixed while the number of dollars per person in existence keeps growing. This growth of the money supply per-capita is what some might call the "real" inflation rate, although a lot of this money just trickles into financial assets (including gold) and luxury items rather than everyday consumer prices.
The following chart shows the price of an ounce of gold (blue line) relative to the growth of broad money supply per-capita (red line) in the United States, indexed to 100 in 1973:
Gold vs Broad Money Chart Source: St. Louis Fed
You can see that in 1980 and 2011, gold hit extreme highs. These occurred during periods of negative real interest rates and unusual monetary policy. In 1980, the country had only been off its gold standard for 9 years and was suffering from double-digit consumer price inflation, so people reached toward precious metals. In 2011, the country was recovering from the subprime mortgage crisis, the European sovereign debt crisis was reaching its peak, and the Fed was performing quantitative easing which people feared would lead to inflation, so again they reached toward precious metals.
On the other hand, during the 1990's and early 2000's, gold went below its long-term trend line.
This was during a period of rapid GDP growth and high real interest rates, which means bonds and banks paid you a high real rate of return for saving in them, which makes holding gold less attractive as a store of value.
This second chart outlines more clearly the inverse relationship that the year-over-year change in the gold price has with real 10-year treasury rates (10-year yields minus inflation):
Gold vs Real Rates Chart Source: St. Louis Fed
Gold is a dense long-lasting store of value (a currency, essentially) that roughly keeps up with monetary inflation (which is different than, and usually faster-growing than, consumer price inflation). Since gold's main competition are cash and bonds, gold tends to lag this trend a bit when real interest rates are high, because the opportunity cost of holding gold is high. In contrast, gold tends to go up faster than the trend when real interest rates become low or negative, or when investors anticipate that weird monetary policy is happening, because the opportunity cost for holding gold goes away, and the safety of holding cash or bonds starts to receive some skepticism.
Currently, gold is a bit above its trend compared to money supply growth since 1973, but only by a marginal amount, and this is a rough measure to begin with. I mainly watch for big deviations from the trend rather than worrying about little deviations. In a world with negative nominal bonds, negative real interest rates, and continued quantitative easing out of Europe and Japan, I consider this mild premium to be justified.
Gold is certainly vulnerable to pullbacks at this price level, and could retest support in the upper-$1,300's per ounce, but I'll leave those details to the technical analysts. As a long-term investor, I'm a gradual buyer at current prices of gold, silver, gold royalty and streaming companies, and to a small extent, gold miners. But I also have some cash in case I get a chance to buy it (or other asset classes) materially lower.
It's becoming more likely that the Fed will need another round of quantitative easing, perhaps in 2020, but for somewhat different reasons than the previous three rounds. I consider this an intermediate and long-term catalyst for gold.
Deficits Don't Matter, Until They Do
People have been worried for decades about U.S. federal debt and deficits. When debt was 40% of GDP they worried, then when it was 80% of GDP they worried, etc. But the sky never fell, even decades later. Now it's over 105%.
Deficit hawks have become the people that "cried wolf", because the more that people call out the growing U.S. government debt without it causing any acute problems, the less credibility those concerns will be given over time. It's always something that is considered a distant future problem rather than a practical issue that we can make or lose money from.
But let's focus on a specific issue that is more intermediate-term in nature.
Due to tax cuts and other factors, U.S. deficits as a percentage of GDP have accelerated in recent years after a period of reduction:
Deficits to GDP Chart Source: Trading Economics
In 2019, the $1 trillion deficit is in the ballpark of 4.5% of GDP, even though we're over 10 years into an economic expansion. These deficits are projected to keep growing by the CBO and others, even without a recession in the forecast. A recession would result in decreased tax revenue and increased spending, which would further widen the deficit beyond the baseline forecast. And so far, the deficits have been coming in a bit bigger than the CBO has been forecasting.
As this chart from Goldman Sachs shows, the United States currently has an increasing federal budget deficit during a period of low unemployment and strong economic growth outside of wartime, which is a major deviation from 70 years of U.S. fiscal policy:
U.S. Deficits and Unemployment
So, this time it is a bit different, and the question is, who is buying all of this extra debt, and at zero real rates?
From the early 2000's until 2015, the U.S. government was reliant on more and more foreign funding.
However, foreign buying of U.S. government debt has leveled off since 2015, and only mildly ticked up in 2019. Around the same time just before 2015, the Federal Reserve ended its last round of quantitative easing, and stopped buying government debt as well.
So, during the past four and a half years, domestic investors (mostly banks, insurers, and pension funds) have been soaking up all of the U.S. debt growth, alone.
This chart shows the federal debt held by domestic institutions/investors (blue line), the Federal Reserve (red line), and foreign sources (green line). I marked the start of 2015 for emphasis:
Federal Debt Holders Chart Source: St. Louis Fed
Since 2015, private U.S. institutions and other domestic investors bought the vast majority of all new debt, and went from holding $4.4 trillion in U.S. debt to $7.4 trillion. They've soaked up $3 trillion in Treasuries in less than five years, and now are being fed another $1 trillion+ per year going forward, so the problem is accelerating. There have already been a number of messy bond auctions this year where demand was weak, and at this point, it's like trying to clean up a puddle with a sponge that is increasingly becoming too saturated to soak up any more.
This summer, there was a bit of a reprieve due to the government running up against the debt ceiling.
The government juggled their books and drew down their cash reserves to low levels rather than issuing new debt for a time, out of necessity. But now that period is over.
During the second half of 2019, the government expects to issue more than $800 billion in debt, which is a bit more than normal for the period because they are in the process of re-filling their depleted cash reserves in addition to funding the normal course of government. They've already issued part of this but still have the majority to go.
This is causing a liquidity problem. Dollars are being soaked up and replaced by Treasuries on bank books. Overnight repo rates have had occasional higher-than-normal spikes lately, including today, when the liquidity shortage temporarily became very acute due to timing issues. There's only so much debt that they can hold, and debt is growing faster than GDP.
The current rate of domestic institutions sucking up Treasuries is becoming unsustainable for them.
Most likely the Fed is going to have to restart quantitative easing, perhaps in 2020 or so, to prevent a more serious liquidity problem. The precise timing is anyone's guess. It could happen as early as the end of 2019, or maybe they can push it into 2021. The market is very focused on quarter-point or half-point rate cut questions but the bigger question in my view is when the Fed will be forced to restart quantitative easing due to domestic debt saturation.
But What About Japan?
Japan has a higher debt-to-GDP ratio than any other country, at well over 200%. This has pushed the boundaries for how much debt a country can seemingly have before it runs into problems, especially for countries that control their own currencies (unlike Greece, Italy, and so forth). When discussing the problem of growing U.S. debt as a percentage of GDP, people often point to Japan as an example of how far it can go.
However, Japan has a few key differences that make it able to sustain a higher debt load. First of all, their central bank is already monetizing their debt with indefinite quantitative easing.
The Bank of Japan's balance sheet is larger than the nation's GDP (compared to less than 20% of U.S. GDP for the Fed's balance sheet). If the BOJ wasn't doing that, their system would be running into similar liquidity problems because their domestic institutions would be unable to soak it all up.

One would assume that this huge level of quantitative easing should weaken the yen, but there are other factors helping to hold it up. In particular, Japan has current account surpluses in most years while the U.S. has a structural current account déficit:
Twin Deficits Data Source: Trading Economics
The Eurozone, despite its many problems, currently has small fiscal deficits and a positive current account. Japan has big fiscal deficits but a positive current account. All of the places that have negative-yielding debt have roughly balanced or positive current account surpluses, unlike the United States.
The United States and the United Kingdom are deep in the red in terms of both fiscal deficits and current accounts, and have the biggest twin deficits as a percentage of GDP among the G7.
Due to decades of current account deficits, the United States has a net international investment position in the ballpark of -50% of GDP:
US NIIP 2018 Chart Source: St. Louis Fed
Japan's net international investment position, in comparison, is positive and more than 60% of their GDP.
In addition, the U.S. dollar is already the second strongest currency in the world after Switzerland based on purchasing power parity according to the semi-useful and semi-comical Economist Big Mac Index:
Big Mac Index Chart Source: The Economist
Based on that index, the yen is already 38% undervalued compared to the U.S. dollar, or just 25% undervalued when adjusted for GDP per-capita differences.
Another way to visualize it is to look at nominal U.S. GDP as a percentage of world GDP in both nominal and purchasing power parity terms over the past three decades:
U.S. Share of World GDP Data Source: World Bank
The purchasing power figure as a percentage of GDP (orange line) is a representation of how much goods and services the U.S. produces as a percentage of the world's total goods and services. We've gradually dropped from 21% to 15% of the world's total over the past two decades because although we're growing, the rest of the world has been growing faster on average (due to certain emerging markets, rather than Japan or western Europe). The United States has less than 5% of the world's population, so 15% of world PPP GDP is still pretty good.
The nominal figure is how it translates into U.S. dollars, which means during periods where the dollar is strong against other currencies, the gap between our nominal GDP and PPP GDP widens. Right now, with 24% of the world's nominal GDP, we're in the middle of one of those periods of notable dollar strength, in part because there's a dollar liquidity shortage.
If the ratio of U.S. nominal GDP vs PPP GDP as a percentage of the world's total were to normalize to 2012 or 2013 figures, as an example, it would mean a dollar devaluation in the ballpark of 20% or more.
For the past few years, since early 2015 (after the final round of quantitative easing ended), the dollar has been on the strong side of its long-term declining trend:
Trade Weighted Dollar Chart Source: St. Louis Fed
If the Fed resumes monetizing debt like Europe and Japan are already doing, the U.S. has more room to devalue its currency. In addition to the dollar already being relatively strong at the moment, the Fed has positive interest rates and owns a smaller percentage of sovereign debt (under 20%) than either the ECB (about 35%) or BOJ (over 100%). The Fed has more ammo in a currency war, in other words. Unfortunately, all ammo in this war hurts the user as well.
It's an If/Else Problem
Investors often run into trouble when they try to time things perfectly, or think they can accurately predict exactly how things will play out.
I can't tell you exactly how this domestic deficit saturation problem will play out, but I see two outcomes that are high on the list of likely occurrences in my opinion. It's almost an if/else problem due to mathematical inevitability, but there's always a big degree of wiggle-room around the timing.
Outcome 1) The Fed does nothing for a while.
If there is no new round of quantitative easing in the coming year or two, we're likely to really start pushing the limits of how much U.S. debt domestic institutions can stuff onto their balance sheets, to the tune of about $1 trillion per year.
A number of Treasury auctions have already gone poorly this year. This chart from Bloomberg a couple months ago shows a snippet of the problema:
Bid to Cover
Chart Source: Bloomberg

Investors submitted bids for 2.39 times the $38 billion of three-year notes offered by the Treasury Department on Tuesday, the smallest so-called bid-to-cover ratio for that maturity in a decade. This is no anomaly. In May, the bid-to-cover ratio at a 10-year auction was also the lowest in a decade.
-Robert Burgess, Bloomberg
If bond auctions keep getting weaker, this could put upward pressure on long-term rates (TLT). It's a cyclical reality that during economic slowdowns, bond yields generally go down, but in this case the cyclical trend may be running up against a secular trend in the opposite direction.
Either way, this outcome would continue to tighten the dollar liquidity problem and could push dollar strength (UUP) higher for a time. This would hurt the competitiveness of U.S. exports, and put more and more strain on the U.S. financial system. Emerging markets (EEM), especially ones like Argentina (ARGT) that have a significant amount of dollar-denominated debt, would be further pressured. Places like Russia (RSX) and Thailand (THD) are more fortified against this due to positive current account balances and large foreign-exchange reserves.
Gold (GLD) might temporarily dip against the dollar in this tightening scenario, unless it causes enough problems worldwide that the fear/volatility trade pushes gold up. Hard to say.
We would likely see greater volatility, and more likely to the downside, in U.S. equities (SPY).
Cash and cash-equivalents would be a good form of defense for this outcome, but ultimately this outcome is unsustainable and ends with the Fed forced to be a buyer of last resort.
Outcome 2) Fed restarts quantitative easing.
If the Fed finds itself forced to step up and start buying bonds to relieve the liquidity shortage from domestic institutions, they could drive bond yields lower, at least for some time.
This might or might not give U.S. equities a temporary boost upward, depending on what else is going on. The dollar would likely weaken, which could relieve some pressure from emerging markets and boost foreign stocks in general in dollar terms. The asset class I'd most want to own under this outcome is precious metals. I'd also want to own gold stocks, with one of my favorites being Sandstorm Gold (SAND).
It seems mathematically inevitable that both outcomes lead to this one eventually, but it's a question of timing. Will the Fed jump in before the problem gets too messy, or will they wait until they are absolutely forced to? I don't know.

I'm holding a cash/gold barbell as a defensive slot in my globally-diversified multi-asset portfolio so that as the outcomes play out, I can rebalance towards areas of weakness as they come.
Either way, I suggest keeping an eye on government bond auctions and domestic liquidity during the remainder of this year and into the next. It's starting to get interesting.

Negative Rate Folly

By Trey Reik

The most troubling legacy of contemporary central banking has been the emergence of negative nominal interest rates. At the risk of self-impeachment, we at Sprott wish to state unequivocally that at least in the real world, negative interest rates are an absurd construct. The fact that they actually exist, especially to today’s sovereign tune of some $15.6 trillion, only highlights the dire nature of global financial imbalances.

Negative interest rates, more than any other manifestation of financial distortion, are proof positive that excessive debt levels are rendering global capital markets increasingly dysfunctional.

Superficially, gold’s zero yield now offers global capital stewards compelling mathematical premium over a burgeoning universe of negative-yielding investment grade (IG) bonds. Far more compelling, however, is gold’s unique immunity to both default and debasement, two forces poised to ravage traditional financial assets in future periods.

An Unabridged History of Negative Interest Rates

If negative interest rates represent the financial-market anathema we perceive, how did the global total of negative-yielding bonds ever get to this point? After all, 5,000 years of financial history never witnessed negative nominal interest rates (Figure 1) until the wake of the Global Financial Crisis (GFC).

Dating back to Mesopotamia in 3000BC and the Babylonian Code of Hammurabi in 1772 BC, customary annual interest rates approximated 20%. After three centuries of Roman stability lowered borrowing costs to the 4% level through 300AD, interest rates oscillated in the high single digits until the early 18th century. The world’s first brushes with the zero bound occurred during the Great Depression and World War II, but even during these black swan events the Fed never felt compelled to employ negative policy rates.

Figure 1. 5,000 Year History of Short-Term and Long-Term Interest Rates (3000 BC- 2017 AD)
Fig 1
Source: Bank of England; Global Financial Data; Homer & Sylla “A History of Interest Rates.” Note: The intervals on the x-axis change through time up to 1700. From 1700 onwards they are annual intervals.
Post GFC: Emergency Central Bank Experimentation
In the wake of the GFC, however, global central bankers chose to deploy all sorts of unprecedented monetary policies to forestall debt deflation and default. Specifically, in response to the severe GFC aftershocks known as the European debt crisis, a few European central banks experimented with negative policy rates as a pointed currency lever. During 2012, Denmark employed negative interest rates to deter capital inflows and support the Danish krone’s peg to the euro. Then, in 2015, the Swiss National Bank took similar action to mute relentless strength in the Swiss franc.

More generally, the European Central Bank (ECB) and the Bank of Japan (BOJ) adopted negative deposit rates for commercial bank reserves in a broad effort to forestall deflation, prompt lending and spark economic growth. In essence, the ECB and BOJ aimed to encourage commercial banks to accelerate their lending by charging them for deposits held at the central banks. From that point forward, especially in Europe and Japan, the negative-interest-rate cat was officially out of the bag.

Figure 2. Various Central Bank Deposit Rates (2012-Present)
Fig 2
Source: Financial Times; Refinitiv.

Of course, the downside of emergency central-bank experimentation is the time-tested truism that once unconventional measures are deployed, they can never be scaled back (without destabilizing impacts). Thus, the financial world is now left with the flat-line trend evident in the colorful depiction of central bank policy rates to the right of Figure 2.

In short, having entered the realm of negative policy rates, it will be extremely difficult for these central banks to return to positive rate structures until painful rationalization of global debt burdens is allowed to run its course. We have written ad nauseam that with global debt now measuring $246 trillion, or 320% of global GDP (Institute for International Finance Q1 2019 Global Debt Monitor 7/15/19), interest rate structures of all types can only decline (further) in future periods.

The Magic of Central Banks

Our point here is that promiscuous central bankers are entirely to blame for unleashing the contemporary capital-market mutation of negative nominal rates. Without revisiting gory details of the post-GFC official debate over negative rates, we would best summarize central-banker hubris during this unprecedented period in the inimitable words of Vitas Vasiliauskas (Lithuanian Central Bank Governor and ECB Governing Council Member), who observed on 5/11/16:

“Markets say the ECB is done, their box is empty. But we are magic people. Each time we take something and give to the markets — a rabbit out of the hat.”

Well there you have it: magic people pulling omnipotent monetary policy levers are not bound by the rules of nature, mathematics or finance. Of course, the rest is now history. From the genesis of central bank experimentation (to avoid long-overdue financial cleansing of economic recession) has sprung what Chirag Mirani, UBS Head of U.S. Rates Strategy, has aptly termed “a yield-suck vortex.”

In essence, if Eurozone commercial banks are forced to pay the ECB interest on reserve balances, while ECB QE removes 2.6 trillion euros of sovereign and corporate bonds from the marketplace, a race-to-the-bottom process of yield-starved musical chairs is the inevitable outcome.

Figure 3. Aggregate Total of Negative-Yielding Sovereign Debt vs. Gold (2015-9/5/19)
Fig 3
Source: MeridianMacro.

Given the synchronized pivot of global central banks back towards easing posture during 2019, it is not surprising that global IG debt has enjoyed a virtually insatiable bid in recent quarters.

We update in Figure 3, a graphic we have frequently referenced, the global total of negative-yielding sovereign bonds, which now stands at some $15.6 trillion (9/5/19).

Gold's Summer Rally

Without question, gold’s summer rally has been closely tied to the global explosion in negative-yielding bonds. Moving forward, however, we expect gold’s prospects to be less correlated to absolute changes in the sum total of negative-yielding paper (the only rational total is zero) than to growing investor concern over the corrosive impacts of negative rates on the global financial system.

Figure 4. Global Negative Yielding Debt by Country (%)
Fig 4
Source: Torsten Slok; Deutsche Bank; as of September 2019.

True to form, American investors remain largely unconcerned about the global surge in negative-yielding debt instruments. After all, as shown in Figure 4, negative interest rates are a phenomenon so far relegated largely to Japan and the Eurozone. Given the frenzied search for yield once again dominating global capital markets, however, reasonable queries are whether and when negative yields might reach the United States?

Well, as the global total of negative-yielding sovereign bonds has tripled from October 2018 lows, it is interesting to note that U.S. Treasury yields have collapsed in tight unison. The 10-year Treasury yield has fallen 55% from 3.234% on 10/5/18 to 1.458% on 9/3/19, while the 30-year yield has fallen 43% during the same span, to an all-time low of 1.953%.

As virtually every segment of the U.S. yield curve has inverted in recent months (for the first time since the GFC), overwhelming investor response has been to dismiss current inversions as less indicative of imminent U.S. recession than of dwindling positive-yielding alternatives.

Our emphatic response to this reasoning is, “Perhaps, but so what?” In our minds, global conditions isolating Treasuries as the world’s last resort for positive IG sovereign yield are far more foreboding for financial-asset valuations than rising probabilities for U.S. recession.

In a mid-August report (Figure 5), BofA Merrill Lynch estimated that U.S. investment grade yields now comprise a patently absurd 94% of the net global total of positive investment grade yield (including both sovereign and corporate paper). Global debt levels are suffocating global capital markets. Relevant implications are far more critical to current portfolio allocation than potential falloff in U.S. GDP.

Figure 5. U.S. Share of Global Investment Grade Fixed Income Yield has Reached 94%
Fig 5
Source: August 1997-August 2019; ICE Data Indices, LLC, BofA Merrill Lynch Global Research. Note: Based on index eligible debt in the GBMI index.
Negative Rates in the U.S.?
It is one thing for us to suggest that domestic debt burdens will exert downward pressure on Treasury yields every bit as relentless as that which has driven so many sovereign yields into negative territory.

It is quite another for legendary monetary stewards and high pedigree bond managers to agree with our reasoning. Along these lines we encourage readers to pay close attention in coming months to the public debate over the likelihood of negative interest rates “arriving” in the U.S.

Our observations in recent weeks have been a touch startling in this regard. On 8/13/19, Former Fed Chair Alan Greenspan raised eyebrows in stating:

“There is international arbitrage going on in the bond market that is helping drive long-term Treasury yields lower. There is no barrier for U.S. Treasury yields going below zero. Zero has no meaning, besides being a certain level.”
Conceding Mr. Greenspan’s capacity for dramatic latitude, it was sobering to hear similar thoughts from PIMCO Global Economic Advisor Joachim Fels (8/6/19):

“It is no longer absurd to think that the nominal yield on U.S. Treasury securities could go negative….If the Fed cuts rates all the way back down to zero and restarts quantitative easing, negative yields on U.S. Treasuries could swiftly change from theory to reality.”
Truth be told, we do not believe the Fed will ever deploy negative policy rates in the U.S., and we would expect any incursion into negative-yielding territory by Treasury securities (of any duration) to be short lived, as during late 2008 when Treasury bill yields briefly turned negative.

Given the overwhelming global dominance of U.S. capital markets, combined with the U.S. dollar’s ongoing prevalence as the world’s reserve currency, we do not believe the global financial system could withstand negative U.S. rate structures for even a brief period.

Additionally, negative U.S. rates would wreak unacceptable havoc on systemic financial platforms such as domestic pension funds, insurance companies and money markets.

It is one thing for Denmark’s third largest bank (Jyske Bank) to curry favor with growth-seeking ECB regulators by launching this past August the world’s first-ever negative-interest-rate 10-year mortgage (-0.5% annual interest rate—yes, Jyske is paying its customers interest to take mortgages), but negative-interest-rate mortgages are an innovation unlikely to gain much traction in the $10 trillion U.S. mortgage market.

The Best Time to Allocate to Gold?

With respect to timing individual portfolio allocations to gold, we tip our hat to legendary emerging market generalist Mark Mobius, who remarked in a 8/20/19 Bloomberg interview:

“Buy gold at any price. I’m talking about physical gold. If the idea goes mainstream and all investors go to a 10% gold allocation, the price will skyrocket. Investors need to move quickly to get ahead of the crowd.”

The ECB’s Beggar-thy-Trump Strategy

The European Central Bank's decision to cut interest rates still further and launch another round of quantitative easing raises serious concerns about its internal decision-making process. The ECB is pursuing an exchange-rate policy in all but name, thus putting Europe on a collision course with the Trump administration.

Hans-Werner Sinn

sinn88_Sean GallupGetty Images_mario draghi ecb

MUNICH – On September 12, the European Central Bank decided to launch yet another asset-purchase program, with plans to buy €20 billion ($22 billion) in new securities per month for an indefinite period of time, using the same structure as it has in the past. The decision was not made unanimously: the German, French, Dutch, Austrian, and Estonian members of the ECB council have all voiced fierce opposition to further quantitative easing (QE).

ECB President Mario Draghi claims that the majority in favor of further loosening was so large that it was unnecessary even to count the votes. Never mind that the countries opposing the decision hold 56% of the ECB’s paid-in equity capital and account for 60% of eurozone output.

Counting their compatriots on the ECB Governing Council, however, they have only seven out of 25 potential votes (subject to a rotating limitation). Draghi did have a majority, then, but it represented a very clear minority of the ECB’s liable capital. This raises considerable concerns about the Governing Council’s decision-making process.

Such concerns are all the more justified considering that US President Donald Trump has been complaining loudly about the implied exchange-rate policy stemming from ECB asset purchases. He has a point. Draghi, of course, insists that the ECB does not “target” the exchange rate. While that may be true, it is beside the point. By purchasing long-term securities, eurozone central banks will once again trigger a currency devaluation. Indeed, it is precisely this effect that likely plays the dominant role in stimulating economic activity.

The problem, of course, is that by stimulating exports and curbing imports, the policy comes at the expense of other countries. Worse, other stimulus effects of interest-rate reductions are rather limited, particularly with respect to investment. There is even reason to fear – as Deutsche Bank CEO Christian Sewing does – that the ECB’s ongoing rate reductions had a detrimental effect on the banking system, thereby putting the credit supply at risk.

The economic mechanism by which the ECB achieves devaluation was explained decades ago by the so-called asset approach. If European central banks purchase European securities with freshly printed money, they distort the international portfolio equilibrium with regard to domestic and foreign currencies and interest-bearing assets, and a currency devaluation is needed to rebalance it.

Some of the sellers will offer euros on the currency markets, in order to purchase non-European securities. And that will put downward pressure on the euro exchange rate. Foreign sellers will trade in their own assets for European securities only when the euro exchange rate is lower. The new international portfolio equilibrium ushered in by the ECB is accompanied by euro depreciation.

During the ECB’s first round of QE, the portfolio shifts were clearly noticeable among sellers of government bonds, as the ECB itself has documented. Those sellers mainly used the proceeds to purchase US Treasury bonds, because they wanted to stay within the same asset class. US sellers, on the other hand, used the euros they received to purchase European corporate assets, which had become cheaper, owing to the fall in the euro exchange rate.

In the context of the ECB’s first large asset-purchase program, the euro’s exchange rate fell by around a quarter against the dollar between mid-2014 and January 2015, when the program was formally launched, because traders generally assumed that the program would happen and acted accordingly. Italian banks, in particular, got a head start in buying up European securities worldwide, by tapping (disproportionately) into funds from the targeted longer-term financing operations (TLTRO) program that the ECB had launched in June 2014.

The ECB vehemently denies that it pursues an exchange-rate policy, because it knows that doing so falls well outside its mandate. But there is simply no denying that its policy comes at the expense of Europe’s trading partners. The situation is eerily reminiscent of the competitive devaluations of the 1930s.

When the US Federal Reserve, following in the footsteps of the Bank of Japan, pursued a similar policy some years ago, then-Fed Chair Ben Bernanke openly acknowledged the exchange-rate effects of QE, although he said that it was not quite clear how they came about. When the Europeans later followed suit with their own QE program, they were, in a manner of speaking, taking their allotted swig from the bottle.

The Trump administration knows all of this, as does everybody else. But Trump has warned Europe repeatedly not to get greedy. To avoid becoming the “beggared” neighbor, he continues to hold out the threat of trade sanctions.

Europe therefore has a choice. It can continue to allow the ECB Governing Council to pursue its own (implicit) exchange-rate policy, or it can decide that the looming trade conflict with America belongs in the hands of democratically controlled institutions. The central banks are out of their league on this one.

Hans-Werner Sinn, Professor of Economics at the University of Munich, was President of the Ifo Institute for Economic Research and serves on the German economy ministry’s Advisory Council. He is the author, most recently, of The Euro Trap: On Bursting Bubbles, Budgets, and Beliefs.