The Peculiar Thing about Currencies and Bonds

As every day passes by our central banks and currency czars head further and further into uncharted territory. What is going on now could not have been predicted, and the resulting behavior cannot be anticipated. Worse, there are no lights at the end of the tunnel, just ever growing darkness.
This weekends newspaper headlines highlight the nightmarish situation:

Japan’s nightmare roots are well known, starting with record breaking public sector debt, which continues defy logic but has yet to become an active challenge. This makes Japan different to other sovereign states but the other roots are common across other nations as follows.

The Bank of Japan (BoJ), like many other central banks, has a never-seen-before burgeoning balance sheet as a result of Quantitative Easing (QE), a process whereby central banks purchase debt and therefore drop billions of dollars (or local currency) from the sky. This policy helps lower interest rates and thus, so the theory goes, encourages private sector investment and so economic growth (e.g. GDP). This has not happened. The ghoulish result is that:

  • Firms did not increase capital spending 
  • But instead took out low cost bonds to fund massive and ongoing share buy-backs and unproductive or natural-cycle meters and acquisitions.

The result is that the investor class has gotten richer and inequality has gotten worse. As the data published by central statistical agencies around the world report the depressing news, corrosion in trust by the public in the political system increase now to the point where national elections are being fought more on distrust with government than with positive policy comparison.

QE encourages the exchange markets to disinvest in the local currency, thus lowering the exchange rate. This should then, so the theory goes, encourage exports. However this has not happened either. The monstrous condition now is that other large, mature, trading nations are in the same boat and all are engaged in the same QE effort. So all markets are flooded with cash, and the trillions of dollars that slosh around in the currency exchange have no clear direction where to call home. In fact, as one nation lowers its rates, in the hope encouraging some increased exports, other nations have reacted with additional QE this neutralizing any advantage sought. The result is a rush-to-the-bottom where we continuously lower rates without any resulting benefits. And bottom we are approaching with zero, even negative rates. At some point banks will have to pas such rates onto households.

As the article about Japan reports, the BoJ must be considering new action at some point, but political considerations will likely figure strongly due to the pending US election. More crucially when everyone is in the same sinking boat, one would think that coordination, nay, collaboration might be the order of the day. And when I mean collaboration, I am thinking along the lines of Bretton Woods or Plaza Accord. We cannot get out of these woods, or prevent the boat from taking on more water, with the current beggar-thy-neighbor approach. 

The other side of this nightmare is just as confounding.  

German yields, the return for holding a bond of government debt over a long period of time, is approaching zero. It could well go negative very soon. Japanese yields went negative earlier this year and US yields are very close to zero too. If you take into account (meager) inflation, real US yields are already negative.

Note that the Federal Reserve holds about 20% of outstanding government bonds (i.e. debt); the Bank of England holds about 26% of the U.K. Government gilts (i.e. debt); and the Bank of Japan holds about 30% of their government debt, as of March. The ECB holds about 10% of outstanding German government debt. So the market is hugely distorted, and private buyers are crowded out. 

But the complication does not stop there. In the interests of QE, the ECB is now expanding beyond government debt into corporate bonds, which crowds out even more the private sector. This changes the dynamics for how forms seek long term capital investment. Investors (see WSJ ECB’s Debt Purchases Cause Concern) are now worried that should private bind holders sell any amount of debt, the price will swing violently due to the loss of liquidity as a result from central banks owning large swathes of the market and not being active in it.

The perverse logic of negative rates means that there is no incentive for investing in the debt. More staggeringly we are slowly learning that we can only just guarantee the return of the capital ‘stored’ in those bonds. And the assumption is that the cash when returned the will be worth less than it is now. But as demand increases for this unproductive asset we have to assume that this is the best of a bad bunch of investment options. What does that say about our confidence in waking up and getting out of this situation?

But do our economic and financial leaders work together to find a global solution? No they do not. They seem happy to assume our problems are not at a global level but can be handled one decision, one policy, one central bank at a time. They have signally failed to solve this problem alone and in tandem. They need to work in parallel and that requires real collaboration, the kind not seen since Bretton Woods and the Plaza Accord.  I have been talking about this need for global collaboration for some time – see my last missive, Preserving our Future Wealth for Future Generations, and my earliest from 2015 Open Letter to Christine Laguarde, head of IMF.

This is an inside down financial world and there are literally no signs of getting out of it. The one hope, the one glimmer of an way out, is if inflation does take root. That once enemy incarnate is now needed to save our economy before our leaders ruin it. They show now signs of taking a global leadership role. So we pin our hopes on inflation. And by the way, if inflation ever did take hold, that won’t be pretty either. Remember the central bank’s balance sheet and amount of QE ‘out there’ in the market? That would have to be sucked out pronto and yields would alike immediately and rates would raise dramatically. We are set for a nightmare that will just go on, and go on.

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