Preserve Capital - Relentless Slide Toward Deflation And Negative Nominal Rates

I have talked a lot about demand for bonds, especially long bonds as collateral in derivatives markets. This demand has driven down yields and raised prices, so much so that Larry Summers fears a shortage of bonds, making the bond prices even more outrageous in a never ending bid for higher prices.

I have written about how the economy cannot boom, but only experience slow growth, in this regime of perma-low interest rates, with the Fed even predisposed to keep rates low. I wrote here about the four ways I see that the Fed is so predisposed:

So, we need to look at the ways in which the Fed has set things up to predispose it to keep rates low.

1. Grumpy's friend says the Fed can't afford to pay the treasury interest if rates are significantly raised. That is almost a hostage situation.

2. The banks have bet on low rates, taking the floating low side of the swaps bet when they issue loans.

3. The Fed pays interest on the excess reserves in order to restrain lending.

4. Long bonds are in massive demand as collateral, the new gold, and there are shortages, even with BRICS nations selling into a deep market.

So, rates are predisposed to stay low barring some unforeseen circumstance.

[Tracking the behavior of TIPS, which had their day but still have reasons for some demand, can help with understanding bond investing in these low interest rate environment. For those simply seeking capital preservation, there is a recommendation at the end of this article]

I shared solutions to the above Fed propensity, from Dr. Werner, to solve the problem of the conundrum of the long bond low yields in times of recovery, resulting in very slow recovery for main street as banks don't lend to consumers or each other. But number 3 will be difficult to implement as is discussed below:

1. Banks should not lend in non GDP transactions at all. No speculation of that sort should be allowed.

2. Central banks should bail out troubled banks by taking the bad loans off the books and nursing them to maturity or until there is a market for the assets.

3. Governments should stop the issuance of government bonds. Governments should borrow from banks in their own nations, instead.

4. Fiscal stimulation should come through bank borrowing, not the issuance of bonds.

America is potentially vulnerable to negative nominal rates just like the rest of the world, because the US is reliant on foreign holdings of the dollar to keep it strong and in reserve status. If the dollar is to remain the reserve currency, people will need to want to hold dollars and US bonds will continue to exist in high demand.

And one of the main reasons they would want to hold dollars is because they know America has never defaulted on its bonds. They need that safety. The bonds are not only gold as collateral in derivatives markets, but they are like gold in the backing of the base currency which was once known as the high powered money, not the same as the larger money supply. The discussion below should clarify how little power high powered money, base money, has become these days.

Gold bugs believe that gold is better than treasuries at backing the US dollar, but that treasuries do indeed at least back base money. But they could live and die before their view of gold versus treasuries is verified! And there isn't enough gold to back the currency anyway. Going to a gold standard for base money or especially for all money, would limit dollars and make trade with other nations impossible.

The Fed takes protection of the financial system seriously in certain situations. In 2009 the Fed protected bonds and banks as I wrote in a comment section on a blog making the point that the real economy is an afterthought and that the derivatives markets were all that mattered:

Back in those days, there were no clearing houses for derivatives, with trillions of dollars of long bonds being used as collateral as is being done today. While I don't believe bonds should be used as collateral in that way, as they back the dollar too, bond demand was likely lower, and the Fed bought them and the MBSs as well.

By 2009, the crash had occurred in the real economy. Banks would not lend. If anything, bank lending got tighter because of Fed actions. The banks should have been divided into bad bank, good bank. What the Fed did was all about the saving the banks and bond demand and had nothing to do with the real economy.

The Fed crushed the interbank lending market, with excess reserves and newly given power to pay interest on those reserves (IOR) to the big banks. The Fed even pays interest on the base money reserves, the required reserves, to the banks. This is new as well, from 2008, during the crisis.  The Fed pays interest on mandated reserves (IOR) and interest on excess reserves (abbreviated as IOR or IOER).  That certainly weakens the power of high powered money, the base money, for increasing the money supply!

Bonds will always back Fed base money. But bonds do not have to always be used as collateral for derivatives trades. Land could work for that. Fiat money from bank loans could work for that. Commodities could work.

The march toward negative is proving to be the main flaw in the otherwise almost foolproof system designed to protect the banks and treasury bond demand (engineered at least in part by Alan Greenspan). The propensity toward a deflationary scenario seems relentless, in Europe, in Japan and even spoken of by the Fed.

Dr Werners' plan to end the long bond may not work, but a return to a normal economy would be welcome news. Wouldn't it be nice if we had government banks that bypassed the issuance of bonds by the treasury. These banks would offer loans to our government, at positive interest rates. Bonds could be issued for special programs, like for infrastructure as was done with war bonds in World War 2.

And regular treasuries would still back the base money. They would carry higher interest rates, reflecting diminished demand, and return the economy to more normal times. The 1 percent would be forced to pay taxes, so that the deficits would not be so large. But the bonds would not be in demand as collateral, so that would take some of the pressure off demand for them.

That way, when the Fed raises interest rates on the short end, there would be half a chance for long bond rates to go up so banks would lend into the real economy and profit. They certainly are not doing much of that now. We have a little inflation in the US, but in Europe, inflation is negative, meaning real interest rates are going up. Economists want to stimulate with negative nominal rates (real rates + inflation) to offset the rise in real rates.

Real rates can be negative, but as long as the nominal rate is positive, you won't have people pulling their money out of banks. But making nominal rates negative does bring in the problem of cash.

We are clearly entering a worldwide deflationary cycle, with the slowing of China and US slow growth and the drop for the Baltic Dry Index. If the experiments of the Japanese and Scandinavian nations fail to stimulate, through their negative rates, it will certainly be back to the drawing board. And eliminating cash is not the answer, with too many unknowns being the result.

For me, there are more questions than answers regarding this march toward negativity. In a deflationary scenario, the banking system wants to reward recklessness and punish frugality. But they brought on the frugality along with globalization and lower wages that resulted.

There is nothing wrong with frugality. Only, if everyone is frugal at the same time there are deflationary pressures and slow growth. The Japanese, and US millennials and boomers, and Europeans are frugal. Banker abuse and globalization caused this frugality in most cases. Easy money followed by credit tightening (which is different than money tightening by the Fed) is not good banker PR!

Preservation of capital is the only way for older people to navigate the slow growth/deflationary waters. Stocks and volatile bonds are not the place to be. Safe bonds or bond funds and capital preservation funds are the place to be unless growth can be rekindled .

Unless something changes, gold and stocks are still speculative in this environment. The article titled  Negative Real Interest Rates: The Conundrum for Investment and Spending Policies was written years ago, but is great for explaining the bond markets and investor risk.  Negative real rates force money managers to take risk, likely too much risk.

And for individual older investors, this risk is unacceptable. BRASX looks like a reasonable place for older people to park their money.

Disclosure: I am not an investment counselor nor am I an attorney so my views are not to be considered investment advice.

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