EC Economic And Monetary Outlook For 2021

Putting ourselves in the shoes of foreign holders who now see both the disturbing trend in yields and the fall in the dollar’s trade weighted since March (see the table in Figure 2 above), it must be increasingly obvious to them that holding onto dollars almost guarantees they will lose money. And the interest compensation on bonds is woefully inadequate to recompense them for the sum of the risks of holding a foreign currency, and given the acceleration of monetary inflation, the general loss of capital values for time deposits and fixed interest bonds. Furthermore, the increasingly immediate prospect of the latter, which is the story being told by the golden cross in Figure 4, is likely to quicken the pace of foreign selling of bond holdings, driving yields higher towards a point where, today, they would compensate foreign holders for future losses of purchasing power. But this is one of those instances where a rise in yields worsens the situation for government finances and will require a reassessment in the market to even higher yields. In short, foreign sellers of dollars will begin to drive interest rate expectations, taking over that role from the Fed.

The false safety of equity markets

An insight into the thinking of central banks with respect to financial assets was given in a paper written for the Bank of England’s Quarterly Review in 2014 Q1, which contained a section on the workings of quantitative easing.[vi] The original intention was to provide an opportunity for pension funds and insurance companies to sell low-yielding government securities to the central bank through the commercial banks. They would then be able to invest in higher yielding securities, such as corporate debt and equities. That was the plan, and undoubtedly pension and insurance funds play this game to some degree even today.

Since 2014 QE has been a dominant feature of monetary policy, and it has become increasingly the means of bolstering bank reserves held at the Fed without the pass-through to investing institutions. Nonetheless, we have an explanation as to why equity markets continue to levitate: QE is an official policy for central banks to inflate equity markets in order to create a wealth effect — this is openly stated in the BoE paper. Presumably, the Fed is confident that a manipulated equity market can continue to be manipulated through QE, dismissing the possibility of policy failure. The ghost of John Law, who saw his money and equity bubble implode three hundred years ago in strikingly similar conditions, has not given FOMC members any sleepless nights, so far.

The John Law lesson is that cracks will begin to show, leading to the collapse of the fiat currency and the equity bubble. Initially, the rejection of the dollar and financial assets will have more to do with fixed interest bonds than equities. But the effect of rising bond yields on the $8,600bn of foreign private sector portfolio investments in equities will be to undermine valuation assumptions. When the trend of rising Treasury yields and the prospect of further falls in the dollar exchange rate take hold, equities are likely to face a barrage of foreign liquidation, likely to coincide with liquidation by domestic investors as well. And leading the domestic investors out of equities will be the pension and insurance funds who sold their low-yielding T-bonds to the Fed through their bankers.

Equity valuations relative to a covid-stricken Main Street are already stretched towards breaking point, and vulnerable to increasing bankruptcies from supply chain disruptions and insolvencies in services sectors, problems that are sure to increase in the coming months. The combination of foreign-owned dollars currently invested in equities, being inherently flighty because their returns are measured in other currencies and are not their core portfolio investments, and a growing realisation for domestic investors that fixed interest yields are rising and undermining equity valuations, is brewing up into a perfect storm.

An expectation of tightening isobars is on the cards, and prescient investors will be battening down the hatches, perhaps early in the new year after the seasonal rally is over. The Fed will then be faced with the same situation that faced John Law in France in early-1720, when the maintenance of asset prices by money printing began to fail, taking both asset values (principally his Mississippi venture and his bank) and his paper currency into a breakdown. The currency became valueless on the foreign exchanges in London and Amsterdam in less than nine months, while the venture’s value measured in virtually worthless paper money also fell by over 80%.

The similarities between then and now are impossible to ignore. Instead of searching for differences, it is far better to learn the lessons of what happens when a monopolist state loses control over markets, a situation which increasingly threatens today. Not only does the value of financial securities collapse, but the currency collapses as well. This is by far the most important message for the American economy and financial markets. And with the dollar as the world’s reserve currency, other major currencies face similar outcomes.

For this reason, it is a mistake to think of the dollar’s future being simply a matter of its trade-weighted index. With other currencies facing losses of their purchasing power, the importance of overweighted dollars in foreign hands is only an initial effect. Others will follow, modified by national problems peculiar to each currency. The collapse of fixed interest and equity values becomes a worldwide phenomenon driving them all.

Today, these dangers are in the earliest stages of acknowledgement, with fixed interest yields on dollars beginning to rise, and investors speculating on where to invest in order to reduce their holdings of surplus dollars. But they are yet to collectively understand the characteristics required of a true hedge against a collapsing paper currency. They are not found in a broad spectrum of equities. The underpinning for them will be destroyed by a currency collapse, as the John Law episode clearly demonstrated. In contemporary markets, zombie companies stuffed full of malinvestments will go to the wall. In order to survive, businesses not in the zombie category will be forced to downsize materially. When these factors become more obvious, portfolios invested in diverse equities will turn out to be the worst form of wealth preservation.

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