“At the core, the “this time is different” syndrome is simple. It consists of the firm conviction that financial crises only happen to other people in other countries and at other times; here, now, in our country, there can be no crisis. We are better at everything, we are smarter, we have learned from the mistakes of the past. Old rules of valuation are no longer important.
Unfortunately, a highly indebted country can stand with its back at the edge of a financial abyss unnoticed for years, before fate and circumstances trigger a crisis of confidence, upon which the country plummets into the depths.” [1]
There has never been before a comparable era of global zero interest rate policy. Since the beginning of this year alone, 25 central banks have lowered their base interest rates. The following chart shows the number of industrialized nations that have implemented a zero or negative interest rate policy.
Sources: IMF, Incrementum AG
Last year, we remarked the following in this context:
“In view of the ongoing low interest rate policy, investors are forced to take on ever greater risks in their search for yield. This hunger for yield is in the meantime producing rather disturbing effects.” [2]
We believe this assessment has been confirmed. A historical first occurred on April 8: Switzerland’s government was the first to succeed in generating a nominal return for itself from issuing a 10-year bond. The bond with a coupon of 1.5% was placed at an issue price of 116%. This “security” thus offers its buyers a guaranteed negative yield over its entire term to maturity. In the rest of Europe, one can also “safely lose money”: in the meantime, bonds valued at more than one trillion euro trade at such high prices, that their yieldsto-maturity are negative. In mid April, the yields of some 35% of all outstanding European government bonds were trading in negative territory. This means that these securities are massively overvalued. Concurrently most market participants regard these securities – in keeping with prevailing financial market theory – as risk-free.
After a correction of financial market excesses, a multitude of books is usually written about this previously “unpredictable” bubble. We wouldn’t be surprised if the topic of negative yields were to enter a number of books as a catastasis a few years down the road.
Source: www.wikipedia.org
From a purely evolutionary perspective, such a herd mentality probably makes sense. If a herd is hunted, it is better for it to stick close together – anyone who leaves the herd soon falls prey to the hunters. However, this tactic doesn’t always work. There are times when it is definitely better to keep one’s distance from the herd. Such as in the bond markets right now. However, it appears to be difficult for most market participants to fight against a herding instinct that is deeply embedded in their subconscious mind.[3]
In a fascinating study[4], professors Schnabl and Hoffmann describe the main characteristics of a bubble formation: “Although speculative bubbles are easily identifiable ex post, they are not recognized by the majority ex ante, and carried forward by the belief that a timely exit prior to the bubble’s bursting is possible, or that the rapid ascent will be followed by a soft landing. Decisive in this are irrational factors like herding (“monkey see, monkey do”) or uneasiness over seeing one’s neighbour growing rich. Although Kindleberger acknowledges that crises at the end of speculative waves are not predictable, he identifies two factors that make them more likely. For one, waves of speculation are tied to positive economic expectations. Secondly, plenty of liquidity is in play, which provides the breeding ground for the excesses.”
Investment in government bonds increasingly involves leverage, due to low yields and the generally high marginability of such bonds. From a regulatory perspective, it is for instance easily possible for regulated funds to greatly leverage a fund’s capital in order to multiply low yields through external financing. These funds have in recent years inter alia employed increasingly popular “risk parity” concepts. Investment in government bonds specifically is thereby massively blown up beyond a fund’s capital by purchasing financial futures.
Bonds are asymmetrical investment assets. An investor cannot receive more than the coupon payments and the repayment of principal. The maximum return is limited, but the risk of loss is unlimited. Moreover, interest rate risk rises when yields are low. Bond investors have been frightened in the months of April and May of this year. 10-year German Bunds (resp. Bund futures) suffered a drawdown of more than 7% in just a few weeks time. The last comparable sell-off has taken place more than a decade ago. Even after this setback, yields are still at less than 1% for maturities of ten years. In the event of a rapid increase to significantly higher yield levels, the potential for losses is enormous (esp. for supposedly safe investments).
A variety of sources has for quite some time warned about possible crash scenarios in the bond markets, as the central bank is no longer (as was the case until 2014) a buyer, but possibly soon a seller of bonds. Market participants would anticipate this step and significantly reinforce the effect, by switching sides concurrently. In our opinion it is especially this factor that makes the intended reduction of the Fed’s balance sheet via selling bonds the Fed has purchased impossible.
The party in bonds is, however, not limited to government bonds: wherever one looks, caution has been thrown to the wind. Numerous short to medium term bonds of international corporations including the likes of Roche and Nestle now exhibit negative yields-to-maturity as well. If one considers these bonds to be too boring, one can always invest in junk bonds, which are currently trading in the 98th percentile, in other words, they have historically been valued more highly in just 2% of all cases. If “return-free risk” has ever existed, it is alive and well today.[5]
Institutional investors such as pension funds and life insurance companies, and especially their beneficiaries, are the biggest losers of loose monetary policy. The yields of most government bonds are once again far below the guaranteed yields on life insurance policies. In Germany, this guaranteed insurance policy interest rate currently stands at 1.25%[6], while the yield on a 10-year German government bond stands at 0.55%.[7] As soon as higher-yielding bonds mature, reinvestment has to be undertaken at significantly lower yield levels. The longer this discrepancy persists, the greater the threat to the survival of many insurance companies becomes. The following statement by a pension fund manager illustrates the pressure under which many institutional investors are working:
“In a world where bonds are yielding inflation minus 1 percent, if you can get something which yields a bit more than that, it’s the way to go.” [8]
This pressure on institutional investors to produce returns has the effect that even governments that have defaulted fairly recently are able to obtain fresh capital at extremely favorable conditions. Ecuador, which defaulted in 2009, was able to issue USD 2 billion of government bonds. Armenia, which is considered “highly speculative” by the credit rating agencies, was likewise able to issue 10-year bonds effortlessly at the most favorable conditions ever.
Among the biggest beneficiaries of the low interest rate environment are frontier markets.[9] Their bond issuance activity has increased by 300% since 2012. Especially bonds from the subSaharan region have recently sold like hot cakes. Thus Ghana, Senegal, Angola Zambia, Rwanda and Kenya all have issued bonds denominated in US dollars.[10] Ivory Coast was able to place a 10-year government bond yielding 5.6% in the middle of a civil war and only three years after defaulting – demand exceeded supply by multiples. We are highly critical of this bond bonanza: The questionable creditworthiness and fragile outlook of these issuers hardly justify coupons ranging from 5.5% to 8%. One must suspect that the risks are massively underestimated and that far higher risk premiums would be appropriate.
In terms of bond maturities, one can also detect signs of a mania. Mexico issued yet another “century bond”. The most recent 100-year bond with a yield of 4.2% is denominated in euro, has a volume of EUR 1.5bn and is set to be redeemed in April 2115 (!!!). And this is not the first of its kind. In 2010, nearly USD 2.7bn of century bonds were issued denominated in dollars. In a historical context, a bet that a system of irredeemable currency will still exist in 100 years is extremely daring. However, if one can rely on Theo Waigel’s expertise, who believes the euro will last another 400 years, then even this government bond may turn out to be a sensible investment for one’s descendants.[11] We remain somewhat skeptical.
The most recent mania in the bond markets, which is characterized by massive over-subscription and record prices at increasingly speculative price levels, reminds us of the excesses in Germany’s “Neuer Markt” and the Nasdaq at the end of the 1990s. While exponential growth can often be observed in nature as well, it is always temporarily limited.
Based on the facts, it can immediately be stated that the situation in the bond markets has reached the most extreme end of the historical range in terms of prices and yields – never has a market depended more strongly on irrational faith. Once creditors have to pay borrowers for the dubious “privilege” of lending them money, there is essentially only one direction left in which this market can possibly move.
Yield chasing such as is currently underway means individual market participants will require a “greater fool” to be able to get out of the market in the nick of time before the bubble bursts. While the 2008 crisis was focused on the sub-prime market and the derivatives tied to it, we are now in an entirely different bubble dimension: government bonds are at the epicenter of the debt money system and represent the bulk of assets held by central banks. Ultimately the bursting of such a bubble can be averted by launching an “infinite QE program”. This means however that sooner or later, confidence in the currency will evaporate and it will lose all purchasing power.
300 years ago, Newton formulated his third law, also called the principle of action-reaction. It states: “Forces always appear in pairs. When one body A exerts a force on a second body B (action), the second body B simultaneously exerts a force equal in magnitude and opposite in direction on the first body A (reaction).”
In a dynamic economy, an action not only triggers just one effect, but always an entire series of different consequences.[12] While the cause of the first effect is easily recognizable, the other effects often occur only later and no such recognition occurs. Frédéric Bastiat described this phenomenon in 1850 in his ground-breaking essay “What is seen and what is not seen”: [13]
“In the economic sphere, an act, a habit, an institution, a law produces not only one effect, but a series of effects. Of these effects, the first alone is immediate; it appears simultaneously with its cause; it is seen. The other effects emerge only subsequently; they are not seen; we are fortunate if we foresee them…
There is only one difference between a bad economist and a good one: the bad economist confines himself to the visible effect; the good economist takes into account both the effect that can be seen and those effects that must be foreseen. Yet this difference is tremendous; for it is almost always the case that when the immediate consequence is favorable, the later consequences are disastrous, and vice versa. Hence it follows that the bad economist pursues a small present good that will be followed by a great evil, while the good economist pursues a great good to come, at the risk of a small present evil.”
A similar phenomenon can be seen with the consequences of artificially suppressed interest rates and monetary stimulus: In the short term, they appear to have positive effects, the long term effects are however disastrous and bear no relation to the advantages. If one studies these processes closely, it becomes clear that the underlying problems cannot be solved by global zero interest rate policy, but that this instead undermines the natural selection process of the market. Governments, financial institutions, entrepreneurs and consumers, who should actually be declared insolvent, all remain on artificial life support.
In line with Bastiat’s thoughts, numerous fatal long-term consequences of zero interest rate policies can be identified:[14]
Conventional monetary policy – this is to say the promotion of credit creation by lowering interest rates – reaches its limits once the “zero-bound” is reached. In order to continue the spiral of stimulus, “unconventional monetary policy” becomes ever more important. The multitude of “newfangled” monetary policy measures is seemingly only limited by the imagination of central bankers, whereby recent years have shown that central bankers can be extraordinarily creative. That this phenomenon is nothing new, is inter alia shown by this quote from 1922:
“But an increase in the quantity of money and fiduciary media will not enrich the world […] Expansion of circulation credit does lead to a boom at first, it is true, but sooner or later this boom is bound to crash and bring about a new depression. Only apparent and temporary relief can be won by tricks of banking and currency. In the long run they must lead to an all the more profound catastrophe.”
Ludwig von Mises [18]
The seeds for the next crisis are already being sown. The longer the zero interest rate policy lasts, the greater risks investors will have to take, especially the ones who have certain return requirements. The point at which confidence in the fragile edifice of debt will be lost is difficult to forecast. We are strongly convinced that gold represents a sensible hedge against such a crisis of confidence.
In line with the tradition of the Austrian School, we do not regard capital as a statistic or uniform blob, but believe a more differentiated perspective is appropriate. Thus, we acknowledge that capital has a heterogeneous structure, which has formed historically as the result of countless individual decisions. At any given point in time, individuals are anticipating potential opportunities to profitably expand on the existing state of the capital structure based on their specific knowledge and are thereby modifying it. Some technologies become obsolete over time, and the associated ends or links of the structure will accordingly regress.
In order to achieve a higher level of consumption, men began to forego some of their present consumption, in order to employ it in investments and the creation of more efficient production methods. In this context, there exists the following famous illustrative example of the Robinson Crusoe economy: Crusoe decides to no longer expend all his time and effort on catching fish barehanded, but also on weaving a fishing net. As a result, he has to reduce his level of consumption for the time being but will be able to increase it in the future.
Transposing this to a complex economy, the basic recognition remains that solely by foregoing consumption can resources be freed up which can then be employed in investment projects. In this more complex economy, one not only confines oneself to creating capital goods which serve directly in the production of consumer goods – so-called goods of second order, such as the above mentioned fishing net (the consumer good fish represents a good of first order, i.e., a good that directly satisfies a need) – but also goods of higher orders, which in turn serve to produce other producer goods, and hence are even further removed from consumption.
Two aspects are of key importance in this context: Specificity and time. The former term designates the fact that available resources will take on specific forms and functions in the largely irreversible process of investment, and with that obtain a specific position in the capital structure. An investment’s success is thus dependent on whether the created capital good fits well into the capital structure as a whole (i.e., that it is capable – in combination with other capital goods – to expand final consumption opportunities as desired).
The second aspect, namely time, is often underestimated, or in an environment in which investments in the real economy appear as cash values in balance sheets or structured financial products, even neglected completely. However, in the Austrian tradition, the time factor is accorded a prominent role; Murray Rothbard explicitly refers to it as a factor of production.[19] This is based on the fact that every human action is connected with the passage of time – and that includes the act of investing. If therefore, as noted above, resources are set aside in the present and invested in more efficient production technologies, time is required until these investments bear fruit. The consumption one renounces today is thus contrasted by greater consumption, but only at a later point in time.
This brings us to the concept of interest rates, which Austrians also approach differently than economists of the neoclassical or monetarist traditions. Their fundamental assumption is that people would prefer to have a clearly defined consumer good available for immediate consumption rather than at a future point in time. Thus, if savers are renouncing present consumption and are making the resources which are thereby freed up available for investment, they are doing so on the precondition that they will be compensated for this by having greater consumption opportunities available in the future. In a free market, the interest rate essentially represents a measure of the compensation payment in return for which actors in the economy are prepared to exchange present against future goods. This interest rate is called the “natural” or “originary” interest rate and provides information about the time preferences of market participants. Investment projects whose expected returns are lower than this interest rate, won’t be initiated in a free market economy, as their returns would not offset the losses in present consumption.
Against the backdrop of the concept of the “natural” interest rate, it is now somewhat easier to understand why the current situation of artificially suppressed low interest rates is not sustainable in the long run: At best, they can – akin to a “tracheotomy” [20] – keep a foundering economy from collapsing, if a liquidity squeeze occurs upon the outbreak of a crisis. However, since interest rates that are kept low in the long term on the one hand foster investments that wouldn’t be profitable under different circumstances, and on the other hand stimulate present consumption as well because savings will produce lower returns, such a policy cannot possibly be sustainable. Ultimately, there simply won’t be enough resources available. Unfortunately, long term investments will appear to be especially profitable, as in the calculation of their viability, discounting by low interest rates will result in very high net present values. Monetary policy manipulations may be able to obscure the actual situation for a long time, and stock markets may rally by chasing a monetary illusion – but sooner or later, the scarcity of real resources and malinvestments will become obvious. Then there is either a crisis in which debts are liquidated and the money supply contracts, or the next step in terms of loose monetary policy is undertaken, which sustains the illusion for longer and leads to an even greater distortion of the capital structure.
The following chart depicts the ratio between spending on capital and consumer goods production over time. A rising ratio indicates that relatively more capital than consumer goods are produced. While it cannot be deduced from this chart how much capital has been malinvested, it is quite conspicuous that the ratio left the range within which it had historically oscillated shortly after the gold exchange standard was abandoned in 1971 and it has risen strongly ever since. Moreover, periods of extreme increases in the ratio are regularly followed by recessions, which tend to go hand in hand with a decline in the ratio.
Source: Federal Reserve St. Louis, Incrementum AG
An increase in the ratio primarily allows one to conclude that the capital structure is deepening, i.e., that production activities are increasingly focused on higher order goods. In an unhampered economy, this wouldn’t be cause for concern: A deepening of the capital structure would indicate that people are saving more in order to invest in more efficient and capital intensive technologies, which will provide them with higher consumption opportunities in the future. However, as savings actually don’t increase in times of artificially suppressed interest rates, but will on the contrary actually tend to decline, an accelerated increase in the ratio points to an unsustainable distortion of the capital structure.
Capital is a complex structure, which contains the decentralized knowledge of countless market participants. The natural interest rate is an expression of the time preferences of acting men, i.e., it reflects to what extent market participants are prepared to employ available resources either in present or future consumption. Thus, a capital structure that comes into being on the basis of natural, freely-formed interest rates, is aligned with people’s needs and wishes.
Artificially suppressed interest rates by contrast result in distortions: A deepening of the capital structure occurs, i.e., investments in segments far removed from the consumption stage are encouraged, while consumption increases simultaneously. In the long term, it will become evident that real resources are insufficient for these investments, and that these projects have to be abandoned and written down. However, at present the illusion of a monetary perpetuum mobile still prevails in the markets.
[1] See: “This time is Different”, Carmen Reinhart und Kenneth Rogoff
[2] See: “In Gold we Trust” 2014, p. 37
[3] See: “Die große Geldschmelze“, Hanno Beck und Aloys Prinz, p. 245
[4] See: “Monetary Policy, Vagabonding Liquidity and Bursting Bubbles in New and Emerging Markets”, Gunther Schnabl and Andreas Hoffmann
[5] See: “Junk Jumpers: The Era of Return-Free Risk“, Acting-man.com
[6] It was lowered from 1.75% to 1.25% on 1.1.2015
[7] As of 25 May 2015
[8] See: ”Pension funds seek riskier, illiquid bets to make returns they need”, Reuters, March 2015
[9] “Frontier markets” are countries with high growth rates, which have however not yet reached the status of “emerging market”. At the moment frontier markets e.g. comprise Algeria, Mocambique, Tunisia, Bangladesh or Colombia.
[10] In light of the recent rally in the dollar, these bonds have become a good sight riskier.
[11] See: “Theo Waigel gibt dem Euro noch weitere 400 Jahre”, Die Welt
[12] Note: Carl Menger had already stressed causality in terms of economic laws, thus the very first sentence in his revolutionary work “Principles of Economics” is: “All things are subject to the law of cause and effect. This great principle knows no exception, and we would search in vain in the realm of experience for an example to the contrary.”
[13] „Ce qu’on voit et ce qu’on ne voit pas”, Frédéric Bastiat
[14] See: “In Gold we Trust“ 2014, p. 33-34
[15] See: „Wenn Menschen zu Ratten werden“, Linus Huber („When men become rats“)
[16] See: „Ein Staatsgeldsystem lädt Regierungen immer zum Betrug ein“, Hubert Milz, Ludwig von Mises Institut Deutschland (“A state money system always invites governments to commit fraud”)
[17] See: “Cantillon Effect describes the uneven distribution of newly created money”, In Gold We Trust, 2013.
[18] “Socialism” (1922), part II, p. 460-462, Ludwig von Mises
[19] See: “Man, Economy, and State with Power and Market”, p. 515, Murray N. Rothbard
[20] See: „Banken liquidieren“, Mayers Weltwirtschaft, FAZ (“Liquidating banks”)
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