• 2 hours Toyota Tests Solar-Powered Prius
  • 20 hours Why The Gold Rally Flatlined
  • 1 day The Uranium Sector Can’t Catch A Break
  • 2 days Upcoming Fed Meeting Has Investors On Edge
  • 2 days Global Gold Sector Outlines Responsible Mining Principles
  • 3 days China’s Giant Vampire Fund Loses $120B
  • 3 days McDonalds To Roll Out Robot Drive-Thru Clerks
  • 3 days Savvy Investors Are Betting Big On This Little Data Company
  • 4 days How The Government Is Wasting Tax Money This Year
  • 4 days Supply Concerns Halt Expansion On Tianqi Lithium Plant
  • 4 days The World’s Biggest IPO Is Almost Here
  • 5 days The Relatively Of Money And Happiness
  • 5 days Wall Street Unfazed By Recession Fears
  • 5 days SoftBank Urges WeWork To Pause IPO Plans
  • 6 days Anti-Aging Market To Hit $55 Billion
  • 6 days JPM, Morgan Stanley Take Advisory Roles In Aramco IPO
  • 6 days Are Bonds In A Bubble?
  • 7 days The Unknown Media Giant Taking The World By Storm
  • 7 days From Millennial To Millionaire With One Simple Trick
  • 8 days The 5 Most Expensive Art Pieces Ever Sold
Billionaires Are Pushing Art To New Limits

Billionaires Are Pushing Art To New Limits

Welcome to Art Basel: The…

Zombie Foreclosures On The Rise In The U.S.

Zombie Foreclosures On The Rise In The U.S.

During the quarter there were…

The Problem With Modern Monetary Theory

The Problem With Modern Monetary Theory

Modern monetary theory has been…

  1. Home
  2. Markets
  3. Other

Low Rates and Deflation

Over the last few days Central bankers have been making statements to firm the dollar. There are also signs that they are taking less visible, coordinated action. While this action may provide short-term stability - by providing supply-side stimulus to inflate financial assets - in total these actions are actually deflationary.

The move to reduce the supply of guaranteed long-dated debt, which began with the withdrawal of 30-year notes, means that any debt retired must be replaced with debt at the shorter end of the yield curve. Of course, this action reduces the government's cost of capital, at least in today's environment. But in our view, this move also was made to encourage the issuance of mortgage-backed securities. Regardless of the reason, this shortening process is ongoing and it represents a major deflationary exposure in a way that investors may not have noticed.

Long bonds and Treasury finance
Long end paper has many uses. For investors, it provides a steady and predictable income stream against money borrowed in the marketplace. Additionally it provides arbitrage profits, which have become the most important aspect of our service-based economy. Every manufacturer has become a financier that borrows and re-lends money against guaranteed notes.

Lowering rates towards zero destroys this "new era" profit equation. With less capital available for arbitrage, there are less financial profits, and less money available for traditional capital expansion. Meanwhile, savers experience a negative return. These forces cause economic contraction and reduce systemic liquidity.

Again, the best profit potential for corporations was to buy the best yielding securities and lend money at a higher rate, without much concern for matching terms. If short rates rise (in response to commodity price inflation), profits on mis-matched arbitrage plays will decrease. If long dated paper becomes increasingly scarce, it becomes much more difficult to structure profitable arbitrage plays to write new business.

In other words, deflation can come from either direction.

Domestically, if rate spreads and durations were to become less assured, arbitrage profits would become arbitrage losses and credit would become unavailable (Who wants to lend to a hedge fund blowing up?). Certainly this scenario would test the effectiveness of the derivative system, and could pose a considerable risk to the economy.

From the second direction, as long-term paper becomes less available, either the spread from arbitrage profits on new business narrows (possibly to the degree that corporate earnings are affected, thus endangering the stock market), or the Fed forces rates into a declining spiral as they desperately try to preserve the interest rate differential. Obviously, a stock market collapse based on declining profits would be deflationary. (A corrective strategy would be to mandate that all loans become adjustable!)

We conclude that the government's reticence to raise rates, in policy statements, and through the coordinated international purchase of US notes as evidenced in today's TIC report, is actually deflationary.

Savers know that the real rate of return in bank and money market funds resides at or near zero. Banks, brokers, and mutual funds are capturing all the interest rate profits, as the consumer has to absorb more risk as to avoid negative return. Guess which party will capture the losses should rates continue to decline or should the market adjust because risk outweighs potential return.

The Treasury's bidding up of the price of the long note may sound counter-productive until you compare today's budget situation with a heavily indebted individual who feels compelled to lower monthly payments or face default. Every dollar removed from the system at higher rates will be replaced with lower cost paper.

But these interest rates moves adversely affect the financial assets and liabilities of corporations using the easy money arbitrage play. That's because the profit incentive caused time horizons to become dangerously mis-matched. (See balance sheets of mortgage lenders for example.)

From a national perspective, since the short rates are dictated through the FED, the shortest paper extends the ability to service debt. Imagine refinancing your house with a monthly adjustable rate mortgage when you reserve the right to set the short-term rate. That's one deal you won't see on a pop-up ad while surfing the Internet.

Deflation with a difference
The current situation differs from 1929 because of increased per-capita demand for core "necessity" commodities such as energy, and food. The rising CRB reflects cumulative demand for a marginal improvement in the quality of life in China and India.

Seventeen cents for 200ml of Cola-cola in India represents a great per-capita marginal improvement in quality of life. Here in the United States the average container has 591ml and costs $1.25. In a global world with free trade purchasing power will become more equal. Labor deflation represents the other side of this dynamic. The value of labor internationally goes down and at the same time it appears that the cost of necessities goes up.

Through this action, External International Inflation can be found in Commodities relative to the dollar. On an individual basis, small improvements in quality of life for billions of people are placing demand on the currency of commodities. Here at home, inflation also occurs in captive sectors such as insurance and taxation.

A DECLINING INTEREST RATE ENVIRONMENT COUPLED WITH THE INFLATIONARY DYNAMIC AT WORK IN COMMODITIES, RESULTS IN NET SAVINGS PROVIDING A NEGATIVE REAL RATE RETURN.

Demand for immediate return has been the major factor inflating the value of domestic assets. Investors have focused on companies with hot stories or those that profit through interest rate differentials. Investment in commodity sectors requires more commitment and a longer time horizon. It's more difficult to make money-developing commodities than finding an income stream through the differential of interest rates. This poor allocation of capital has the potential to severely drain liquidity.

Most people forget that China remains a partial command economy. In the future it will function through central planning and in partnership with India (Technology) and Russia (Commodities) to an agenda that excludes US input and participation. Rhetorically, investors must ask, "What value can the Untied States provide to the world?"

Yes, the government's debt becomes more serviceable as rates move lower. However, every short-term piece of paper printed makes it more a difficult policy questions of when to raise interest rates. Thus, interest rate policy locks itself into an environment of zero percent return (and chronic negative real return) until liquidity becomes unavailable.

Currently, an inflationary bias is also reflected in the weakening dollar and rising gold prices. But it is the long term interest rate that provides clues as to whether or not we will experience a deflationary depression, stagflation (deflation-inflation), or hyperinflation.

A deflationary depression would be the worst scenario possible.

Back to homepage

Leave a comment

Leave a comment