CHAPTER 4

Testing the Limits of
Monetary Policy

From Risk-Free Interest to Interest-Free Risk

Gold-Backed Currencies

In 1694, the Bank of England (“BOE”) was created and given the responsibility to print notes and back them with gold, becoming the first effort toward independent monetary policy. The BOE was designed to maintain the nation’s peg to the gold standard and to trade in a narrow band with other gold-backed currencies.

Over time, other central banks were created and expanded their responsibilities to become the lender of last resort to banks during liquidity crises. The metallic currency system evolved to incorporate paper money as a convenient form of legal tender, but always within the bounds of the gold standard, which provided a physical anchor and prevented dilution via printing.

Ben Bernanke, in his book “Great Depression” argues that the world depression was partially caused by a “structurally flawed and poorly managed international gold standard.” In his view, what was initially a mild deflationary process began to snowball when the banking and currency crises of 1931 instigated an international “scramble for gold.” Sterilization of gold inflows by surplus countries (the United States and France), substitution of gold for FX reserves, and runs on commercial banks all led to increases in the gold backing of money, and consequently to sharp unintended declines in national money supplies.

In Ben Bernanke’s opinion, effective international cooperation could have permitted a worldwide monetary expansion despite gold standard constraints, but disputes over World War I reparations and war debts, and the insularity and inexperience of the Federal Reserve, among other factors, prevented the monetary expansion to happen. As a result, individual countries could only escape the deflationary vortex by unilaterally abandoning the gold standard and re-establishing domestic monetary stability.

In 1933, the United States decided to go off the gold standard. Anyone holding significant amounts of gold was mandated to exchange it for the existing fixed price of U.S. dollars. Gold was no longer considered legal tender, and the U.S. Federal Reserve would no longer redeem gold on demand. The dollar was allowed to float freely on FX markets with no guaranteed price in gold.

In 1934, the United States Gold Reserve Act required that all gold held by the Federal Reserve be surrendered and vested in the sole title of the U.S. Treasury and outlawed most private possession of gold, forcing individuals to sell it to the Treasury, who stored it in Fort Knox and other locations.

During the following years, the lack of cooperation among countries within what was an increasingly global and complex financial system led to competitive devaluation of currencies and imbalances, which had been compounded by the World Wars.

In 1944, at Bretton Woods, as a result of the collective conventional wisdom, representatives from all the leading allied nations collectively favored a regulated system of fixed exchange rates, indirectly disciplined by a U.S. dollar tied to gold—a system that relied on a regulated market economy with tight controls on the values of currencies. Flows of speculative international finance were curtailed by shunting them through and limiting them via central banks. This meant that international flows of investment went into foreign direct investment (such as construction of factories overseas) rather than international currency manipulation or bond markets. Although the national experts disagreed to some degree on the specific implementation of this system, all agreed on the need for tight controls.

In 1971, President Richard Nixon unilaterally put an end to the direct convertibility of the U.S. dollar to gold, ending the Bretton Woods system of international financial exchange. A negative balance of payments, growing public debt incurred by the Vietnam War and Great Society programs, and monetary inflation by the Federal Reserve caused the dollar to become increasingly overvalued. The drain on U.S. gold reserves culminated with the London Gold Pool collapse in March 1968, and by 1970, the United States had seen its gold coverage deteriorate from 55 to 22 percent. This, in the view of neoclassical economists, represented the point where holders of the dollar had lost faith in the ability of the United States to cut budget and trade deficits.

President Nixon’s decision was taken without consulting members of the international monetary system or even his own State Department, and was soon dubbed the Nixon Shock.

From Conventional to Unconventional to No Limits

During normal times the central bank can manage liquidity requirements and pursue its primary objective of price stability by steering the level of the key interest rates, known as conventional monetary policy.

On the other hand, during abnormal times, Central Banks have additional policy measures at their disposal, which include bringing short-term interest rates to zero, introducing guidance of medium to long-term interest rate expectations, expanding the size and changing the composition of the central bank’s balance sheet, introducing negative interest rates, and even giving money away via the so-called “helicopter money,” all of which are designed to help improve financing conditions and to enhance a credit transmission process that may be significantly impaired.

As discussed in the Lehman Squared investment thesis section, the acronyms are mechanisms that “lend a lot of money, to the wrong people, in the wrong size, and at the wrong price.”

Quantitative Easing

The first one of the acronyms, QE, defines the process whereby Central Banks expand their balance sheets by buying longer-term government bonds from banks.

QE has a dual objective of bringing down long-term yields in corporate bonds and stimulating longer-term investments and aggregate demand, both of which support the objective of price stability.

The effectiveness of QE depends on the ability and willingness of banks to pass on the additional liquidity to the nonfinancial sector.

In addition, QE programs run the risk of accumulating significant losses for the Central Bank, creating concerns about the balance sheet and financial independence, which seriously impede monetary policy. In Europe, these policies need to be mindful of the Treaty requirements relating to the prohibition of monetary financing.

The U.S. Federal Reserve gained significant first mover advantage adopting QE after Lehman 1.0. Europe and Japan were slow to react and would pay the consequences via much stronger EUR and JPY versus the USD and the CNY. The European crisis that followed a few years later was not a coincidence. Mario Draghi was late to react, but he did it with enormous determination.

The Left Pocket Lends to the Right Pocket

Unconventional monetary policy has enabled the Central Bank (the left pocket) to print and lend money to the Government (the right pocket), a process that questions key basic principles of fiat currencies: Central Bank independence and the risk of Monetary Financing.

Quis custodiet ipsos custodes? Who polices the police, I wonder. A dynamic I discuss in detail in the Lehman Squared section.

Qualitative Easing

Another acronym, “QQE” refers to the Quantitative and Qualitative Easing, which includes “interest rate guidance.” The Federal Reserve introduced “the dots,” an ingenious communication process that indicated the expectations for forward interest rates by key Fed officials, an effective way to try to bring down and flatten the long-end of the yield curve.

Indirect Quantitative/Credit Easing

The list of acronyms continues with “LTRO,” Long-Term Repurchase Obligations. A policy designed to increase the size of the balance sheet by lending to banks at longer maturities against collateral, which includes assets whose markets are temporarily impaired.

The LTRO program was a stroke of genius by the European Central Bank, which achieved a triple objective:

First, provide much needed funding to European Government bonds, some of which on the brink of collapse at the time.

Second, provide much needed help to the European Banks, who had access to liquidity and a risk-free arbitrage whereby they could buy government bonds financed by cheap debt, and capture a healthy spread.

Third, squeeze all the speculative shorts that had been betting against the European Government bonds and the Euro.

Mario Draghi’s legend continued to grow.

Negative Interest Rates

The introduction of negative interest rates was a game changer that broke the theoretical ceiling imposed by the Zero Interest Rate Policy (“ZIRP”).

Negative interest rates have changed the rules of asset valuation, breaking the theoretical ceiling in prices (a zero coupon bond can now trade above par), squeezing-out shorts, squeezing-in underweight positions, effectively perpetuating the bubble in fixed income.

Tax on Cash

Another interpretation of negative interest rates is some form of tax on cash. Clearly, it is very challenging for Central Banks to impose such tax on notes and coins. It is however much easier to apply on bank account balances, on digital money.

Digital Money

The convenience of digital money (with credit cards, PayPal, Apple Pay, etc.) is reducing the need and appeal of paying with cash. An unstoppable trend that puts policies that tax cash, such as negative interest rates, on a silver tray for Central Banks.

Prohibition of Cash

In my view it is just a matter of time before cash disappears. The rationale is clear: avoid tax evasion and illegal activities. The process has already started with the elimination of high denomination notes and introducing legal limits on cash payments.

Virtual Money

Technological developments go further and are supporting the development of virtual currencies such as Bitcoin. I recognize the transformational forces that disrupt the payments and banking industry, but I am very skeptical about the role as a “store of value” and “money.” As the world looks for alternatives for fiat currencies, my faith is in gold, not in algorithms.

From Cash Is King to Cash Is Trash

The aggressive policies introduced by the main Central Banks dramatically transformed the perception of cash from “cash is king” in the aftermath of Lehman 1.0, to “cash is trash” as the monetary snowball has pushed interest rates into negative territory.

Direct Credit Easing

The less known acronym, HGCB QE, High Grade Corporate Bond Quantitative Easing, a natural expansion of QE, but applied to nongovernment bonds. Following the mixed success of negative interest rates and the currency wars truce that followed the G20 meetings in Shanghai, the European Central Bank decided to expand QE to high-grade corporate credit in an effort to disintermediate banks, directly addressing liquidity shortages and bringing down credit spreads across commercial paper, corporate bonds, and asset-backed securities.

Yet another major win for Mario Draghi.

Yield Curve Control

This acronym has been coined in Japan. YCC, Yield Curve Control, describes the direct targeting of long-term interest rates (in this case the 10-year) in Japanese Government bonds (JGB).

Yet another creative way to expand the control of long-term interest rates. To achieve that, the BOJ quietly and conveniently removed the restrictions on the duration of its balance sheet, which is yet another step in the direction of “QE infinity” that reinforces the belief (in my view misconception) that Central Banks are in full control.

Something will eventually give. In my view, the JPY has the potential to depreciate very substantially over the medium term. A devaluation that would be welcomed by the Japanese Government, but in my view has the potential to become a “be careful what you wish for” situation, which will enhance currency wars and global imbalances.

Helicopter Money

Already happening, although in a small scale, for now. Helicopter money refers to money that is given (not lent) for consumption purposes. For example, student grants, cash for childcare, cash for elderly care. It is an incentive from the government, that is:

In the current environment, there is a risk that helicopter money could be financed by Central Banks forgiving the debt of governments, known as monetary financing. Following QE, Central Banks have extensive amount of government debt in their balance sheets.

Debt forgiveness would be very inflationary, as the assets in the Central Bank balance sheet are written down to zero, diluting the value of the paper currency sitting on the liability side against them.

The Frog in Boiling Water

Central Banks tend to have objectives that combine some form of price stability (such as inflation target) and growth (such as achieve full employment). The best case scenario is to fulfill potential in the economy, as close to full employment as possible, as close to the inflation targets as possible. A fine balancing act.

The magic inflation target tends to be 2 percent, which I would describe as a “the frog in the boiling water” policy: small enough to be contained and pass unnoticed in the short term, and large enough to compound very quickly and erode government debt liabilities in the long term.

A compound inflation rate of 2 percent means $1.02 in one year, $1.219 after 10 years, $1.486 after 20 years (worth noting how the interest on interest compounds as 2 percent linear without compounding would be $1.40), and if we continue would be $2.69 after 50 years, well inside an average lifetime.

The Wealth Effect

In addition to diluting the liabilities, inflation creates the so-called wealth effect by which is the change in spending that accompanies a change in perceived wealth.

	Conventional	Unconventional	“No Limits”
Short term	Controlled by Central Bank Money Supply Short-Term Target Rates	Controlled by Central Bank Zero Interest Rate Policy (ZIRP)	Controlled by Central Bank Negative Interest Rates Helicopter Money Prohibit Cash?
Long term	Not Controlled by Central Bank Credit Risk Government Inflation expectations	Controlled by Central Bank Government Bond Quantitative Easing (QE), Long Term Repurchase Obligation (LTRO) Qualitative Easing (dots, QQE)	Controlled by Central Bank Yield Curve Control (YCC) Corporate Bond “QE” Public Equity Purchases by Central Bank

The Law of Diminishing Returns

The U.S. Federal Reserve enjoyed a first-mover advantage with the first round of QE, known as “QE1.” Encouraged by the success of the program, the perceived fragility of the recovery, and a range of deflationary forces, the U.S. Federal Reserve embarked upon subsequent programs.

The success of the second program, known as “QE2,” was less obvious. Indeed, in my opinion it was marginal.

The third program, faced with the law of diminishing returns, which implied “greater volumes for smaller returns,” was an open-ended one known as “QE Infinity.” The determination of Central Banks was once again proven. The motto “never bet against a Central Banker” reinforced. The impact however was somewhat muted.

In my opinion QE1 was needed, QE2 was justified, and QE3 was a mistake, as it reinforced the belief in the Central Bank put, incentivizing the wrong behaviors, and forcing other Central Banks, such as the ECB and BOJ, to defend themselves with even more aggressive measures.

Currency Wars

Central Banks have always positioned QE as a domestic policy (reduce long-term yields borrowing costs and improve the credit transmission process), but in practice it is also a powerful foreign policy measure via the competitive depreciation of the currency.

The actions from the U.S. Federal Reserve had a direct one-for-one impact on currencies that were pegged to it, such as the Chinese Yuan (CNY, also known as Renminbi RMB). As a result, the competitive devaluation of the USD implied a competitive devaluation of the CNY (a currency arguably already too cheap), which increased their competitiveness against Europe and Japan.

Initially, the ECB, led by the then President Jean-Claude Trichet, was the “good kid on the block” and maintained course with conventional monetary policies. The widening of the interest rate differential between the United States and Europe resulted in a steep appreciation of the EUR, which reached highs close to 1.60 in 2009. Too much for Europe, who would pay in the following years and would lead to an aggressive response. Monetary policy is contagious.

The Theory of Monetary Relativity

Central Banks don’t act in isolation. Their decisions factor-in many nondomestic factors, such as exchange rates or interest rate differentials. Among all, the monetary policy of the United States is the single-most important driver of global monetary policy. Everyone else’s monetary policy is run relative to the Fed. Monetary policy is a relative game.

In fact, I believe the primary reason why Europe and Japan adopted negative interest rates was to create a positive interest rate differential versus the United States. If USD rates had stayed at 2 percent we would have never seen negative interest rates. A direct implication of what I call the “theory of monetary relativity.”

The Duration Bubble

Faced with low or negative interest rates and yields for cash and “risk-free” government bonds, savers and investors have been incentivized—if not forced—to take more risk to generate the fixed income they need. A dynamic that has led to a monetary snowball of lending for longer and longer maturities to generate lower and lower yields: a duration bubble.

Savers who had traditionally been lending for one to three years are today lending for ten, twenty, or even further in order to lock in some positive yields, which is building significant duration risk in their portfolios.

Are investors fully aware of how much more incremental risk they are taking? I don’t think so.

The lack of awareness may turn into panic as and when interest rates start to move, as they may experience volatility that they don’t want, expect, not may be ready for.

We are witnessing the largest bubble in duration in history. At the time of writing, trillions of dollars of government and corporate bonds are trading at negative nominal yields, a new paradigm to the valuation of fixed income that the market seems to have accepted with complacency.

From Risk-Free Interest to Interest-Free Risk

Finance textbooks have traditionally referred to government bond yields as the risk-free interest rate. The idea is that governments will never default on their obligations because, at the end of the day, they can print paper money to repay their obligations. In Ben Bernanke’s words:

Under the new paradigm of negative yields, government bonds are earning interest on their borrowings. That is, the lender is paying interest to the borrower (the world in reverse, as in a normal world, the borrower should be paying interest to the lender).

As a consequence, we have transitioned from a world of “risk-free interest” to “interest-free risk.” An absurdity that in my view will implode sooner or later, but the market is currently accepting with complacency.

The Theory of Inflation Relativity

Inflation is relative. It is not absolute. Inflation depends on many factors, such as the country we live in (Japan is currently fighting deflation while Venezuela is fighting hyperinflation), our base currency (inflation and deflation can be imported or exported via the FX channel), the stage in our lives, and lifestyle (a family with young children and no property has a very different inflation basket and risk to inflation than a retired elderly person who owns his own house), just to name a few examples.

Despite being relative, we however tend to generalize and model inflation via single indicators such as Consumer Price Index (“CPI”) or Produce Price Index (“PPI”) that may give the impression that inflation is an absolute and universal, which is not the case. The convenience of having inflation benchmarks give the government’s significant power, as they can conveniently adjust composition and weightings of the inflation basket to achieve their own objectives, and explains why many of these indicators conveniently exclude energy prices or housing, despite being major components of our true inflation basket.

Inflation, Deflation, or Stagflation?

The global financial crisis of 2008 and the lessons learnt during the Great Depression and Japan, the U.S. Federal Reserve engaged in monetary expansion without precedents. The threat of the new nemesis, deflation, was considered as serious as the threat from the traditional and better known enemy: inflation.

Faced with the risk of death by “freezing” (deflation), the Central Banks have undertaken unconventional measures that would raise the risk of death by “boiling” (inflation). Following the lead from Ben Bernanke and the U.S. Federal Reserve, most Central Banks within the G10 leading global economies adopted unconventional expansive policies via contagion. The battle against deflation had turned global.

The lead came from Ben Bernanke, who earned his nickname of “helicopter Ben” following a famous speech in November 2002 (prior to his appointment as Chairman of the U.S. Fed) at the National Economists Club in Washington, D.C. where he referred to economist Milton Friedman’s famous “helicopter drop” of money as a viable solution for deflation.

There are, however, second-order and third-order effects in the battle against deflation that complicate things further. For example, financial inflation via monetary policy without limits can lead to speculation, gross misallocation of capital, overcapacity, and other forms of bubbles, which as/when they burst can be extraordinarily disinflationary, negating any growth and inflationary benefits. A path-dependent process that could lead to a worst-case scenario of persistent high inflation combined with high unemployment, and stagnant demand, known as stagflation.

Energy Deflation

The collapse in energy prices and The Flattening of the Energy World have been notable deflationary forces (and a convenient excuse) for the European and Japanese Central Banks to join the monetary party started in the United States, and push ahead with their own monetary experiments.

The Flattening of the Energy World investment thesis I presented in my first book continues to be validated by new evidence and data, and in my opinion, despite the efforts by OPEC and Russia (“ROPEC” as I like to call them) will continue to be the unstoppable trend toward more global, abundant, cleaner, and cheaper energy. Energy deflation will continue to be a key driver of monetary policy, global growth, and geopolitical risks for the foreseeable future.

Monetary Radiation: Cause and (Delayed) Effect

Originated in physics, the principle of causation is that every effect has a cause. Sometimes the effect can be observed immediately. Some other times, the effect can only be observed with a time lag, in some cases a very long time lag.

Sun radiation falls in the category of cause and delayed effect. We can spend the day happily in the sun, only feeling the effects during the night or many years later in the form of skin cancer.

Nuclear radiation is also another form of cause and delayed effect with devastating effects.

Monetary policy has a delayed effect. In a complex and interrelated world, it is not always obvious to see what caused what effects. Looking back, we can “connect the dots,” borrowing Steve Jobs’ famous lines. But it is possible that we may overexpose ourselves, creating problems later. This is known as “being behind the curve” in monetary policy, which introduces a sense of time and path dependency in monetary policy.

Kicking the Can Down Monetary Road

There is an almost philosophical debate behind monetary policy without limits. It is clear that the actions of the Central Banks helped avoid an even larger crisis in 2008. It is also clear that those same actions may be artificially inflating asset prices, leading to greater inequality. The rich (who own financial assets) get richer, and the poor (who don’t own financial assets) get poorer and lose purchasing power.

A generational debate that is leading to growing populism and protectionism, among other second-order and third-order unintended consequences of monetary inflation. More on this later.

The Point of No Return: BOJ JGB OMG

In my opinion, a country such as Japan has passed the point of no return in their monetary policy. As of December 2016, the Bank of Japan (BOJ) owned 41.3 percent of the total JGB market. The BOJ purchased 10 trillion yen during the month of November 2016 alone, which annualized implies at a pace of accumulation of over 13 percent per year. Fast forward two years of accumulation at the current pace and years, and the BOJ will own close to 70 percent of the outstanding JGB market. A situation I describe as BOJ, JGB, OMG (Bank of Japan, Japanese Government Bonds, Oh My God).

I refer to The Point of No Return to a situation when the addiction or dependency has reached such an extreme that the patient can no longer survive without the support. In the case of Japan, an effort to normalize monetary policy by hiking interest rates could lead to significant capital losses in investments and a large rise in debt servicing costs, which could contribute to a larger crisis.

As a result, I no longer believe that the JGB market will ever fail. It is much more likely that the “left pocket” (the Central Bank) will forgive the right pocket (the Government). A process called monetary financing, which would result in a significant devaluation of the Japanese Yen. More on this later.

Japan is in my view the most extreme example, but not the only one. In Europe, the situation is still under control, but at the time of writing, negative yields are a reality not only in the government bond market, but also in many short-term corporate debts. A situation that I call “flirting with the point of no return.”

China is in my view another major risk in the global financial system. In my article published at Spanish newspaper El Mundo titled “The great devaluation of China,” published early 2016, I analyzed the need and rationale for a major devaluation versus the USD. In my view, China is a strong candidate to adopt many of the unconventional monetary policies used in the West as and when required, which will exacerbate the currency wars and add significant deflationary pressures to the rest of the world. As the marginal consumer of many commodities, a 10 percent devaluation of the CNY has the potential to result in a 10 percent sell-off in USD-denominated commodity prices (so that CNY-denominated prices stay constant). Watch this space, because it is the epicenter of many of the global imbalances and possibly the next global crisis.

Emerging markets are in my view “caught between a rock and a hard place.” They have been major beneficiaries of the “yield-seeking bubble” as investors seek for income-generating alternatives in other markets. The hot money and speculative flows can be very distorting both on the way in and the way out, as we well know.

Central Bank Leadership Risk

The surge in duration risk has been extraordinary. Many investors have extended the average maturity of their bond portfolio in order to generate some positive yield, incurring a somewhat hidden risk: election risk.

What happens in Europe if Angela Merkel and Mario Draghi were not re-elected? What happens in Japan if Shinzo Abe and Haruhiko Kuroda were not re-elected? What if the newcomers were to unwind their policies? As described in the Point of No Return, perhaps the newcomers have no choice but to continue the current direction. We will find out in the not-too-distant future.

The Myth of Central Banks’ Infallibility

I have referred several times to the so-called “Central Bank Put,” the complacent belief (in my view misconception) that Central Banks are in full control and will continue to be in control no-matter-what.

The perception that Central Banks will keep interest rates low for the foreseeable future creates a very powerful, almost unstoppable, monetary snowball effect. The successes of the Central Bank feed on themselves and strengthen the perception of infallibility. More on this later.

Exit Strategy

Exit Plan A for Central Banks is to smoothly normalize monetary policy when the economy rebounds and inflationary prospects are back in line with the Central Bank’s price stability objective.

The normalization requires some careful planning and execution. First, devising the right sequence for the phasing out of the conventional and unconventional monetary policy accommodation. Second, deciding on the speed at which the unconventional accommodation is removed. A careful balance, as withdrawing liquidity in such large quantities too quickly would trigger a substantial contractionary monetary policy shock whereby policymakers risk choking off the economic recovery or imposing heavy capital losses on lenders. On the other hand, keeping such exceptional measures in place for too long might aggravate the upside risks to price stability and plant the seeds for future imbalances in financial markets. Getting the timing right in withdrawing additional liquidity is likely to be decisive in order to ensure a noninflationary recovery. Generally speaking, the lower the reversibility of the nonconventional operations, the larger the risk of being behind the curve when the macroeconomic and financial market situation improves.

Ceteris paribus, the unwind of unconventional policies by Central Banks implies the liquidation of massive holdings of government bonds and other assets, which investors and savers would need to buy in order to keep the level of government debt constant. Effectively a reversal of the past few years, which in my view could expose the duration bubble and other forms of financial inflation that have been built in the system.

Alternatively, the Government could buy-back its outstanding debt prior to the maturity. Wishful thinking in my view.

Exit Plan B for Central Banks is to maintain by current stimuli by holding the government bonds to expiry. At that point in time, the Government may decide whether to repay or refinance the debt. Plan B is identical to Plan A, except that it gives the Central Bank and the Government plenty of time. The challenges remain the same though.

Exit Plan C for Central Banks is to forgive the debt to the Governments. A process that goes against the principle of independence of Central Banks and, as discussed earlier in the section “BOJ JGB OMG,” could lead to monetary financing as the “left pocket” (the Central Bank) forgives the debt of the right pocket (the Government). As a believer of the Austrian School of Economics, or “no free-lunch economics” as I call it, something would give and in my view the imbalances would manifest via a significant devaluation of the currency, which would revive and exacerbate currency wars. A monetary supercycle in the making. More on this shortly.