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How the Monetary Endgame Will Play Out

Jun 9, 2016


The problem British savers now confront is unprecedented. Yields on ten-year gilts have never been this low. Ever. In all the history of British bonds.

The ten-year gilt yield fell to 1.263% during trading yesterday, according to Tradeweb. Also on Tuesday, the UK auctioned a 30-year bond with the paltry yield of 2.095%. That was the lowest average auction yield ever for a 30-year UK bond, according to The Wall Street Journal.

You can't blame the Bank of England. Its bond buying program hasn't changed since 2012, according to the Journal. And it's left the bank rate at 0.5% since 2009. Mark Carney hasn't lifted a finger - or an interest rate. But the pressure on UK bond yields is a global phenomenon; a combination of low growth, global capital flows, and the deathly fear (and memory) of deflation.

But let's not forget the European Central Bank (ECB) element either. Today is the day Mario Draghi and his henchmen are scheduled to begin their corporate bond buying programme. Remember, the ECB announced its commitment last month to buying €80 billion per month in AAA rated corporate debt. That programme begins today.

Keep in mind the universe of bonds eligible for the programme is relatively small, about 1,049 securities according to the Journal. And what's worse, the yield curve is already grossly distorted in the government bond market. German bund five-year yields are now below the threshold where they'd be eligible for ECB purchase. That threshold, you may recall, is minus 0.4%.

Like a great greedy Hoover, these central bank asset purchase programmes buy up all the eligible high quality credits and leave institutional and retail investors in the wilderness to scratch out an income from rocks and weeds. Out in the wilderness, you have to take higher risks to hunt your yield. Risks lead to danger. Danger can lead to death. Only in certain cases does death lead to resurrection.

"Minus bonds" a bad deal

The slim chance of financial resurrection following death is, perhaps, why the Bank of Tokyo-Mitsubishi UFJ has asked to be relieved of its duties as a primary dealer in Japanese government bonds. The position usually comes with privileges. You agree to purchase government bonds issued by the national treasury at auction. Then you sell them to investors, pension funds, and anyone who wants a long-term "risk free" income security. In the selling comes the profit.

Why has the bank baulked at such a cosy relationship? Negative rates have led to less selling and more owning of government bonds by banks. Holding negative yielding securities to maturity guarantees a loss. But now that the appetite for said securities is on the wane with investors, primary dealers in Japan have to hold more of the "minus bonds" in their inventory. This exposes them to massive capital losses if and when interest rates ever rise again.

That's the real question, though, isn't it? Is it a rational investment position to buy negative yielding bonds? It is, if you are convinced we're in a period of prolonged deflation (caused by excess credit, globalisation, low labour costs, and cheap energy). If you believe inflation is dead, or at least in a Yellen-induced coma indefinitely, and that there will be no second coming of Weimar, bonds and cash are the rational position.

But there is something self-fulfilling about the negative rate phenomenon. To paraphrase Karl Marx, the model contains the seeds of its own destruction. Rate cut by rate cut, asset purchase by asset purchase, central banks are eroding their own credibility and authority. And as their main product is paper money, they are building the pyre on which their product will go up in an inflationary inferno. That's what happens when money dies. Confidence in government issued debt instruments goes with it.

Don't think it can happen? It's how all money dies. The real question is when it will happen. And in another paraphrase, there is a lot of ruin in a welfare state debt funding model. Even if you took away all the primary dealers, a treasury could still issue new debt and have the central bank buy it.

That's a more direct route, actually. It's just the facade of having commercial demand for low-rate or minus-rate government bonds would be gone. The central bank would have to buy the debt directly. This is debt monetisation. And it is surely part of the monetary endgame.

Please Note: This article was first published in Capital & Conflict on June 08, 2016.

Dan Denning studied literature and history, moving to Agora Financial in Baltimore fresh out of college. Working alongside Bill Bonner and Addison Wiggin, he became managing editor of Strategic Investments. He then moved via Paris and London to Australia, publishing a book - The Bull Hunter - along the way, and opened Agora's successful office Down Under. He returned to London in 2015 and became the publisher of Fleet Street Publications' financial newsletters.

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