The End of Monetary Policy

Thoughts from the Frontline: The End of Monetary Policy

By John Mauldin

We are the hollow men
We are the stuffed men
Leaning together
Headpiece filled with straw. Alas!
Our dried voices, when
We whisper together
Are quiet and meaningless
As wind in dry grass
Or rats’ feet over broken glass
In our dry cellar…

This is the way the world ends
This is the way the world ends
This is the way the world ends
Not with a bang but a whimper.

            –  T. S. Eliot, “The Hollow Men”

What we may be witnessing is not just the end of the Cold War, or the passing of a particular period of postwar history, but the end of history as such: that is, the end point of mankind’s ideological evolution and the universalization of Western liberal democracy as the final form of human government. This is not to say that there will no longer be events to fill the pages of Foreign Affairs' yearly summaries of international relations, for the victory of liberalism has occurred primarily in the realm of ideas or consciousness and is as yet incomplete in the real or material world. But there are powerful reasons for believing that it is the ideal that will govern the material world in the long run.

– Francis Fukuyama, The End of History and the Last Man

Francis Fukuyama created all sorts of controversy when he declared “the end of history” in 1989 (and again in 1992 in the book cited above). That book won general applause, and unlike many other academics he has gone on to produce similarly thoughtful work. A review of his latest book, Political Order and Political Decay: From the Industrial Revolution to the Globalisation of Democracy, appeared just yesterday in The Economist. It’s the second volume in a two-volume tour de force on “political order.”

I was struck by the closing paragraphs of the review:

Mr. Fukuyama argues that the political institutions that allowed the United States to become a successful modern democracy are beginning to decay. The division of powers has always created a potential for gridlock. But two big changes have turned potential into reality: political parties are polarised along ideological lines and powerful interest groups exercise a veto over policies they dislike. America has degenerated into a “vetocracy”. It is almost incapable of addressing many of its serious problems, from illegal immigration to stagnating living standards; it may even be degenerating into what Mr. Fukuyama calls a “neopatrimonial” society in which dynasties control blocks of votes and political insiders trade power for favours.

Mr. Fukuyama’s central message in this long book is as depressing as the central message in “The End of History” was inspiring. Slowly at first but then with gathering momentum political decay can take away the great advantages that political order has delivered: a stable, prosperous and harmonious society.

While I am somewhat more hopeful than Professor Fukuyama is about the future of our political process (I see the rise of a refreshing new kind of libertarianism, especially among our youth, in both conservative and liberal circles, as a potential game changer), I am concerned about what I think will be the increasing impotence of monetary policy in a world where the political class has not wisely used the time that monetary policy has bought them to correct the problems of debt and market restricting policies. They have avoided making the difficult political decisions that would set the stage for the next few decades of powerful growth.

Make sure you get our new FREE eBook "Understanding Options"....Just Click Here!

So while the title of this letter, “The End of Monetary Policy,” is purposely provocative, the longer and more appropriate title would be “The End of Effective and Productive Monetary Policy.” My concern is not that we will move into an era of no monetary policy, but that monetary policy will become increasingly ineffective, so that we will have to solve our social and physical problems in a much less friendly economic environment.
In today’s Thoughts from the Frontline, let’s explore the limits of monetary policy and think about the evolution and then the endgame of economic history. Not the end of monetary policy per se, but its emasculation.

The End of Monetary Policy

Asset classes all over the developed world have responded positively to lower interest rates and successive rounds of quantitative easing from the major central banks. To the current generation it all seems so easy. All we have to do is ensure permanently low rates and a continual supply of new money, and everything works like a charm. Stock and real estate prices go up; new private equity and credit deals abound; and corporations get loans at low rates with ridiculously easy terms. Subprime borrowers have access to credit for a cornucopia of products.

What was Paul Volcker really thinking by raising interest rates and punishing the economy with two successive recessions? Why didn’t he just print money and drop rates even further? Oh wait, he was dealing with the highest inflation our country had seen in the last century, and the problem is that his predecessor had been printing money, keeping rates too low, and allowing inflation to run out of control. Kind of like what we have now, except we’re missing the inflation.

Let’s Look at the Numbers

The Organization for Economic Cooperation and Development has a marvelous website full of all sorts of useful information. Let’s start by looking at inflation around the world. This table is rather dense and is offered only to give you a taste of what’s available.



What we find out is that inflation is strikingly, almost shockingly, low. It certainly seems so to those of us who came of age in the ’60s and ’70s and who now, in the fullness of time, are watching aghast as stupendous amounts of various currencies are fabricated out of thin air. Seriously, if I had suggested to you back in 2007 that central bank balance sheets would expand by $7-8 trillion in the next half decade but that inflation would be averaging less than 2%, you would have laughed in my face.

Let’s take a quick world tour. France has inflation of 0.5%; Italy’s is -0.2% (as in deflation); the euro area on the whole has 0.4% inflation; the United Kingdom (which still includes Scotland) is at an amazingly low 1.5% for the latest month, down from 4.5% in 2011; China with its huge debt bubble has 2.2% inflation; Mexico, which has been synonymous with high inflation for decades, is only running in the 4% range. And so on. Looking at the list of the major economies of the world, including the BRICS and other large emerging markets, there is not one country with double digit inflation (with the exception of Argentina, and Argentina is always an exception – their data lies, too, because inflation is 3-4 times what they publish.) Even India, at least since Rajan assumed control of the Reserve Bank of India, has watched its inflation rate steadily drop.

Japan is the anomaly. The imposition of Abenomics has seemingly engineered an inflation rate of 3.4%, finally overcoming deflation. Or has it? What you find is that inflation magically appeared in March of this year when a 3% hike in the consumption tax was introduced. When government decrees that prices will go up 3%, then voilà, like magic, you get 3% inflation. Take out the 3% tax, and inflation is running about 1% in the midst of one of the most massive monetary expansions ever seen. And there is reason to suspect that a considerable part of that 1% is actually due to the ongoing currency devaluation. The yen closed just shy of 110 yesterday, up from less than 80 two years ago.

I should also point out that, one year from now, this 3% inflation may disappear into yesteryear’s statistics. The new tax will already be factored into all current and future prices, and inflation will go back to its normal low levels in Japan.

Inflation in the US is running less than 2% (latest month is 1.7%) as the Fed pulls the plug on QE. As I’ve been writing for … my gods, has it really been two decades?! – the overall trend is deflationary for a host of reasons. That trend will change someday, but it will be with us for a while.

Where’s my GDP?

Gross domestic product around the developed world ranges anywhere from subdued to anemic to outright recessionary:



The G-20 itself is growing at an almost respectable 3%, but when you look at the developed world’s portion of that statistic, the picture gets much worse. The European Union grew at 0.1% last year and is barely on target to beat that this year. The euro area is flat to down. The United Kingdom and the United States are at 1.7% and 2.2% respectively. Japan is in recession. France is literally at 0% for the year and is likely to enter recession by the end of the year. Italy remains mired in recession. Powerhouse Germany was in recession during the second quarter.

Let’s put those stats in context. We have seen the most massive monetary stimulation of the last 200 years in the developed world, and growth can be best described as faltering. Without the totally serendipitous shale oil revolution in the United States, growth here would be about 1%, or not much ahead of where Europe is today.

Demographics, Debt, Bond Bubbles, and Currency Wars

Look at the rest of the economic ecology. Demographics are decidedly deflationary. Every country in the developed world is getting older, and with each year there are fewer people in the working cohort to support those in retirement. Government debt is massive and rising in almost every country. In Japan and many countries of Europe it is approaching true bubble status. Anybody who thinks the current corporate junk bond market is sustainable is smoking funny smelling cigarettes. (The song from my youth “Don’t Bogart That Joint” pops to mind. But I digrass.)

We are seeing the beginnings of an outright global currency war that I expect to ensue in earnest in 2015. My co-author Jonathan Tepper and I outlined in both Endgame and Code Red what we still believe to be the future. The Japanese are clearly in the process of weakening their currency. This is just the beginning. The yen is going to be weakening 10 to 15% a year for a very long time. I truly expect to see the yen at 200 to the dollar somewhere near the end of the decade.

ECB head Mario Draghi is committed to weakening the euro. The reigning economic philosophy has it that weakening your currency will boost exports and thus growth. And Europe desperately needs growth. Absent QE4 from the Fed, the euro is going to continue to weaken against the dollar. Emerging-market countries will be alarmed at the increasing strength of the dollar and other developed world currencies against their currencies and will try to fight back by weakening their own money. This is what Greg Weldon described back in 2001 as the Competitive Devaluation Raceway, which back then described the competition among emerging markets to maintain the devaluation of their currencies against the dollar.

Today, with Europe and Japan gunning their engines, which have considerable horsepower left, it is a very competitive race indeed – and one with far reaching political implications for each country. As I have written in past letters, it is now every central banker for him or herself.

That Pesky Budget Thing

Developed governments around the world are running deficits. France will be close to a 4% deficit this year, with no improvement in sight. Germany is running a small deficit. Japan has a mind boggling 8% deficit, which they keep talking about dealing with, but nothing ever actually happens. How is this possible with a debt of 250% of GDP? Any European country with such a debt structure would be in a state of collapse. The US is at 5.8% and the United Kingdom at 5.3%, while Spain is still at 5.5%.

Let’s focus on the US. Everyone knows that the US has an entitlement driven spending problem, but very few people I talk with understand the true nature of the situation, which is actually quite dire, looming up ahead of us. In less than 10 years, at current debt projection growth rates, the third largest expenditure of the United States government will be interest expense. The other three largest categories are all entitlement programs. Discretionary spending, whether for defense or anything else, is becoming an ever smaller part of the budget. Social Security, Medicare, and Medicaid now command nearly two thirds of the national budget and rising. Ironically, polls suggest that 80% of Americans are concerned about the rising deficit and debt, but 69% oppose Medicare cutbacks, and 78% oppose Medicaid cutbacks.



At some point in the middle of the next decade, entitlement spending plus interest payments will be more than the total revenue of the government. The deficit that we are currently experiencing will explode. The following chart is what will happen if nothing changes. But this chart also cannot happen, because the bond market and the economy will simply implode before it does.



A Multitude of Sins

Monetary policy has been able to mask a multitude of our government’s fiscal sins. My worry for the economy is what will happen when Band-Aid monetary policy can no longer forestall the hemorrhaging of the US economy. Long before we get to 2024 we will have a crisis. In past years, I have expected the problems to come to a head sooner rather than later, but I have come to realize that the US economy can absorb a great deal of punishment. But it cannot absorb the outcomes depicted in those last two charts. Something will have to give.

And these projections assume there will be no recession within the next 10 years. How likely is that? What happens when the US has to deal with its imbalances at the same time Europe and Japan must deal with theirs? These problems are not resolvable by monetary policy.

Right now the markets move on every utterance from Janet Yellen, Mario Draghi, and their central bank friends. Central banking dominates the economic narrative. But what happens to the power of central banks to move markets when the fiscal imperative overcomes the central bank narrative?

Sometime this decade (which at my age seems to be passing mind-numbingly quickly) we are going to face a situation where monetary policy no longer works. Optimistically speaking, interest rates may be in the 2% range by the end of 2016, assuming the Fed starts to raise rates the middle of next year and raises by 25 basis points per meeting. If we were to enter a recession with rates already low, what would dropping rates to the zero bound again really do? What kind of confidence would that tactic actually inspire? And gods forbid we find ourselves in a recession or a period of slow growth prior to that time. Will the Fed under Janet Yellen raise interest rates if growth sputters at less than 2%?

An even scarier scenario is what will happen if we don’t deal with our fiscal issues. You can’t solve a yawning deficit with monetary policy.

Further, at some point the velocity of money is going to reverse, and monetary policy will have to be far more restrained. The only reason, and I mean only, that we’ve been able to get away with such a massively easy monetary policy is that the velocity of money has been dropping consistently for the last 10 years. The velocity of money is at its lowest level since the end of World War II, but it is altogether possible that it will slow further to Great Depression levels.

When the velocity of money begins to once again rise – and in the fullness of time it always does – we are going to face the nemesis of inflation. Monetary policy during periods of inflation is far more constrained. Quantitative easing will not be the order of the day.

For Keynesians, we are in the Golden Age of Monetary Policy. It can’t get any better than this: free money and low rates and no consequences (at least no consequences that can be seen by the public). This will end, as it always does…..

Not with a Bang but a Whimper

Will we see the end of monetary policy? No, policy will just be constrained. The current era of easy monetary policy will not end (in the words of T.S. Eliot) with a bang but a whimper. Janet or Mario will walk to the podium and say the same words they do today, and the markets will not respond. Central banks will lose control of the narrative, and we will have to figure out what to do in a world where profits and productivity are once again more important than quantitative easing and monetary policy.

You need to be thinking about how you will react and how you want to protect your portfolios in such a circumstance. Even if that volatility is years off, “war-gaming” how you will respond is an important exercise. Because it will happen, unless Congress and the White House decide to resolve the fiscal crisis before it happens. Calculate the odds on that happening and then decide whether you need to have a plan.

Unless you think the bond market will continue to finance the US government through endless deficits (as so far has happened in Japan), then you need to start to contemplate the end of effective monetary policy. I would note that, even in Japan, monetary policy has not been effective in restarting an economy. It is a quirk of Japan’s social structure that the Japanese have devoted almost their entire net savings to government bonds. As the savings rate there is getting ready to turn negative, we are going to see a very different economic result. Japan with the yen at 200 and an even older society will look a great deal different than the country does today.

Current market levels of volatility and complacency should be seen as temporary. Plan accordingly.

Washington DC, Chicago, Athens (Texas), and Boston

I am in Washington DC as you read this. I have a few meetings set up, as well as a speaking engagement, and then I’ll return home to meet with my business partners at Mauldin Economics later in the week. In the middle of October I will go to Chicago for a speech, fly back to a meeting with Kyle Bass and his friends at the Barefoot Ranch in Athens, Texas, and then fly out to Boston to spend the weekend with Niall Ferguson and some of his friends. I am sure I will be happily surfing mental stimulus overload that week.

Next weekend (October 4) is my 65^th birthday. I had originally thought I would do a rather low key event with family; but my staff, family, and friends have different plans. I’m not really supposed to know what’s going on and don’t really have much of an idea as I am not allowed around planning sessions, but it sounds like fun.

I am walking on legs that feel like Jell-O, as it was “legs day” yesterday, working out with The Beast. My regular workout partner couldn’t make it, so he was able to focus on exhausting me to the maximum extent possible. I’ve never been all that athletic. As a kid, for the most part I was not allowed to participate in PE due to some physical limitations (which fortunately went away as I grew older).

I became a true geek. Not that that is all bad: it has served me rather well later in life. Geeks rule. It wasn’t until I was in my mid 40s that I began to go to the gym on more than a haphazard basis. And I must confess that I was a typical male in that I focused on my upper body as opposed to my legs and abdominals. That oversight is catching up with me now. The Beast is forcing me to devote more time to my legs and core. Much better for me as I approach the latter half of my 60s, but it’s painful to realize the cost of my negligence.

In the last five or six years my travel has reduced my gym time, or at least that’s my excuse. For whatever reason, my travel has been reduced for the last two months, so I’m getting much more time in the gym, and my workouts are more well rounded. I typically try to do at least another 30 minutes of cardio after our training sessions, even if the session was based around cardio. Except on leg days. There’s nothing left for extra walking or cycling after leg days.

I share this because I want you to understand that working out is just as important as your investment strategy. I fully intend to be going strong for a very long time. But that doesn’t happen (at least as easily) if you lose your legs. As much as I hate leg days, I probably need those workouts more than any others.

It’s time to hit the send button. I hear kids and grand kids gathering in the next room. That’s something else that is just as important as investment strategy. You have a great week.

Your thinking about how to profit from the coming crisis analyst,

John Mauldin

The article Thoughts from the Frontline: The End of Monetary Policy was originally published at mauldineconomics.com.

Make sure you get our new FREE eBook "Understanding Options"....Just Click Here!

Europe Takes the QE Baton

By John Mauldin

If the wide, wide world of investing doesn’t seem a little strange to you these days, it can only be because you’re not paying attention. If you’re paying attention, strange really isn’t the word you’re probably using in your day-to-day investing conversations; it may be more like weird or bizarre. It increasingly feels like we’re living in the world dreamed up by the creators of DC Comics back in the 1960s, called Bizarro World. In popular culture "Bizarro World" has come to mean a situation or setting that is weirdly inverted or opposite from expectations.

As my Dad would say, “The whole situation seems about a half-bubble off dead center” (dating myself to a time when people used levels that actually had bubbles in them). But I suppose that now, were he with us, he might use the expression to refer to the little bubbles that are effervescing everywhere. In a Bizarro French version of very bubbly champagne (I can hardly believe I’m reporting this), the yield on French short term bonds went negative this week. If you bought a short-term French bill, you actually paid for the privilege of holding it. I can almost understand German and Swiss yields being negative, but French?

And then Friday, as if to compound the hilarity, Irish short term bond yields went negative. Specifically, roughly three years ago Irish two year bonds yielded 23.5%. Today they yield -0.004%! In non-related un-news from Bizarro World, the Spanish sold 50-year bonds at 4% this week. Neither of these statistics yielded up by Bloomberg makes any sense at all. I mean, I understand how they can technically happen and why some institutions might even want 50-year Spanish bonds. But what rational person would pay for the privilege of owning an Irish bond? And does anyone really think that 4% covers the risk of holding Spanish debt for 50 years? What is the over-under bet spread on the euro’s even existing in Spain in 50 years? Or 10, for that matter?

Don't miss a single free Trading webinar, tonight "Beating the Market Makers Trading Weekly Options"

We might be able to lay the immediate, proximate cause of the bizarreness at the feet of ECB President Mario Draghi, who once again went all in last Monday for his fellow teammates in euroland. He gave them another round of rate cuts and the promise of more monetary easing, thus allowing them to once again dodge the responsibility of managing their own economies. The realist in me scratches my already well scratched head and wonders exactly what sort of business is going to get all exuberant now that the main European Central Bank lending rate has dropped to 0.05% from an already negligible 0.15%. Wow, that should make a lot of deals look better on paper.

We should note that lowering an already ridiculously low lending rate was not actually Signor Draghi’s goal. This week we’ll look at what is happening across the pond in Europe, where the above-mentioned negative rates are only one ingredient in a big pot of Bizarro soup. And we’ll think about what it means for the U.S. Federal Reserve to be so close to the end of its quantitative easing, even as the ECB takes the baton to add €1 trillion to the world’s liquidity. And meanwhile, Japan just keeps plugging away. (Note: this letter will print longer than usual as there are a significant number of graphs. Word count is actually down, for which some readers may be grateful.)

But first, I’m glad that I can finally announce that my longtime friend Tony Sagami has officially come to work for us at Mauldin Economics. Tony has been writing our Yield Shark advisory since the very beginning, but for contractual reasons we could not publicize his name. I will say more at the end of the letter, but for those of you interested in figuring out how to increase the yield of your investments, Tony could be a godsend.

The Age of Deleveraging

Extremely low and even negative interest rates, slow growth, unusual moves by monetary and fiscal authorities, and the generally unseemly nature of the economic world actually all have a rational context and a comprehensible explanation. My co-author Jonathan Tepper and I laid out in some detail in our book End Game what the ending of the debt supercycle would look like. We followed up in our book Code Red with a discussion of one of the main side effects, which is a continual currency war (though of course it will not be called a currency war in public). Both books stand up well to the events that have followed them. They are still great handbooks to understand the current environment.

Such deleveraging periods are inherently deflationary and precipitate low rates. Yes, central banks have taken rates to extremes, but the low rate regime we are in is a natural manifestation of that deleveraging environment. I’ve been doing a little personal research on what I was writing some 15 years ago (just curious), and I came across a prediction from almost exactly 15 years ago in which I boldly and confidently (note sarcasm) projected that the 10-year bond would go below 4% within a few years. That was a little edgy back then, as Ed Yardeni was suggesting it might go below 5% by the end of the following year. That all seems rather quaint right now. The Great Recession would send the 10-year yield below 2%.

Sidebar: The yield curve was also negative at the time, and I was calling for recession the next year. With central banks holding short-term rates at the zero bound, we no longer have traditional yield curve data to signal a recession. What’s a forecaster to do?

I was not the only one talking about deflation and deleveraging back then. Drs. Gary Shilling and Lacy Hunt (among others) had been writing about them for years. The debt supercycle was also a favorite topic of my friend Martin Barnes (and prior to him Tony Boeckh) at Bank Credit Analyst.

Ever-increasing leverage clearly spurs an economy and growth. That leverage can be sustained indefinitely if it is productive leverage capable of creating the cash flow to pay for itself. Even government leverage, if it is used for productive infrastructure investments, can be self sustaining. But ever increasing leverage for consumption has a limit. It’s called a debt supercycle because that limit takes a long time to come about. Typically it takes about 60 or 70 years. Then something has to be done with the debt and leverage. Generally there is a restructuring through a very painful deflationary bursting of the debt bubble – unless governments print money and create an inflationary bubble. Either way, the debt gets dealt with, and generally not in a pleasant manner.

We are living through an age of deleveraging, which began in 2008. Gary Shilling summarized it this week in his monthly letter:

We continue to believe that slow worldwide growth is the result of the global financial deleveraging that followed the massive expansion of debt in the 1980s and 1990s and the 2008 financial crisis that inevitably followed, as detailed in our 2010 book, The Age of Deleveraging: Investment strategies for a decade of slow growth and deflation. We forecast back then that the result in the U.S. would be persistent 2% real GDP growth until the normal decade of deleveraging is completed. Since the process is now six years old, history suggests another four years or so to go.

We’ve also persistently noted that this deleveraging is so powerful that it has largely offset massive fiscal stimuli in the form of tax cuts and rebates as well as huge increases in federal spending that resulted in earlier trillion dollar deficits. It has also swamped the cuts in major central bank interest rates to essentially zero that were followed by gigantic central bank security purchases and loans that skyrocketed their balance sheets.  Without this deleveraging, all the financial and monetary stimuli would surely have pushed real GDP growth well above the robust 1982–2000 3.7% average instead of leaving it at a meager 2.2% since the recovery began in mid-2009.

The problems the developed world faces today are the result of decisions made to accumulate large amounts of debt over the past 60 years. These problems cannot be solved simply by the application of easy-money policies. The solution will require significant reforms, especially labor reforms in Europe and Japan, and a restructuring of government obligations.

Mohammed El-Erian called it the New Normal. But it is not something that happens for just a short period of time and then we go back to normal. Gary Shilling cites research which suggests that such periods typically last 10 years – but that’s if adjustments are allowed to happen. Central banks are fighting the usual adjustment process by providing easy money, which will prolong the period before the adjustments are made and we can indeed return to a “normal” market.

How Bizarre Is It?

We are going to quickly run through a number of charts, as telling the story visually will be better than spilling several times 1000 words (and easier on you). Note that many of these charts display processes unfolding over time. We try to go back prior to the Great Recession in many of these charts so that you can see the process. We are going to focus on Europe, since that is where the really significant anomalies have been occurring.

First, let’s look at what Mario Draghi is faced with. He finds himself in an environment of low inflation, and expectations for inflation going forward are even lower. This chart depicts inflation in the two main European economies, Germany and France.



Note too that inflation expectations for the entire euro area are well below 1% for the next two years – notwithstanding the commitment of the European Central Bank to bring back inflation.



But as I noted at the beginning, ECB policy has already reached the zero bound. In fact the overnight rate is negative, making cash truly trash if it is deposited with the ECB.



With inflation so low and a desperate scramble for yield going on in Europe, rates for 10-year sovereign debt have plummeted. It is not that Italy or Spain or Greece or Ireland or France is that much less risky than it was five years ago.

Note that banks can get deposits for essentially nothing. They can lever those deposits up (30 or 40 times), and the regulators make them reserve no capital against investments made in sovereign debt. Even after their experience with Greek debt, they essentially claim that there is no risk in sovereign debt. If your bank’s profits are being squeezed and it’s hard to find places to put money to work in the business sector, then the only game in town is to buy sovereign debt, which is what banks are doing. Which of course pushes down rates. Low interest rates in Europe are as much a result of regulatory policy as of monetary policy.

Next is a chart of 10 year bond yields. We’ve also included the US, Japan, and Switzerland. Note that Japan and Switzerland are in the 50-basis point range. (Japan is at 0.52%, and Switzerland is at 0.45%). Italy and Spain now have 10 year bond yields below that of the US.



The following chart is a screenshot of a table from Bloomberg, listing 10 year bond yields around Europe. Note that Greece is at 5.48%. Hold that thought while you look at the table.



This next chart requires a minute or two of analysis, and looking at it in black and white probably won’t work. Essentially, this is the spread of the yields of 10-year bonds of various European countries over German bunds. Note that only two years ago Greek debt paid 25% per year more than German debt did. Anyone who bought Greek debt when that country was busy defaulting has scored big. (While I probably take far too much risk in my portfolio, I will readily admit to not having enough nerve to do something like that.) The other thing to note, and it is a little bit more difficult to see on this chart, is that for all intents and purposes the market is treating European-wide EFSF debt as German debt. There are only 10 basis points of difference.



Now let’s take a little stroll through history and view a chart of the yield curve of French debt. The top dotted line is where the yield curve was on January 1, 2007. We took our first look at this chart last Tuesday in preparation for this letter, noting that short-term French debt was at the zero bound. It went negative on Thursday, and negative all the way out to two years! Note that a 50-year French note (which I’m not sure actually trades) yields a hypothetical 2.5%, only modestly more than a 30-year would yield. You might have to have the patience of Job, and I’m not sure quite how you would go about executing the trade, but that has to be one of the most loudly screaming shorts I’ve ever seen!



Here is the equivalent chart for the German yield curve going back to January 2007. Note that German debt has a negative yield out to three years!!!



While it should surprise no one, German long-term bond yields are at historic lows. I recall reading that Spanish bond yields are lower now than they have been at any other time in their history. I actually applaud the Spanish government for issuing 50-year bonds at 4%. I can almost guarantee you the day will come when Spain looks back at those 4% bonds with fondness. (I assume that the buyers are pension funds or insurance companies engaged in a desperate search for yield. I guess the extra 2% over a ten-year bond looks attractive … at least in the short term.)

And finally, let’s really widen our time horizon on German yields:



Time to Ramp up the Currency War

The yen hit a six-year low this week (over 105 to the dollar), creating even more of a problem for Germany and other European exporters to Asia. The chart below shows that Germany’s exports to the BRIICS except China are down significantly over the past few years, partially due to competition from Japan as the yen has dropped against the euro.

The yen-versus-euro problem (at least from Germany’s standpoint) is exacerbated by the remarkable appetite of Japanese investors for French bonds. This has been going on for over a year. In May and June of this year alone, Japanese investors bought $29.3 billion worth of French notes maturing at one year or more (presumably, this was before rates went negative). Note that even with minimal yields, the Japanese investors are up because of the currency play. (Interestingly, Japanese investors are dumping German bonds, again a yield play.)

Japanese analysts say that Japanese investors are hesitant to take the risks on the higher-yielding Italian and Spanish bonds, but for some reason they see almost no risk in French bonds. (Obviously not many Thoughts from the Frontline readers in Japan.) This behavior, of course, helps to drive down the price of the yen relative to the euro. (Source, Bloomberg)



Interesting side note: the third-largest country holding of US treasuries behind Japan and China is now Belgium. When you first read that, you have to do a double-take. Digging a little deeper, you find out there’s been a 41% surge in Belgian ownership of US bonds in just the first five months of this year. As it turns out, Euroclear Bank SA, a provider of security settlements for foreign lenders, is based in Belgium and is where countries can go to buy bonds they are not holding in their own treasuries. This buying surge is helping hold down US yields even as the Federal Reserve is reducing its QE program. Further, there is serious speculation, or rather speculation from serious sources, that Russian oligarchs are piling into US dollars by the tens of billions, again through Belgium.

Europe Takes the Baton

It is probably only a coincidence that just as the Fed ends QE, Europe will begin its own QE program. Note that the ECB has reduced its balance sheet by over $1 trillion in the past few years (to the chagrin of much of European leadership). There is now “room” for the ECB to work through various asset-buying programs to increase its balance sheet by at least another trillion over the next year or so, taking the place of the Federal Reserve. Draghi intends to do so.

Risk-takers should take note. European earnings per share are significantly lower than those of any other developed economy. Indeed, while much of the rest of the world has seen earnings rise since the market bottom in 2009, the euro area has been roughly flat.


Both the US and Japanese stock markets took off when their respective central banks began QE programs. Will the same happen in Europe? QE in Europe will have a little bit different flavor than the straight-out bond buying of Japan or the US, but they will still be pushing money into the system. With yields at all-time lows, European investors may start looking at their own stock markets. Just saying.

Draghi also knows there is really no way to escape his current conundrum without reigniting European growth. One of the textbook ways to achieve easy growth is through currency devaluation; and as we wrote in Code Red, the ECB will step up and do what it can to cheapen the euro in competition with Japan.
Just as the world is getting fewer dollars (in a world where global trade is done in dollars), Draghi is going to flood the world with euros.

Bank of Japan Governor Kuroda has steered the BOJ to where it now owns 20% of all outstanding Japanese government debt and is buying 70% of all newly issued Japanese bonds. The BOJ hoped that by driving down long-term rates it could encourage Japanese banks to invest and lend more, but bond-hungry regional Japanese banks are still snapping up long-term Japanese bonds, even at 50 basis points of yield. Given the current environment, the Bank of Japan cannot stop its QE program without creating a spike in yields that the government of Japan could not afford. Hence I think it’s unlikely that Japanese QE will end anytime soon, thus putting further pressure on the yen.

The BOJ is going to continue to buy massive quantities of bonds and erode the value of the yen over time in an effort to get 2% inflation.

In a world where populations in developed countries are growing older and are thus more interested in fixed-income securities, yields are going to be challenged for some time. Those planning retirement are going to generally need about twice what would have been suggested only 10 or 15 years ago in order to be able to achieve the same income. Welcome to the world of financial repression, brought to you by your friendly local central bank.

Introducing Tony Sagami

When we first launched Mauldin Economics some two years ago, my partners and I thought there was a need for a good fixed-income letter with a little different style and focus. My very first phone call was to my longtime friend Tony Sagami, to ask if he would write it. I have known Tony for almost 25 years. We have worked together, he has worked for me, and we have been competitors, but we’ve always been good friends.

Even though he now lives in Bangkok most of the year, we still visit regularly by email and Skype, and try to make a point of catching up in some part of the world at least twice a year. In addition to his talents as a writer, Tony brings a seasoned perspective and huge experience as a trader and investor. (Seasoned is a technical term for getting older, having made lots of instructive mistakes in your early years.) He has a way of taking my macro ideas and efficiently and effectively putting them to work. I know Yield Shark subscribers must be happy, because our renewal rates are very high by industry standards.

As I mentioned early in the letter, for contractual reasons we haven’t been able to name Tony as the editor of Yield Shark. I’m really pleased that we can do so now. Tony was recently in Dallas, and we did a short video together so that I could introduce him. You can watch the video and learn more about Tony here. You will soon be receiving information from my partners about a new newsletter that Tony will also be writing, which we are tentatively calling The Rational Bear.

San Antonio, Washington DC, Chicago, and Boston

My respite from travel will be over in a few weeks as I head to the Casey Research Summit in San Antonio, September 17-21. It actually takes place at a resort in the Hill Country north of San Antonio, which is a fun place to spend a weekend with friends. Then the end of the month will see me traveling to Washington DC for a few days.

I'll be back in Dallas in time for my 65^th birthday on October 4, and then I get to spend another two weeks at home before the travel schedule picks back up. I will make a quick trip to Chicago, then swing back to Athens, Texas, before I head on to Cambridge, Massachusetts, for conferences. There are a few other trips shaping up as well.

My time at home has been well spent, as I’m catching up on all sorts of projects, spending more time in the gym, and just enjoying being home. Surprisingly, being at home has allowed me to see more friends than usual as they’ve come through town. Dennis Gartman was in yesterday, and we spent two pleasant hours catching up over lunch. He is one of the truly consummate gentlemen in our business and a bottomless reservoir of great stories. A perfect evening would be Dennis Gartman and Art Cashin holding court at the Friends of Fermentation after the market closes. You’d just sit there and scribble notes.

The other thing about being home is that it makes me want to get on a plane and go see even more friends! Yesterday I caught up with George and Meredith Friedman on the phone, and we realized it has been well over a year since we’ve seen each other, which is unusual for us. I really enjoy them, and they are their own source of endless stories. George and Meredith travel much more than I do, and all over the world at that, doing speeches and research and the like; but we agreed that sometime in October we will make a visit happen, whoever is doing the flying. I think one of the reasons that God made planes was so that friends could see each other more often.

A special hat tip goes to my associate Worth Wray for finding and creating most of the charts for this week. Plus helping me think through the letter. He has been a huge help this last year.
You have a great week and take a friend who tells great stories to lunch. It will do wonders for your outlook on life.

Your still can’t believe negative French interest rates analyst,

The article Thoughts from the Frontline: Europe Takes the QE Baton was originally published at mauldin economics.com.

Make sure to check out our next webinar "How to Beat the Market Makers with Weekly Options"....Just Click Here!

Every Central Bank for Itself

By John Mauldin

“Everybody has a plan until they get punched in the face.”

– Mike Tyson

For the last 25 days I’ve been traveling in Argentina and South Africa, two countries whose economies can only be described as fragile, though for very different reasons. Emerging market countries face a significantly different set of challenges than the developed world does. These challenges are compounded by the rather indifferent policies of developed world central banks, which are (even if somewhat understandably) entirely self centered. Argentina has brought its problems upon itself, but South Africa can somewhat justifiably express frustration at the developed world, which, as one emerging market central bank leader suggests, is engaged in a covert currency war, one where the casualties are the result of unintended consequences. But the effects are nonetheless real if you’re an emerging market country.

While I will write a little more about my experience in South Africa at the end of this letter, first I want to cover the entire emerging market landscape to give us some context. Full and fair disclosure requires that I give a great deal of credit to my rather brilliant young associate, Worth Wray, who’s helped me pull together a great deal of this letter while I am on the road in a very busy speaking tour here in South Africa for Glacier, a local platform intermediary. They have afforded me the opportunity to meet with a significant number of financial industry participants and local businessman, at all levels of society. It has been a very serious learning experience for me. But more on that later; let’s think now about the problems facing emerging markets in general.

Every Central Bank for Itself

Every general has a plan before going into battle, which immediately begins to change upon contact with the enemy. Everyone has a plan until they get hit… and emerging markets have already taken a couple of punches since May 2013, when Fed Chairman Ben Bernanke first signaled his intent to “taper” his quantitative easing program and thereby incrementally wean the markets off of their steady drip of easy money. It was not too long after that Ben also suggested that he was not responsible for the problems of emerging-market central banks – or any other central bank, for that matter.

As my friend Ben Hunt wrote back in late January, Chairman Bernanke turned a single data point into a line during his last months in office, when he decided to taper by exactly $10 billion per month. He established the trend, and now the markets are reacting as if the Fed's exit strategy has officially begun.

Whether the FOMC can actually turn the taper into a true exit strategy ultimately depends on how much longer households and businesses must deleverage and how sharply our old age dependency ratio rises, but markets seem to believe this is the beginning of the end. For now, that’s what matters most.

Under Fed Chair Janet Yellen’s leadership, the Fed continues to send a clear message to the rest of the world: Now it really is every central bank for itself. 

The QE-Induced Bubble Boom in Emerging Markets

By trying to shore up their rich-world economies with unconventional policies such as ultra low rate targets, outright balance sheet expansion, and aggressive forward guidance, major central banks have distorted international real interest rate differentials and forced savers to seek out higher (and far riskier) returns for more than five years.

This initiative has fueled enormous overinvestment and capital misallocation – and not just in advanced economies like the United States.

As it turns out, the biggest QE-induced imbalances may be in emerging markets, where, even in the face of deteriorating fundamentals, accumulated capital inflows (excluding China) have nearly DOUBLED, from roughly $5 trillion in 2009 to nearly $10 trillion today. After such a dramatic rise in developed world portfolio allocations and direct lending to emerging markets, developed world investors now hold roughly one third of all emerging market stocks by market capitalization and also about one third of all outstanding emerging market bonds.

The Fed might as well have aimed its big bazooka right at the emerging world. That’s where a lot of the easy money ran blindly in search of more attractive real interest rates, bolstered by a broadly accepted growth story.

The conventional wisdom – a particularly powerful narrative that became commonplace in the media – suggested that emerging markets were, for the first time in a long time, less risky than developed markets, despite their having displayed much higher volatility throughout the past several decades.

As a general rule, people believed emerging markets had much lower levels of government debt, much stronger prospects for consumption led growth, and far more favorable demographics. (They overlooked the fact that crises in the 1980s and 1990s still limited EM borrowing limits until 2009 and ignored the fact that EM consumption is a derivative of demand and investment from the developed world.)

Instead of holding traditional safe haven bonds like US treasuries or German bunds, some strategists (who shall not be named) even suggested that emerging market government bonds could be the new safe haven in the event of major sovereign debt crises in the developed world. And better yet, it was suggested that denominating these investments in local currencies would provide extra returns over time as EM currencies appreciated against their developed market peers.

Sadly, the conventional wisdom about emerging markets and their currencies was dead wrong. Herd money (typically momentum based, yield chasing investors) usually chases growth that has already happened and almost always overstays its welcome. This is the same disappointing boom/bust dynamic that happened in Latin America in the early 1980s and Southeast Asia in the mid 1990s. And this time, it seems the spillover from extreme monetary accommodation in advanced countries has allowed public and private borrowers to leverage well past their natural carrying capacity.

Anatomy of a “Balance of Payments” Crisis

The lesson is always the same, and it is hard to avoid. Economic miracles are almost always too good to be true. Whether we’re talking about the Italian miracle of the ’50s, the Latin American miracle of the ’80s, the Asian Tiger miracles of the ’90s, or the housing boom in the developed world (the US, Ireland, Spain, et al.) in the ’00s, they all have two things in common: construction (building booms, etc.) and excessive leverage. As a quick aside, does that remind you of anything happening in China these days?

Just saying…...Broad based, debt fueled overinvestment may appear to kick economic growth into overdrive for a while; but eventually disappointing returns and consequent selling lead to investment losses, defaults, and banking panics. And in cases where foreign capital seeking strong growth in already highly valued assets drives the investment boom, the miracle often ends with capital flight and currency collapse.

Economists call that dynamic of inflow induced booms followed by outflow induced currency crises a “balance of payments cycle,” and it tends to occur in three distinct phases.

In the first phase, an economic boom attracts foreign capital, which generally flows toward productive uses and reaps attractive returns from an appreciating currency and rising asset prices. In turn, those profits fuel a self-reinforcing cycle of foreign capital inflows, rising asset prices, and a strengthening currency.

In the second phase, the allure of promising recent returns morphs into a growth story and attracts ever stronger capital inflows – even as the boom begins to fade and the strong currency starts to drag on competitiveness. Capital piles into unproductive uses and fuels overinvestment, overconsumption, or both; so that ever more inefficient economic growth increasingly depends on foreign capital inflows. Eventually, the system becomes so unstable that anything from signs of weak earnings growth to an unanticipated rate hike somewhere else in the world can trigger a shift in sentiment and precipitous capital flight.

To continue reading this article from Thoughts from the Frontline – a free weekly publication by John Mauldin, renowned financial expert, best-selling author, and Chairman of Mauldin Economics – Please Click Here.

The article Thoughts from the Frontline: "Every Central Bank for Itself" was originally published at Mauldin Economics

Sign up for one of our Free Trading Webinars....Just Click Here!

The Time of Maximum Pessimism Is the Best Time to Buy

By Nick Giambruno

“The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell.”—Sir John Templeton


As you may have heard, Doug Casey and I traveled to Cyprus in search of crisis driven bargains… and we found them. This has been previously outlined in the articles here and in our specific investment picks in Crisis Investing in Cyprus.

Speaking of those picks, we outlined eight companies on the Cyprus Stock Exchange that we thought were fundamentally sound, but unjustly beaten down by the crisis. And thus far they have performed exactly as we thought they would.

The eight stocks that Doug and I identified are all up since the publication of Crisis Investing in Cyprus. Two of them have more than doubled, including one that’s up 335%ⁱ.

While those returns are nothing to bat an eye at, we believe there is still a lot more room for upside, and that it’s not too late to get in.

The top three catalysts for an economic recovery are still at the very earliest stages of being played out. And if the returns to date on our picks are any indication, we expect them to go much higher once these catalysts are fully under way.

Additionally, for the vast majority of people, there is still an aura of “maximum pessimism” surrounding Cyprus, which is what makes it an excellent contrarian investment. However, it’s clear this sentiment—and the current buying opportunity—won’t last forever.

Here are the three main catalysts to watch for.

Catalyst #1 Elimination of Capital Controls

Cyprus was the first eurozone country to implement official capital controls (but probably not the last). The restrictions put in place during the crisis are still there, though they are being gradually eased.

The first step toward the relaxation of capital controls occurred last week, and it’s possible that they will be fully lifted later this year. While it remains to be seen whether that will actually happen, there has been tangible progress in that direction.

Additionally, Cyprus has been meeting and exceeding its benchmarks set by the Troika (the IMF, the European Commission, and the European Central Bank), including the privatization of inefficient state-run enterprises and quickly enacting reforms, such as cutting government spending. This progress and the gradual relaxation of the capital controls are reasons for guarded optimism.

A couple of points to clarify about the capital controls:

First, they do not apply to new money brought into Cyprus (nor the capital gains and income generated from that money). That money can be taken out of the country without restriction. Second, the bank deposit confiscation only applied to cash balances above the guaranteed amount of €100,000 at the two troubled banks, Laiki Bank and Bank of Cyprus. Relatively sound institutions were not affected. Also, there was no forced selling or conversion of securities held in brokerage accounts. All of the brokers whom we met with held the majority of their cash in institutions outside of the country for additional protection.

Of course, the government could always come up with a new edict or decree, but we view that as unlikely at the moment, since they’re actively encouraging new investments in the island.

Catalyst #2 Offshore Gas Bonanza

In 2011 there was a discovery of a massive gas field about 100 miles south of Cyprus. The resources there are estimated to be worth tens of billions of dollars (not insignificant for a country with a $23 billion GDP)—and are enough to turn Cyprus into an energy exporter. Though it could be a number of years before these resources are monetized, it gives Cypriots a lot to look forward to over the intermediate term.

 

 

Catalyst #3 Relisting of the Bank of Cyprus

Previously the Bank of Cyprus and Laiki Bank accounted for a large chunk of the volume traded on the Cyprus Stock Exchange. Laiki Bank is now defunct, with its good parts having been folded into a restructured Bank of Cyprus—whose shares have been suspended from the stock exchange.
The restructured Bank of Cyprus is expected to start trading again sometime midyear, which will be an important catalyst in rejuvenating the stock market.

This is not to say the Bank of Cyprus is completely out of the woods. Far from it. While it has restored its capital base following the bail-in, it still has major issues with non-performing loans (NPLs).

That said, the Bank of Cyprus is the cornerstone of the Cypriot financial system, which is a major pillar of the Cypriot economy, and it has the backing of the Troika. The IMF believes that, despite the NPLs, the bank will be able to maintain an adequate capital base through at least 2016.

Owning a country’s premier bank—especially after it’s been chastised by a near-death experience—can be a profitable speculation.

It’s Not Too Late to Snatch These Bargains

While our eight investment picks are all up since the publication of Crisis Investing in Cyprus, including two of which that have more than doubled (including one that is up 335%ⁱ), that doesn’t mean it’s too late to get in.

The fact that we’re still at the very early stages of these three catalysts, combined with the continued “maximum pessimism” sentiment tells us that there’s still a lot more upside potential.

With features that make it a popular tourist and retirement destination combined with the potential economic boon from exploiting the offshore gas reserves, the Cypriot economy has a good chance to recover over the medium term.

When you weigh it all together, it’s clear that now is the time to start deploying speculative capital.
In order to invest on the Cyprus Stock Exchange, you’ll need a local brokerage account. Our preferred Cypriot broker can open accounts remotely for online trading, with no minimum balance requirements, and they still accept American clients.

This is information that you won’t find anywhere else. And there’s nobody better to guide you through it all than legendary crisis investor Doug Casey.

You can find out more about Crisis Investing in Cyprus by clicking here.
ⁱReturns denominated in euro terms from 11/6/2013 through 3/4/14

The article The Time of Maximum Pessimism Is the Best Time to Buy was originally published at International Man.

Don't miss a single Premier Trader University Webinar!

What are Business Development Companies?

By Andrey Dashkov

Business Development Companies (BDCs) are publicly traded private debt and equity funds. I know that description isn’t terribly sexy, but keep reading and you’ll find there’s a lot to be excited about.


BDCs provide financing to firms too small to seek traditional bank financing or to do an IPO, but at the same time are too advanced to interest the earliest-stage venture capitalist. These companies are often near or at profitability and just need extra cash to reach the next milestone. Filling this void, BDCs provide funds to target companies in exchange for interest payments and/or an equity stake.

BDCs earn their living by lending at interest rates higher than those at which they borrow. Conceptually, they act like banks or bond funds, but with access to yields unlike any you’ll see from a traditional bond fund. The interest rate spread—meaning the difference between their capital costs and interest they charge their clients—is a major component of their business.

Oftentimes, a BDC will increase its dividend when market interest rates have not changed. Like a bank, the more loans it has in force, the more it profits. Increasing its dividend payout will generally have a very positive effect on its share price.

Unlike banks or many other traditional financial institutions, however, BDCs are structured to pay out more than 90% of their net profits to the shareholders. In return, BDCs don’t pay any income tax. In essence, their profits flow through to the owners. Many investors like to own BDCs in an IRA to create tax deferred or tax free income. The opportunity to use them for tax planning purposes, access to diversified early stage financing, and the impressive dividend yields they deliver make them a perfect fit for the Bulletproof Income strategy we employ at Miller's Money Forever.

The Clients

 

As a business model, BDCs emerged in response to a particular need: early-stage companies needed funding but couldn’t do it publicly due to their small size. At the same time, these companies didn’t match the investment criteria of so-called angel investors or venture capital providers. Enter the Business Development Company.

BDC teams, through expertise and connections, select the most promising companies in their fields and provide funds in return for a debt or equity stake, expecting gains from a potential acquisition scenario and a flow of interest payments in the meantime. The ability to selectively lend money to the right startup companies is paramount. It makes little difference how much interest they charge if the client defaults on the loan.

With limited financing options, BDCs’ clients may incur strict terms regarding their debt arrangements. The debt often comes with a high interest rate, has senior level status, and is often accompanied by deal sweeteners like warrants which add to the upside potential for those with a stake in the borrowing company.

In return for these stringent terms, the borrower can use the funds to:

•  Increase its cash reserve for added security;

•  Accelerate product development;

•  Hire staff and purchase licenses necessary to advance R&D, etc.

•  Invest in property, plant, and equipment to produce its product and bring it to market.

Turning to a BDC for funds allows a company to finance its development and minimize dilution of equity investors while reaching key value adding milestones in the process.

What’s in It for Investors?

 

In addition to the unique opportunity to access early-stage financing, we like BDCs for their dividend policy and high yield. The Investment Act of 1940 requires vehicles such as BDCs to pay out a minimum of 90% of their earnings. In practice, they tend to pay out more than that, plus their short term capital gains.

This often results in a high yield. Yields of 7-12% are common, which makes this vehicle unique in today’s low yield environment. The risk is minimized by diversification—like a good bond fund, they spread their assets over many sectors. This rational approach and the resulting income make the right BDC(s) a great addition to our Bulletproof Income strategy.

BDCs and the Bulletproof Income Strategy

 

In short, BDCs serve our strategy by:

• Providing inflation protection in the form of high yields and dividend growth;

• Limiting our exposure to interest rate risk, thereby adding a level of security (some BDCs borrow funds at variable rates, but not the ones we like);

• Maintaining low leverage, which BDCs are legally required to do;

• Distributing the vast majority of their income to shareholders, thereby creating an immediate link between the company’s operating success and the shareholders’ wellbeing… in other words, to keep their shareholders happy, BDCs have to perform well.

How Should You Pick a BDC?

 

Not every BDC out there qualifies as a sound investment. Here’s a list of qualities that make a BDC attractive.

• Dividend distributions come from earnings. This may sound like common sense, but it’s worth reiterating. A successful BDC should generate enough quarterly income to pay off its dividend obligations. If it doesn’t, it will have to go to the market for funds and either issue equity or borrow, or deplete cash reserves it would otherwise use to fund future investments. An equity issuance would result in share dilution; debt would increase leverage with no imminent potential to generate gains; and a lower cash reserve is no good either. We prefer stocks that balance their commitments to the shareholders with a long term growth strategy.

• The dividends are growing. This is another characteristic of a solid income pick, BDC or otherwise. Ideally, the dividend growth would outpace inflation, in addition to the yield itself being higher than the official CPI numbers. This growth can come from increasing the interest rate spread and also having more loans on the books.

• Yields should be realistic. We’d be cautious about a BDC that pays more than 12% of its income in dividends. Remember, gains come from the interest it receives from the borrowers. Higher interest indicates higher risk debt on a BDC’s balance sheet, which should be monitored regularly.

• Fixed-rate liabilities are preferred. We need our BDC to be able to cover its obligations if interest rates rise. Fixed rates are more predictable than floating rates; we like the more conservative approach.

• Their betas should be (way) below 1. We don’t want our investment to move together with the broad market or be too interest-rate sensitive. Keeping our betas as low as possible provides additional opportunities to reduce risk, which is a critical part of our strategy.

• They are diversified across many sectors. A BDC that has 100 tech companies in its portfolio is not as well diversified as a one with 50 firms scattered across a dozen sectors, including aerospace, defense, packaging, pharmaceuticals, and others. Review a company’s SEC filings to see how many baskets its eggs are in.

Wrap up......

 

Right now, BDCs look very interesting to income-seeking investors. They provide excellent yields, diversification opportunities, and access to early-stage companies that previously only institutions enjoyed. They also fit in with Miller Money Forever's Bulletproof Income strategy, the purpose of which is to provide seniors and savers with real returns, while offering maximum safety and diversification.

Catching a peek our Bulletproof portfolio is risk-free if you try today. Access it now by subscribing to Miller's Money Forever, with a 90-day money-back guarantee. If you don't like it, simply return the subscription within those first three months and we'll refund your payment, no questions asked. And the knowledge you gain in those months will be yours to keep forever.


Posted courtesy of our trading partners at Casey Research

Outside the Box: A Limited Central Bank

By John Mauldin

This week’s Outside the Box is unusual, even for a letter that is noted for its unusual offerings. It is a speech from last week by Charles I. Plosser, President of the Federal Reserve Bank of Philadelphia at (surprisingly to me) the Cato Institute’s 31st Annual Monetary Conference, Washington, DC.

I suppose that if Dallas Fed President Richard Fisher had delivered this speech I would not be terribly surprised. I suspect there are some other Federal Reserve officials here and there whoare in sympathy with this view Plosser presents here, but for quite some time no serious Fed official has outlined the need for a limited Federal Reserve in the way Plosser does today. He essentially proposes four limits on the US Federal Reserve:

• First, limit the Fed’s monetary policy goals to a narrow mandate in which price stability is the sole, or at least the primary, objective;
• Second, limit the types of assets that the Fed can hold on its balance sheet to Treasury securities;
• Third, limit the Fed’s discretion in monetary policymaking by requiring a systematic, rule-like approach;
• And fourth, limit the boundaries of its lender-of-last-resort credit extension.

“These steps would yield a more limited central bank. In doing so, they would help preserve the central bank’s independence, thereby improving the effectiveness of monetary policy, and they would make it easier for the public to hold the Fed accountable for its policy decisions.”

Some of you will want to read this deeply, but everyone should read the beginning and ending. I find this one of the most hopeful documents I have read in a long time. Think about the position of the person who delivered the speech. You are not alone in your desire to rein in the Fed.

Two points before we turn to the speech. Both Fisher and Plosser will be voting members of the FOMC this coming year. Look at the lineup and the philosophical monetary view of each of the members of the FOMC. Next year we could actually see three dissenting votes if things are not moving in a positive direction, although another serious proponent of monetary easing is being added to the Committee, so it may be that nothing will really change.



I am not seriously suggesting that the reigning economic theory that directs the action of the Fed is going to change anytime soon, but you will see assorted academics espousing a different viewpoint here and there. I think there may come a time in the not-too-distant future when the current Keynesian viewpoint is going to be somewhat discredited and people will be open to a new way to run things. This will not happen due to some great shift in philosophical views but because the current system has the potential to create some rather serious problems in the future. This is part of the message in my latest book, Code Red.

A lot of education and change in the system is needed. I want to applaud Alan Howard and his team at Brevan Howard for making one of the largest donations in business education history to Imperial College to establish the new Brevan Howard Centre for Financial Analysis to study exactly these topics and counter what is a particularly bad direction in academia. The two leaders at the new center, Professors Franklin Allen and Douglas Gale, are renowned for their pioneering research into financial crises and market contagion – that is, when relatively small shocks in financial institutions spread and grow, severely damaging the wider economy. This new center will help offer a better perspective. What we teach our kids matters. I hope other major fund managers will join this effort!

And speaking of Code Red, let me pass on a few quick reviews from Amazon:

“Excellent review of our current economic circumstances and what we can do about it to protect our assets. Even better, it is written with the non-economist in mind.”

“I read this book from cover to cover in 24 hours and was glued to every page. Do I know how to protect my saving exactly? No. But I have the critical information necessary to make informed decisions about my investments. My husband recommended this book to me after reading a brief article, and I'm so glad I impulsively bought it. It will definitely change my investment decisions moving forward and perhaps even provide me with more restful nights of sleep.”

You can order your own copy at the Mauldin Economics website or at Amazon, and it is likely at your local book store.

It is getting down to crunch time here in Dallas as far as the move to the new apartment is concerned. Work is coming along and most of it is done, although some things will need to be finished after I move in. Furniture is being delivered and moved in as I write, and today an the new kitchen is being entirely stocked, courtesy of Williams-Sonoma – they'll be showing up in a few minutes. I am fulfilling a long-held dream (maybe even a fantasy or fetish) of throwing everything out of the kitchen and starting over from scratch. Between my kids and a returning missionary couple, all the old stuff will find a new home, and I will renew my role as chief chef with new relish next week.

I have always maintained that I think I am a pretty good writer but I a brilliant cook. With a new kitchen from top to bottom, I intend to spend more time developing my true talent. Between the new media room and my cooking, I hope I can persuade the kids (and their kids!) to come around more often. Yes, there are a few bumps and issues here and there, but in general life is going well. I just need to get into the gym more. Which we should all probably do!

Your feeling like a kid in a candy store analyst,

John Mauldin, Editor Outside the Box

---

 

A Limited Central Bank

 

Presented by Charles I. Plosser, President and Chief Executive Officer, Federal Reserve Bank of Philadelphia

Cato Institute’s 31st Annual Monetary Conference, Washington, D.C.

Highlights

• President Charles Plosser discusses what he believes is the Federal Reserve’s essential role and proposes how this institution might be improved to better fulfill that role.

• President Plosser proposes four limits on the central bank that would limit discretion and improve outcomes and accountability.

• First, limit the Fed’s monetary policy goals to a narrow mandate in which price stability is the sole, or at least the primary, objective;

• Second, limit the types of assets that the Fed can hold on its balance sheet to Treasury securities;

• Third, limit the Fed’s discretion in monetary policymaking by requiring a systematic, rule-like approach;

• And fourth, limit the boundaries of its lender-of-last-resort credit extension.

• These steps would yield a more limited central bank. In doing so, they would help preserve the central bank’s independence, thereby improving the effectiveness of monetary policy, and they would make it easier for the public to hold the Fed accountable for its policy decisions.

 

Introduction: The Importance of Institutions

 

I want to thank Jim Dorn and the Cato Institute for inviting me to speak once again at this prestigious Annual Monetary Conference. When Jim told me that this year’s conference was titled “Was the Fed a Good Idea?” I must confess that I was little worried. I couldn’t help but notice that I was the only sitting central banker on the program. But as the Fed approaches its 100th anniversary, it is entirely appropriate to reflect on its history and its future. Today, I plan to discuss what I believe is the Federal Reserve’s essential role and consider how it might be improved as an institution to better fulfill that role.

Before I begin, I should note that my views are not necessarily those of the Federal Reserve System or my colleagues on the Federal Open Market Committee (FOMC).

Douglass C. North was cowinner of the 1993 Nobel Prize in Economics for his work on the role that institutions play in economic growth.¹ North argued that institutions were deliberately devised to constrain interactions among parties both public and private. In the spirit of North’s work, one theme of my talk today will be that the institutional structure of the central bank matters. The central bank’s goals and objectives, its framework for implementing policy, and its governance structure all affect its performance.

Central banks have been around for a long time, but they have clearly evolved as economies and governments have changed. Most countries today operate under a fiat money regime, in which a nation’s currency has value because the government says it does. Central banks usually are given the responsibility to protect and preserve the value or purchasing power of the currency.² In the U.S., the Fed does so by buying or selling assets in order to manage the growth of money and credit. The ability to buy and sell assets gives the Fed considerable power to intervene in financial markets not only through the quantity of its transactions but also through the types of assets it can buy and sell. Thus, it is entirely appropriate that governments establish their central banks with limits that constrain the actions of the central bank to one degree or another.

Yet, in recent years, we have seen many of the explicit and implicit limits stretched. The Fed and many other central banks have taken extraordinary steps to address a global financial crisis and the ensuing recession. These steps have challenged the accepted boundaries of central banking and have been both applauded and denounced. For example, the Fed has adopted unconventional large-scale asset purchases to increase accommodation after it reduced its conventional policy tool, the federal funds rate, to near zero.

These asset purchases have led to the creation of trillions of dollars of reserves in the banking system and have greatly expanded the Fed’s balance sheet. But the Fed has done more than just purchase lots of assets; it has altered the composition of its balance sheet through the types of assets it has purchased. I have spoken on a number of occasions about my concerns that these actions to purchase specific (non-Treasury) assets amounted to a form of credit allocation, which targets specific industries, sectors, or firms.

These credit policies cross the boundary from monetary policy and venture into the realm of fiscal policy.³ I include in this category the purchases of mortgage-backed securities (MBS) as well as emergency lending under Section 13(3) of the Federal Reserve Act, in support of the bailouts, most notably of Bear Stearns and AIG. Regardless of the rationale for these actions, one needs to consider the long-term repercussions that such actions may have on the central bank as an institution.

As we contemplate what the Fed of the future should look like, I will discuss whether constraints on its goals might help limit the range of objectives it could use to justify its actions. I will also consider restrictions on the types of assets it can purchase to limit its interference with market allocations of scarce capital and generally to avoid engaging in actions that are best left to the fiscal authorities or the markets. I will also touch on governance and accountability of our institution and ways to implement policies that limit discretion and improve outcomes and accountability.

Goals and Objectives

 

Let me begin by addressing the goals and objectives for the Federal Reserve. These have evolved over time. When the Fed was first established in 1913, the U.S. and the world were operating under a classical gold standard. Therefore, price stability was not among the stated goals in the original Federal Reserve Act. Indeed, the primary objective in the preamble was to provide an “elastic currency.”

The gold standard had some desirable features. Domestic and international legal commitments regarding convertibility were important disciplining devices that were essential to the regime’s ability to deliver general price stability. The gold standard was a de facto rule that most people understood, and it allowed markets to function more efficiently because the price level was mostly stable.

But, the international gold standard began to unravel and was abandoned during World War I.⁴ After the war, efforts to reestablish parity proved disruptive and costly in both economic and political terms. Attempts to reestablish a gold standard ultimately fell apart in the 1930s. As a result, most of the world now operates under a fiat money regime, which has made price stability an important priority for those central banks charged with ensuring the purchasing power of the currency.

Congress established the current set of monetary policy goals in 1978. The amended Federal Reserve Act specifies the Fed “shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Since moderate long-term interest rates generally result when prices are stable and the economy is operating at full employment, many have interpreted these goals as a dual mandate with price stability and maximum employment as the focus.

Let me point out that the instructions from Congress call for the FOMC to stress the “long run growth” of money and credit commensurate with the economy’s “long run potential.” There are many other things that Congress could have specified, but it chose not to do so. The act doesn’t talk about managing short-term credit allocation across sectors; it doesn’t mention inflating housing prices or other asset prices. It also doesn’t mention reducing short-term fluctuations in employment.

Many discussions about the Fed’s mandate seem to forget the emphasis on the long run. The public, and perhaps even some within the Fed, have come to accept as an axiom that monetary policy can and should attempt to manage fluctuations in employment. Rather than simply set a monetary environment “commensurate” with the “long run potential to increase production,” these individuals seek policies that attempt to manage fluctuations in employment over the short run.

The active pursuit of employment objectives has been and continues to be problematic for the Fed. Most economists are dubious of the ability of monetary policy to predictably and precisely control employment in the short run, and there is a strong consensus that, in the long run, monetary policy cannot determine employment. As the FOMC noted in its statement on longer-run goals adopted in 2012, “the maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market.” In my view, focusing on short-run control of employment weakens the credibility and effectiveness of the Fed in achieving its price stability objective. We learned this lesson most dramatically during the 1970s when, despite the extensive efforts to reduce unemployment, the Fed essentially failed, and the nation experienced a prolonged period of high unemployment and high inflation. The economy paid the price in the form of a deep recession, as the Fed sought to restore the credibility of its commitment to price stability.

When establishing the longer-term goals and objectives for any organization, and particularly one that serves the public, it is important that the goals be achievable. Assigning unachievable goals to organizations is a recipe for failure. For the Fed, it could mean a loss of public confidence. I fear that the public has come to expect too much from its central bank and too much from monetary policy, in particular. We need to heed the words of another Nobel Prize winner, Milton Friedman. In his 1967 presidential address to the American Economic Association, he said, “…we are in danger of assigning to monetary policy a larger role than it can perform, in danger of asking it to accomplish tasks that it cannot achieve, and as a result, in danger of preventing it from making the contribution that it is capable of making.”⁵ In the 1970s we saw the truth in Friedman’s earlier admonitions. I think that over the past 40 years, with the exception of the Paul Volcker era, we failed to heed this warning. We have assigned an ever-expanding role for monetary policy, and we expect our central bank to solve all manner of economic woes for which it is ill-suited to address. We need to better align the expectations of monetary policy with what it is actually capable of achieving.

The so-called dual mandate has contributed to this expansionary view of the powers of monetary policy. Even though the 2012 statement of objectives acknowledged that it is inappropriate to set a fixed goal for employment and that maximum employment is influenced by many factors, the FOMC’s recent policy statements have increasingly given the impression that it wants to achieve an employment goal as quickly as possible.⁶

I believe that the aggressive pursuit of broad and expansive objectives is quite risky and could have very undesirable repercussions down the road, including undermining the public’s confidence in the institution, its legitimacy, and its independence. To put this in different terms, assigning multiple objectives for the central bank opens the door to highly discretionary policies, which can be justified by shifting the focus or rationale for action from goal to goal.

I have concluded that it would be appropriate to redefine the Fed’s monetary policy goals to focus solely, or at least primarily, on price stability. I base this on two facts: Monetary policy has very limited ability to influence real variables, such as employment. And, in a regime with fiat currency, only the central bank can ensure price stability. Indeed, it is the one goal that the central bank can achieve over the longer run.

Governance and Central Bank Independence

 

Even with a narrow mandate to focus on price stability, the institution must be well designed if it is to be successful. To meet even this narrow mandate, the central bank must have a fair amount of independence from the political process so that it can set policy for the long run without the pressure to print money as a substitute for tough fiscal choices. Good governance requires a healthy degree of separation between those responsible for taxes and expenditures and those responsible for printing money.

The original design of the Fed’s governance recognized the importance of this independence. Consider its decentralized, public-private structure, with Governors appointed by the U.S. President and confirmed by the Senate, and Fed presidents chosen by their boards of directors. This design helps ensure a diversity of views and a more decentralized governance structure that reduces the potential for abuses and capture by special interests or political agendas. It also reinforces the independence of monetary policymaking, which leads to better economic outcomes.

Implementing Policy and Limiting Discretion

 

Such independence in a democracy also necessitates that the central bank remain accountable. Its activities also need to be constrained in a manner that limits its discretionary authority. As I have already argued, a narrow mandate is an important limiting factor on an expansionist view of the role and scope for monetary policy.

What other sorts of constraints are appropriate on the activities of central banks? I believe that monetary policy and fiscal policy should have clear boundaries.⁷ Independence is what Congress can and should grant the Fed, but, in exchange for such independence, the central bank should be constrained from conducting fiscal policy. As I have already mentioned, the Fed has ventured into the realm of fiscal policy by its purchase programs of assets that target specific industries and individual firms. One way to circumscribe the range of activities a central bank can undertake is to limit the assets it can buy and hold.

In its System Open Market Account, the Fed is allowed to hold only U.S. government securities and securities that are direct obligations of or fully guaranteed by agencies of the United States. But these restrictions still allowed the Fed to purchase large amounts of agency mortgage-backed securities in its effort to boost the housing sector. My preference would be to limit Fed purchases to Treasury securities and return the Fed’s balance sheet to an all-Treasury portfolio. This would limit the ability of the Fed to engage in credit policies that target specific industries. As I’ve already noted, such programs to allocate credit rightfully belong in the realm of the fiscal authorities — not the central bank.

A third way to constrain central bank actions is to direct the monetary authority to conduct policy in a systematic, rule-like manner.⁸ It is often difficult for policymakers to choose a systematic rule-like approach that would tie their hands and thus limit their discretionary authority. Yet, research has discussed the benefits of rule-like behavior for some time. Rules are transparent and therefore allow for simpler and more effective communication of policy decisions. Moreover, a large body of research emphasizes the important role expectations play in determining economic outcomes. When policy is set systematically, the public and financial market participants can form better expectations about policy. Policy is no longer a source of instability or uncertainty. While choosing an appropriate rule is important, research shows that in a wide variety of models simple, robust monetary policy rules can produce outcomes close to those delivered by each model’s optimal policy rule.

Systematic policy can also help preserve a central bank’s independence. When the public has a better understanding of policymakers’ intentions, it is able to hold the central bank more accountable for its actions. And the rule-like behavior helps to keep policy focused on the central bank’s objectives, limiting discretionary actions that may wander toward other agendas and goals.

Congress is not the appropriate body to determine the form of such a rule. However, Congress could direct the monetary authority to communicate the broad guidelines the authority will use to conduct policy. One way this might work is to require the Fed to publicly describe how it will systematically conduct policy in normal times — this might be incorporated into the semiannual Monetary Policy Report submitted to Congress. This would hold the Fed accountable. If the FOMC chooses to deviate from the guidelines, it must then explain why and how it intends to return to its prescribed guidelines.

My sense is that the recent difficulty the Fed has faced in trying to offer clear and transparent guidance on its current and future policy path stems from the fact that policymakers still desire to maintain discretion in setting monetary policy. Effective forward guidance, however, requires commitment to behave in a particular way in the future. But discretion is the antithesis of commitment and undermines the effectiveness of forward guidance. Given this tension, few should be surprised that the Fed has struggled with its communications.
What is the answer? I see three: Simplify the goals. Constrain the tools. Make decisions more systematically. All three steps can lead to clearer communications and a better understanding on the part of the public. Creating a stronger policymaking framework will ultimately produce better economic outcomes.

Financial Stability and Monetary Policy

 

Before concluding, I would like to say a few words about the role that the central bank plays in promoting financial stability. Since the financial crisis, there has been an expansion of the Fed’s responsibilities for controlling macroprudential and systemic risk. Some have even called for an expansion of the monetary policy mandate to include an explicit goal for financial stability. I think this would be a mistake.

The Fed plays an important role as the lender of last resort, offering liquidity to solvent firms in times of extreme financial stress to forestall contagion and mitigate systemic risk. This liquidity is intended to help ensure that solvent institutions facing temporary liquidity problems remain solvent and that there is sufficient liquidity in the banking system to meet the demand for currency. In this sense, liquidity lending is simply providing an “elastic currency.”

Thus, the role of lender of last resort is not to prop up insolvent institutions. However, in some cases during the crisis, the Fed played a role in the resolution of particular insolvent firms that were deemed systemically important financial firms. Subsequently, the Dodd-Frank Act has limited some of the lending actions the Fed can take with individual firms under Section 13(3). Nonetheless, by taking these actions, the Fed has created expectations — perhaps unrealistic ones — about what the Fed can and should do to combat financial instability.

Just as it is true for monetary policy, it is important to be clear about the Fed’s responsibilities for promoting financial stability. It is unrealistic to expect the central bank to alleviate all systemic risk in financial markets. Expanding the Fed's regulatory responsibilities too broadly increases the chances that there will be short-run conflicts between its monetary policy goals and its supervisory and regulatory goals. This should be avoided, as it could undermine the credibility of the Fed’s commitment to price stability.

Similarly, the central bank should set boundaries and guidelines for its lending policy that it can credibly commit to follow. If the set of institutions having regular access to the Fed’s credit facilities is expanded too far, it will create moral hazard and distort the market mechanism for allocating credit. This can end up undermining the very financial stability that it is supposed to promote.

Emergencies can and do arise. If the Fed is asked by the fiscal authorities to intervene by allocating credit to particular firms or sectors of the economy, then the Treasury should take these assets off of the Fed’s balance sheet in exchange for Treasury securities. In 2009, I advocated that we establish a new accord between the Treasury and the Federal Reserve that protects the Fed in just such a way.⁹ Such an arrangement would be similar to the Treasury-Fed Accord of 1951 that freed the Fed from keeping the interest rate on long-term Treasury debt below 2.5 percent. It would help ensure that when credit policies put taxpayer funds at risk, they are the responsibility of the fiscal authority — not the Fed. A new accord would also return control of the Fed’s balance sheet to the Fed so that it can conduct independent monetary policy.

Many observers think financial instability is endemic to the financial industry, and therefore, it must be controlled through regulation and oversight. However, financial instability can also be a consequence of governments and their policies, even those intended to reduce instability. I can think of three ways in which central bank policies can increase the risks of financial instability. First, by rescuing firms or creating the expectation that creditors will be rescued, policymakers either implicitly or explicitly create moral hazard and excessive risking-taking by financial firms. For this moral hazard to exist, it doesn’t matter if the taxpayer or the private sector provides the funds. What matters is that creditors are protected, in part, if not entirely.
Second, by running credit policies, such as buying huge volumes of mortgage-backed securities that distort market signals or the allocation of capital, policymakers can sow the seeds of financial instability because of the distortions that they create, which in time must be corrected.

And third, by taking a highly discretionary approach to monetary policy, policymakers increase the risks of financial instability by making monetary policy uncertain. Such uncertainty can lead markets to make unwise investment decisions — witness the complaints of those who took positions expecting the Fed to follow through with the taper decision in September of this year.

The Fed and other policymakers need to think more about the way their policies might contribute to financial instability. I believe that it is important that the Fed take steps to conduct its own policies and to help other regulators reduce the contributions of such policies to financial instability. The more limited role for the central bank I have described here can contribute to such efforts.

Conclusion

 

The financial crisis and its aftermath have been challenging times for global economies and their institutions. The extraordinary actions taken by the Fed to combat the crisis and the ensuing recession and to support recovery have expanded the roles assigned to monetary policy. The public has come to expect too much from its central bank. To remedy this situation, I believe it would be appropriate to set four limits on the central bank:

• First, limit the Fed’s monetary policy goals to a narrow mandate in which price stability is the sole, or at least the primary, objective;

• Second, limit the types of assets that the Fed can hold on its balance sheet to Treasury securities;

• Third, limit the Fed’s discretion in monetary policymaking by requiring a systematic, rule-like approach;

• And fourth, limit the boundaries of its lender-of-last-resort credit extension and ensure that it is conducted in a systematic fashion

• These steps would yield a more limited central bank. In doing so, they would help preserve the central bank’s independence, thereby improving the effectiveness of monetary policy, and, at the same time, they would make it easier for the public to hold the Fed accountable for its policy decisions. These changes to the institution would strengthen the Fed for its next 100 years.

Like Outside the Box?

Sign up today and get each new issue delivered free to your inbox.

It's your opportunity to get the news John Mauldin thinks matters most to your finances.

Don't miss our latest video...."Why Trading Options on ETFs is Perfect for Small Accounts"