Preparing for a negative interest world

Apr 29, 2015

Bill Bonner
Gualfin, Argentina

Dear Diary,

Not much to report from the financial markets.

And things seemed to have settled down in our hometown, Baltimore, after they called out the National Guard.

So, we'll return to our exploration of the Fed's fabulous fantasyland.

Yesterday, we looked at the coming debt deflation. It is roughly what has been happening in California already. When more liquidity is being used up than is coming in, things dry up.

Liquidity - money available for buying stocks and bonds - is what floats asset prices. And today's liquidity comes from the feds and their banking system. Their EZ money policies in the '90s and '00s created a huge flow of funds into US capital markets - the financial surplus - that caused the Nasdaq bubble of 1999 and the housing and finance bubble of 2007.

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When those bubbles popped,households pulled back. Then the feds came up with QE I, II, and III - about $3.5 trillion worth -- to keep the juice flowing. But now that QE has come to an end in the US, things are starting to look a little peaked.

And if economist Richard Duncan is right, in the next quarter, net liquidity will be substantially negative. And then we'll see the flower of Wall Street begin to yellow and shrivel.

Our own short-term indicator also turned negative on April 9th - predicting a return of MINUS 1% over the following 94 days.

But wait? Do the feds have a still-untapped aquifer of cash and credit they can pump dry? Interest rates are already as low as they've been - ever. Could they go lower? Yes, they could.

Ask your wife or husband: 'what will you give me if I kiss you?' If the answer is nothing, you have established the value of your kiss -- zero. But suppose the answer comes:

"If you take out the trash, maybe I'll let you kiss me."

There, the value of your kiss is even lower - below zero. You have to add something to it to make it acceptable.

Likewise, it appears that lenders to Japan, Switzerland, Germany and many other nations and must add something to their money each year in order to persuade the government to take it.

We have already been humbled and flummoxed by zero interest rates. Even when we are in our cups...or deprived of oxygen...they still make no sense. How could something simultaneously have no value...and still be worth something? Money is worth something, right? Then, how could it be lent out for nothing, or less?

Perhaps there is something in the early Christian literature that will help us understand. The church fathers had to wrestle with conundrums of their own, such as the nature of Jesus. Was he a man? God? Or both? How could he be both the son of God and God Himself? That would be a little weird, wouldn't it?

The question led to long discussion and mass slaughter. In the end the issue was never decided in any convincing way. Instead, each church came to a practical entente, with the Catholics declaring at the Council of Nicea that Jesus and God were "of one substance." How they knew that was never explained.

So we will probably never understand the true nature of negative yield debt either. Is it valuable? Or worthless? Let's take one example. What is the real yield on a 10-year Japanese government bond? That is to say, if you lend money to the Japanese government - which controls the world's number 3 economy - how much interest do you earn? MINUS 2% is the answer.

Does this mean what we think it means? That the value of the money lent is LESS THEN ZERO? So, if you have a trillion dollars' worth of Japanese Government Bonds, JGBs, what is it really worth?

Well, if you had to pay a mortgage of 2%, you wouldn't have an asset, but a liability. So wouldn't the portfolio of JGBs also be considered a liability, not an asset? And if it is a liability to you, wouldn't it have to be an asset to the Japanese government So, let's get this straight...the borrower gets an asset. The lender gets a liability. In what kind of a universe does that happen?

In a negative interest world, money has no meaning...no reality. You could build automobiles that don't run...airplanes that don't fly...or computers that can't add. It would make no difference. Because you could stay in business for an eternity.

What? You couldn't sell your products? You couldn't pay the interest on your debt? Ha ha...at zero interest rate...you could pay it forever for less than the cost of a postage stamp.

What? You're not creditworthy? But that's just the point. In a zero-interest world it makes no difference. Your kisses are as good as any. All are equally cold. You can always pay your debts by borrowing money - and infinite amount of money - and pay anything you want.

Attentive readers will realize immediately that we do not live in a zero-interest world. We live in the real world of flesh and blood. We live in a world where cash, kisses and credit still count. Because in this real world you still have to pay for what you get.

But little by little, day by day, the world we live in gets stranger - thanks to this funny money system. And little by little, the curiouser the financial world becomes, the more people want to hold cold, hard (sort of) cash to protect themselves from it.

One of the strangest things to happen recently was that the government of Switzerland, of all places, has refused to allow big depositors to withdraw cash. Comes now Forbes magazine with a report:

    The Swiss National Bank confirms that hoarding cash to circumvent negative interest rates is not welcome. "The National Bank has been recommending that banks with cash demands (...) act restrictively."

    The SNB may indeed be recommending that banks limit physical cash withdrawals to prevent hoarding. But it is normal for banks to impose limits on cash withdrawals anyway. International anti-money laundering (AML) guidelines require banks to monitor and report suspicious activity on accounts. Very large cash withdrawals that are not part of the normal activity of the account would be regarded as "suspicious activity".

    Banks are completely within their rights to refuse to enact transactions that they believe may be intended to facilitate financial crime or money laundering. For this reason, banks in most countries impose restrictions on physical cash withdrawals: they usually require notice of a large cash withdrawal, they may limit the amount that can be withdrawn and they may demand a written explanation of the purpose for which the cash will be used.

    This could have far-reaching consequences. The monetary policy of the last few years has been hampered by the supposed existence of the "zero lower bound", at which (it is assumed) everyone would opt for physical cash instead of bank deposits and bonds... But if investors simply cannot obtain large amounts of physical cash because banks won't issue it to them, the slightly-below-zero lower bound cannot bind. In which case negative rates could be very negative indeed and no-one would be able to do much about it.

We have been predicting a 'run on the dollar.' Which is to say, when going gets crazy, people will want something in their wallets other than credit cards. Credit cards are forms of IOU. They require willing and able counterparties. But what counterparty in his right mind will lend you money in a negative interest world, where his loan to you immediately turns into his liability?

Our head swims.

In the last financial crisis, cash was fast draining out of the system and almost every bank on Wall Street would have failed if it had been allowed to do so. Instead, the feds stopped the correction, and we live with the results - including an even bigger bubble, in debt.

Now, governments are trying to keep you from holding cash. For three reasons:

  1. It is hard for them to control, track and tax.

  2. There is not enough of it around to run our modern economy.

  3. As long as you can hold cash, you can escape the feds' fantasyland. That is, if you can go to cash they can't enforce negative interest rates. You can just take your cash and hold onto it...paying nothing for the privilege.
France has already made it illegal to use cash for large purchases. Citibank's Willem Buiter has recommended taxing cash (a form of negative interest rate). And down the street, JP Morgan has advised some of its clients not to use safe deposit boxes to store cash or coins.

In the US cash is not yet illegal; it is suspect. Show up with a large amount of cash at a bank and you will likely have some explaining to do. Let the police find it on you in a routine traffic stop and they are likely to confiscate it.

It is probably just a matter of time before cash is more tightly controlled and negative interest rates are announced for large cash holdings. Will that be enough to raise liquidity levels and asset prices?

Stay tuned...

Bill Bonner is the President & Founder of Agora Inc, an international publisher of financial and special interest books and newsletters.

Disclaimer: The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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