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Dollars & Nonsense – Part 2

By David Robertson | August 9, 2019

Investing is hard enough that there isn’t much room for unforced errors, yet many investors allow themselves to get distracted and miss important things. For long-term investors this mistake often manifests itself by getting caught up in day-to-day news stories and losing perspective on key structural factors.

One such key factor is the global monetary system. Part 1 of “Dollars and nonsense” provided the basics of how the system works and what has changed. Part 2 takes those ideas further to show how understanding the monetary system is essential for successfully navigating the current investment landscape.

One of the striking features of the economy since the Global Financial Crisis (GFC) is the tendency to have a near-death experience every two or three years. Then, just as soon as things get serious, troubles quickly recede as if a magic wand had been waved over them. Indeed, the one lesson that has been learned best is to look past “risks” in the markets and to “buy the dip” (BTD).

This zeitgeist was captured perfectly in the Financial Times in relation to Brexit, but it is widely applicable:

The bounceback plus the monetary response have combined to create a Pavlovian response to risk. If there is a shock, central banks will step in; if there is a dip, momentum buyers will emerge. Put the two together and risk is priced out before it can be priced in.

There actually has been a magic wand of sorts and it has come in the form of monetary policy. Asset purchases by major central banks are especially powerful in boosting liquidity because they create base money from which even more money may be created through bank lending and other activities. 

As a result, asset purchases have a multiplier effect and can therefore be powerful tools for avoiding existential market risks due to lack of liquidity. They can also be useful in “buying time” to allow underlying conditions to improve. Indeed, this has happened several times since the GFC.

While these policies can produce short-term benefits that appear “magical”, as with most things in life, they come with longer term consequences. After ten years of such policies, the consequences are becoming increasingly visible. 

Foremost among these is the harm caused to the banking system by persistently low rates. Banks make money on the spread between funds (deposits) and loans. When rates drop below zero, it creates real stress for banks as noted in the FT:

But in the long term, negative rates are unambiguously problematic for lending. Retail deposits are fixed at zero and cannot be moved lower; the public, understandably, will not accept it. Cutting rates below zero puts banks’ profit and loss statements in a vice. No amount of hedging can offset the grip of a large chunk of funding stuck at zero and the ECB deposit rate being pushed further into the abyss. As time goes by, the vice tightens.

Evidence of the “vice tightening” is becoming increasingly apparent in Europe and Japan where rates have been held lower for longer. The Economist describes: 

People with very different ideas about the role of central banks and the fundamental drivers of the economy can nevertheless agree that, in the long term, low rates produce financial instability.

Given such dire consequences of radical monetary policy, it is curious why central bankers seem so inclined to take the risk. While there are certainly many reasons, some history provides useful perspective.

Across much of the world after World War II, there was very strong economic growth as soldiers returned home, factories converted to making consumer goods, and consumer demand took off. By the late 1960s, however, things were slowing down. This happened “just as governments had promised their citizens a substantial share of the high anticipated future growth,” as Raghuram Rajan notes in his book, The Third Pillar. He explains:

These countries also made two important sets of commitments that will continue to reverberate into the future. They made substantial promises of social security to their populations. Many also expanded immigration, and over time, emphasized their respect for civil rights of both their minority and immigrant populations. These were commitments made by prosperous confident societies based on projections of continuing strong growth.

As it turned out, the significant incremental entitlements such as Medicare amounted to bad promises. They were made in the context of a postwar landscape that was characterized by a great deal of public trust in the Allied governments that had won the war. As such, those governments were also given a great deal of latitude in regulating economies and markets.

It quickly became evident, however, that such promises could not be honored unless the historically higher levels of growth could be restored. Confronted with such challenges, sentiment shifted in favor of market forces over state forces (Rajan’s work focuses on the dynamic relationship among the competing forces of markets, state, and community). 

The combination of high entitlement costs, structurally slowing growth, and increasing acceptance of risky market forces helps explain much of what has happened economically and politically in the last fifty years. Many policy developments since then can be explained in the context of trying to compensate for overly generous entitlements by engaging in risky or unproven strategies to boost growth.

It was from this environment that much of the shadow banking and eurodollar systems evolved. According to a Federal Reserve Bank of New York report on “Shadow banking“, the new system revolves around the activities of securitization and wholesale funding with the process of credit intermediation being “performed through a daisy-chain of non-bank financial intermediaries in a multi step process”. As a result of these developments:

“The nature of banking has changed from a credit-risk intensive, deposit-funded, spread-based process, to a less credit-risk intensive, but more market-risk intensive, wholesale funded, fee-based process.” 

This expansion and evolution of the monetary system brought important changes. As the FRB report describes, the flow of credit was no longer dependent on banks only, “but on a process that spanned a network of banks, broker-dealers, asset managers and shadow banks—all under the umbrella of FHCs [Financial holding companies] …” An important consequence of this development was that money supply expanded beyond the traditional definitions such as “M2” to also include non-traditional shadow money.

Further, as non-bank financial companies have become progressively more important in the provision of liquidity, their balance sheets have become progressively more important as risk factors. If their balance sheets shrink, then liquidity goes down. Alhambra Partners describes how the process unfolds:

Compressing and negative swap spreads: balance sheet capacity at a premium; US banks cut back on US$ activities outside the US; foreigners buy less and even outright sell their US$ holdings; and US$ money markets exhibit terrible breakdowns of hierarchy. Classic tight money symptoms, only officials cannot define nor locate the money which might be tight.

As a result, central bankers have exceptionally little capacity to manage liquidity in these cases.

Another phenomenon that arose out of the shifting political winds in the 1970s and 1980s was an increase in global trade. Indeed, increased trade was an explicit goal in the formation of the European Union with the ultimate objective of also boosting growth. That trade needed to be financed, however, and the shadow banking and eurodollar systems emerged to meet those needs.

As Gillian Tett describes in the FT, “Companies need hefty amounts of working capital to run their supply chains, and about two-thirds of this typically comes from their own resources, with the other third coming from bank and non-bank finance.” The important lesson is that if you want to understand the global economy, you had better study “financial channels in tandem with ‘real’ economic trends.”

One need look no further than the GFC to see a link between financial channels and economic trends. Tett observes, “Research suggests that the pre-2007 credit bubble not only created a house price boom, but also helped create a trade and GVC [global value chain] bubble too.” 

Further, financial channels are driven by the US dollar as Martin Wolf points out in the FT, “One traditional issue is the reliance on the US dollar in the global monetary system.” When dollars are easily available bubbles form, but when dollar liquidity dries up so too does associated economic activity. Wolf forecasts a continuation of negative trends: “A depressingly familiar issue is the future of the trading system. Global liberalisation has halted.” 

Another related “feature” of monetary system has been the demand it has created for US Treasuries. Russell Napier describes in the FT:

“The roughly $10tn rise in world foreign exchange reserves between 1999 and 2014 resulted in the forced purchasing of US Treasuries. Foreign central bankers owned 13 per cent of the Treasury market in 1995, but held a third of it by 2014.”

This wave of buying had the effect of depressing rates. As Napier describes, “This monetary system thus provided a funding holiday for global savers, freeing them to focus on funding the private sector instead.”

“What could be better for global investors than a monetary system that depressed the global risk-free rate while boosting growth through an explosive rise in the money supply of emerging markets, particularly China?”

Conversely, what could be worse for global investors than a monetary system that inflates the global risk-free rate while choking liquidity in emerging markets? As Napier describes, this scenario is unfolding:

“Since then [2014], as foreign exchange reserves have stopped climbing, funding the US government has fallen to savers, not central bankers. Foreign central bank ownership of US Treasuries has fallen from a third five years ago to just under a quarter today. Savers must take up the funding slack, while also buying Treasuries being sold by the Federal Reserve. This structural shift in demand for Treasuries comes as supply is boosted by the Trump administration’s fiscal policy. Savers now have to fund the US government, and to do so they have to either sell other assets or save more.” These dynamics have “negative implications for economic growth.”

Putting all of this together creates a very different impression of today’s investment dynamics. Much of what has happened in terms of monetary and fiscal policy the last fifty years has ultimately been an effort to cope with unaffordable entitlements granted at the end of a long run of economic prosperity. With that understanding, it is easier to see the rapid increase in debt levels and the philosophical preference for market forces (despite higher risks) more as desperate attempts to forestall the inevitable reckoning than as well-reasoned policy.

In this context, the expanded and increasingly market-driven monetary system is yet one more desperate attempt to grow out of unaffordable promises. Nonetheless, this flawed and crisis-prone system is now a pre-eminent investment factor. Jeffrey Snider hinted at this in an interview with Macrovoices when he argued that the Great Financial Crisis is more properly labeled “the Great Global Monetary Crisis.” 

Napier also highlights the importance of the monetary system as an investment factor:

While many investors are fretting over what stage of the business cycle we are in, the global monetary system is collapsing — with a whimper initially, but ultimately a bang.

In short, the US dollar based global monetary system is a key structural issue that long-term investors need to factor into their strategy. From this perspective, it is clearer to see how both significant deflation and inflation are real possibilities in the not-too-distant future. As a result, a top priority should be to appropriately calibrate exposure to financial assets to one’s investment horizon. Failure to do so is the one thing that can cause real harm to retirement plans.

In the meantime, central bankers can temporarily alleviate liquidity droughts by expanding their balance sheets and probably will try to provide short-term relief. What they can’t do is meaningfully improve the configuration of the system without creating significant glitches in liquidity. It is nonsense to believe that central banks can keep markets afloat forever simply by continuing to add liquidity.

The increasingly global nature of the monetary system also presents a special challenge for US investors. Whereas factors affecting dollar liquidity used to be confined to the US, increasingly the system is global and interconnected and incorporates various feedback loops. As a result, factors affecting dollar liquidity can pop up in lots of places. 

This presents a very different situation than in the early 1970s when Treasury Secretary John Connally famously (and arrogantly) told complaining European finance ministers, “The dollar is our currency, but your problem.”

Today, US dollar still reigns supreme relative to other fiat currencies (and therefor crucial for funding growth), but the US economy is a smaller part of the global total. At the same time, the Fed has considerably less control over US dollar liquidity which feeds back into lower global growth when it contracts.

Now the dollar is everybody’s problem.

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David Robertson CFA is the CEO of Areté Asset Management and founded Areté with the mission of helping people to get the most out of their investing activities. Most of his career has focused on researching stocks and markets, valuing securities, and managing portfolios for mutual funds, institutional accounts, and individuals. He has a BA in math from Grinnell College and a Masters of Management from the Kellogg School of Management at Northwestern University. Follow Dave on LinkedIn and Twitter.

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