Here's to the crazy ones, the misfits, the rebels, the troublemakers, the
round pegs in the square holes... the ones who see things differently -- they're
not fond of rules... You can quote them, disagree with them, glorify or vilify
them, but the only thing you can't do is ignore them because they change
things... they push the human race forward, and while some may see them as the
crazy ones, we see genius, because the ones who are crazy enough to think that
they can change the world, are the ones who do.

Steve Jobs
US computer engineer & industrialist (1955 - 2011)

Sunday, March 20, 2016

Going Negative (Rates)

It started in Europe, has spread to Japan, and sits on the horizon for other central banks across the western world - negative rates. Historically, central banks used their interest rate setting power to curb inflation. When the national economies became too hot central banks would continuously raise their interest rate that banks had to pay in order to borrow money. Banks would then increase their interest rates to clients. Eventually, interest rates would reach a high enough point that economic activity would slow down and typically a recession would take place. That's been the traditional way to containing too much growth too fast.

But what happens when the problem is the reverse? What happens when deflation can not be stopped, and no matter how low the central banks decrease their interest rates the economy does not reengage and bounce back to growth? That is the precise problem facing central bankers across the western world. I say western world, because Russia, and to a lesser extent China, still have fairly high national interest rates - 11% and 4.5 % respectively. Other countries like Brazil and Argentina have extremely high interest rates based on their position versus the US dollar - 14.5 % and 25 % respectively. Deflation is an issue primarily facing western economies. Economies of South America typically have excellent demographics for growth with some of the youngest populations in the world, but they can't consume due to cost of borrowing, or if they do their ability to continue borrowing will be severely restrained by interest costs.

The European Central Bank, as well as Switzerland kicked off the idea that negative central bank rates were the way to go. In reality, they had very little choice. Deflationary pressures had caused the ECB to drop rates to zero, and as the ECB was not willing to allow a recession to take place in order to correct the balance, they were forced to take the other course - negative rates. Now the Central Bank of Japan has jumped on board. These central banks now charge, rather than give interest, to banks they hold cash for. The intended effect is to create a "quantitative easing" at the central bank level. When the US economy crashed in 2008, and much of the world followed, central banks infused massive sums of money into banks to "create liquidity", or in other words give banks money almost free to spur them to lend money and get the economies growing again. However, many banks around the world horded the new money, credit remained difficult to get, and interest rates continued to tumble as national economies deflated (shrunk).

The purpose of negative rates is to act as the stick in the carrot and stick game. The carrot was the "quantitative easing" of extremely low or free interest rates charged to banks - so they would lend. They didn't, or at least not in enough volume to spark the economies. So, now the central banks have brought out the stick - negative rates. The hope is that rather than lose money to the central banks by way of negative rates, the banks will lend out cash far faster and in much greater volume - thereby spurring economic growth. The possible downside to that strategy is that banks may simply take the negative rate cost to their bottom-line, write it off at tax time, and keep their money out of a deflating economy thereby avoiding risk. Accordingly, central banks have warned they will continue to increase the negative rates they charge banks until the banks finally let their fingers off their cash stores. The gamble is that the banks will do as their told, the economy will respond to essentially free cash, and the debt ridden western economies will continue to grow.

Quite a switch in roles. The central banks used to be the place of discipline. If economies became over burdened with debt they would have recessions create by imposed higher rates. Central banks were the voice of discipline and reason in the money market. Banks on the other hand, especially the litany of them in the US, were notoriously reckless in their lending. That's how sub-prime mortgages torpedoed the US economy in 2008. Now it's the banks, once recently burned, who are holding fast to some sort of economic discipline. The crucial thing here is that central banks have abandoned their role as dealers of reality, and become essentially instruments of policy that properly belong in the hands of national governments. In other words, central banks have crossed the line, and are becoming lost in their purpose.

My bet is this: negative rates will wholly fail, and fail miserably. First off, there is nowhere left to go after negative rates. That line has been crossed. A great deal of unsupported wealth and debt is being created without interest reward - which really means the value of that wealth and debt has no real value. That's a very dangerous Rubicon to cross. It's actions like this, completely undisciplined, that are creating massive uncertainty among investors, and pointing toward gold as the only real safe haven in this deflationary period. The Chinese and the Russians know it. They've been stocking up on gold for a decade. The Germans know it. They have recalled all their gold from the US, with the final delivery scheduled for 2020.

In many ways the central banks have failed us by their own greed. Rather than forsake profit now, or even more so back in 2008, they simply took on a social role and abused their power by not holding the big companies and banks to account. They bailed them out and upset the balance of nature in the finance world. They haven't stopped crossing the line since. Their role is to let nature take its course, have businesses fail if necessary so that wealth and debt have meaning. They are meant to control consumption, not encourage it. My advice to folks is the same as always, invest whatever cash you can in gold, because the central banks have left that as the only safe bastion in these deflationary times that aren't going away any time soon.  

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