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Exploiting Insanity – Part II

In the first article of this series (in the Safehaven archive) I described the starting point of a development that will ultimately lead to hyperinflation in many parts of this world. This second article revolves around the Negative Interest Rate World.

Many observers and analysts struggle with this concept and hope that it is a temporary and short lived phenomenon. Bond King Bill Gross, the sage of the bond market, advises investors to reduce risk and to accept lower than historical returns. He states in his August 2016 investment outlook for Janus Capital: "I don't like bonds, I don't like most stocks; I don't like private equity. Real assets such as land, gold, and tangible plant and equipment at a discount are favored asset categories." Comments on his recommendations indicated to me that his message is difficult to understand for an audience that does not follow his work studiously. There is an article that Bill wrote in February 2013 when he was still at PIMCO. It is called CREDIT SUPERNOVA. It is a superb and prophetic analysis of the state of global financial markets. It should be read alongside his August 2016 outlook to understand the thinking behind Bill's recommendations. He describes and forecasts in great detail how the exorbitant expansion of credit ultimately fuels inflation and threatens capital and savings. I concur with his findings and my observations are similar. For investors timing is crucial and I want to sketch a timeline for the future. Economic developments can be divided into different stages and the question is what are the stages and how long do they last?

We have now arrived in the stage of the Negative Interest Rate World and try to find our way around. This world is unknown to us and feels very strange. Like in the times of Christopher Columbus, many sailors fear that sea monsters may assault them and that their ship will ultimately fall into the abyss because the world is flat. I may very well be the reckless adventurer, boarding a rotten old Caravel, setting sail never to be seen again. Presumably eaten alive by a gigantic squid or something equally dreadful.

The amount of bonds with negative interest rates is rising steadily. At this point in time more than 10 trillions of sovereign bonds have negative yields. This is the result of the creation of the equivalent of USD180 billion of new money every month by the Bank of Japan (BOJ) and the European Central Bank (ECB). This money flows into the financial markets and relentlessly drives down bond yields. Money creation by the Swiss Central Bank and from now on by the Bank of England (BOE) reinforces this trend. The present, official stance of the boards of Federal Reserve Bank and the BOE is that they are sceptical about the usefulness of negative interest rates as a policy tool. The Federal Reserve maintains that they will raise interest rates in a gradual pace, depending on the state of the US economy and global developments. Unfortunately the business cycle is working against them. Most economic indicators show that we are now in the last innings of the current economic expansion. GDP growth in the US has trickled down to 1 per cent in the first half of this year and factory orders have been falling on a year on year basis for 20 months in a row. Almost half of all US households live pay cheque to pay cheque and more than 22 million US households receive food stamps to protect them against starvation. The confidence of US firms in the future is so low that the general measure for business investing, Durable Goods Orders, has been decidedly negative for most of the past 20 months. Corporate profitability keeps on falling; S&P earnings have been sinking for almost two years now. The payroll numbers are touted as proof of a strong economy. If the expansion of labour in serf like conditions together with seasonal adjustments were proof of a thriving economy, the Dark Ages would have been the all time pinnacle of economic success.

Global growth is slowing too. Even the IMF, famous for its overoptimistic growth forecasts, had to downgrade its world GDP growth expectations to 3.4 per cent for 2016. It needs to be stressed that this forecast includes wildly overstated growth figures of 6.7 per cent for the Chinese economy for the first half of this year. A study of the PMI figures suggests that it is in recession or very close to one.

Is this a reason for concern? US financial markets seem to think not. The S&P Index has just climbed to a new all time high. Treasury bond prices are close to a record high and the property market is up year on year. The VIX volatility index, a gage for investor fear is close to record low levels. There are good reasons for this. Investors have learnt that central banks are backstopping the markets. Not via explicit policy but implicitly by their actions. The Federal Reserve Bank has not only tried anxiously to avoid anything that could disrupt US markets. Whenever the market flagged, a mysterious buyer, mainly of futures contracts, gave it a lift. But foreigners are active too. The Swiss National Bank has identified itself as a major investor in the US stock market. At the end of the second quarter of this year its holdings of US stocks rose to a record of USD 62bn. In Japan the BOJ is the biggest investor in the bond and equity market and in the US it is the biggest foreign investor in the stock market. In Europe, the ECB vigorously supports stock markets with its sovereign and corporate bond purchases.

US and European financial markets appear to be safer than ever for investors due to the limitless support of central banks. In a fiat money world there is no limit to the amount of money central banks can create. Unlike in Weimar Germany trillions can be created within seconds as most of today's money is just a number on a computer. Central bank firepower has never been greater. All doom sayers, announcing Armageddon for the financial world, have so far been proven disastrously wrong. Central banks have followed a consistent policy of steadfastly supporting financial markets. They know that there would be serious economic and political repercussions if they were to be seen to plunge the world into another Great Depression. There is even room for a valid legal case to force central banks to stay on course. If an institution follows a certain policy whether explicitly or implicitly for a period of time a legal claim can arise for the beneficiaries of this policy. A very common case is labour law where i.e. a firm pays its employees a 13th monthly salary without a legal obligation. If it maintains this practice for a number of years, employees gain a legal claim to keep on receiving this benefit in the future. The same could be argued for companies  (i.e. a bank) and other entities that are dependent in their existence on central bank policy. Let us assume that the Federal Reserve Bank would bankrupt the US financial industry, the US government, the world financial industry and foreign governments because of a policy error. Politically and legally it would be billions against twelve members of the Federal Open Market Committee. Who would win this battle?

On 2 August the Japanese broker Nomura forecast that the yield for the US 30year Treasury bond could go to zero as 900 trillion yen (8.9 trillion USD) tied up in Japanese bonds with negative yields are looking for a new home in the US. European investors may be hot on their heels as they too experience negative interest rates. The Federal Reserve will be powerless to stop this arbitrage without the introduction of capital controls. The inclusion of the US into the realm of negative interest rates appears to be inevitable. It is an upside down world. Bonds are being bought for capital appreciation and equities to generate an income.

This creates a new thinking and radically changes companies business plans. Before the Great War a citizen of repute did not have any permanent debt. After World War One hire purchase contacts became popular and little by little a debt culture developed. Today, most people do not know what life without debt is, they are debtaholics. Their big time has come because debt is starting to generate an income thanks to negative interest rates.

Zero or negative interest rates allow almost every company to be profitable regardless of its debt situation. Just take on debt if you need an additional income stream. It also lowers the break even level and makes previously unprofitable projects profitable. Massive over production and over investment are one result, the case of the US shale oil industry comes to mind. Over production and over investment  leads to increased competition and depresses prices. In that respect central bank policy has been a failure. Lowering interest rates and introducing Quantitative Easing has not brought them closer to their inflation targets. Quite the reverse; It has unleashed powerful deflationary forces. Even the weakest companies can survive as losses transform into profits, if they are financed by additional debt at negative interest rates. The Negative Interest Rate World will beget a new company type; the debt accumulator. Its main purpose will be to borrow money. The proceeds from the loan are hoarded or invested in gold. The negative interest rate is booked as revenue and profit of the company. Almost unlimited amounts of debt can be amassed if lending standards are sufficiently lax. Governments will be jubilant. Debt becomes an asset and social security liabilities something to relish. Taxes could be reduced even further and benefit payments can be increased. Some countries may even introduce a minimum income sponsored by the welfare office. Governments and large corporations will want to make the most of this new situation. Treasury or investment grade corporate debt at 3 per cent will become a thing of the past. The new normal will be a perpetual bond with 1 basis point of interest.

Banks, insurance companies and other financial institutions have been suffering for a while in the Zero/Negative Interest Rate World. It reduces their profit margins and endangers their survival. Insurance companies with a sizeable annuity business are threatened by bankruptcy. Currently European banks are in the headlines because of increasing worries about their solvency. According to a recently published stress test based on the US methodology, the 51 systemically most important banks in the European Union (EU) have a combined capital deficit of 123bn Euros. Deutsche Bank, Germany's biggest bank, appears to be in a tough spot with a deficit of 19bn, more than its market value of 17bn (Zero Hedge, 10 August). Governments are restricted in their capacity to recapitalise banks by EU laws and their own horrendous indebtedness. This may prompt the ECB to expand its money creation operations and to march forcefully into the territory of negative interest rates to restore the financial health of governments, banks, insurance companies, pension funds and other entities via the printing press. How far into negative territory can negative interest rates go? This will be determined by the perceived size of the insolvency problem. The deceptive nature of public and private accounting methods suggests that we only see the tip of the iceberg. Most governments have not accounted for entitlements. They produce a fiscal gap, an ever widening chasm between tax receipts and expenditure for state liabilities like social security payments, health care and Medicare payments, Medicaid payments, and defence programs. In the United States it is more than 200 trillion USD. The US fiscal gap rises by many trillions each year. This issue is almost completely ignored by the media and the financial markets. 17 Nobel Laureates in Economics are backing the introduction of the "Inform Act" to force the government to account for this debt. So far they have been blocked by politicians.

What does it mean for individuals if fiat money generates negative returns? That it has lost its role as a store of value and as a useful means for savings. One might even say that it highlights fiat money as a toxic asset that holders will endeavour to dispose of as soon as possible. Negative interest rates are reinforcing an existing trend. Since the year 1900 all major currencies with the exception of the Swiss Franc have lost 99 per cent of their value if measured against gold. This is a creeping process and therefore not much noticed by the public. Gresham's law kicks in. It states that "bad money drives out good". If a new coin ("bad money") is issued with a lesser amount of precious metal than an older coin ("good money") with the same face value, then the new coin will be used in circulation (and spent as quickly as possible) whilst the old coin is retained and taken out of circulation. In our context it means that fiat money drives out gold.

The Negative Interest Rate World was created by central bank policy. In their exuberance, central bankers in the  European Union, Japan and the US have taken on the roles of masters of the economic universe, pretending to be able to solve our nation's structural problems. In previous times, this was done by governments. For a good reason. Only governments have the appropriate tools, i.e. legislative powers. The policy of negative interest rates is a logical expansion of central bank decisions after the Great Financial Crisis of 2008 to bail out and subsidise debtors at the expense of savers and the value of the currency. Unfortunately their policy has backfired badly. Today the indebtedness of governments, corporations and individuals is worse than before and growing far faster than the economy. It has also lead to a most amazing asset bubble in bonds and equities. At this stage there are only bad choices left. Pricking the bubble risks a global depression. Feeding the bubble will only delay the final explosion and make it far worse. In December last year the Federal Reserve Bank had its finger on the trigger. They hiked and planned four more interest rate hikes for 2016. Now it looks as if there will be none. I conclude that this means that they have decided to feed the bubble.

The lack of an exit strategy has serious consequences for all of us. The longer the zero or negative interest rate regime persists, the more individuals, companies, governments and economies will adapt to this environment. Savings and capital formation will diminish. Being over-indebted is the new normal. For many individuals, companies and governments, a point of no return will be reached where the repayment or a mere servicing of the debt will not be possible in a positive interest rate environment. On 10 August Bloomberg published an article titled: "Soaring Debt Has U.S. Companies as Vulnerable to Default as 2008". Ouote: "Corporate leverage in the U.S., excluding financial firms, is at the highest level in 10 years, driven by a combination of low interest rates and slowing profits, S&P analysts Jacob Crooks and David Tesher wrote."

A reversal to the old normal would cause an enormous upheaval in the world economy, with large scale bankruptcies and mass unemployment.

How long can the Negative Interest World last? Until the public understands that fiat money represents a wicked scam at their expense. Awareness is rising slowly and it steadily erodes central bank power. The renaissance of gold as an investment for the global elites is a result of this development. Unfortunately most people are still unaware of the magnitude of the problems we are talking about. They do not even understand what money is. In all likelihood this subject will not become relevant in the next 6 months. I will deal with this later in this series.


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