Federal Reserve Notes – The Worlds Problem
Federal Reserve Notes – The Worlds Problem by David Robertson for Real Investment Advice
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: