Guest Post: On Risk Convergence, Over-Determined Systems, And Hyperinflation

Tyler Durden's picture

Submitted by Martin Sibileau of A View From The Trenches,

This week, we want to follow up on some thoughts from our last two letters, where we deduce the impact of the policies undertaken by both the Fed and the European Central Bank (ECB). As well, we provide a few comments on an ongoing debate: Will we ever experience hyperinflation?

Last week, we came up with three important conclusions:

-Conclusion No.1: The ECB backstop generates capital gains for the banks of the Euro zone and transforms risky sovereign debt into a carry product (i.e. an asset whose price is mostly driven by the interest it pays, rather than its risk of default, because this risk has been removed by the central bank)

This is what we wrote on Sept. 10th“… Until now, selling distressed sovereign bonds to the ECB to avoid losses was a positive thing for the EU banks. However, going forward, as the backstop of the ECB is in place and the expectation of default is removed from the front end (i.e. 1 to 3 years), exchanging carry (i.e. interest income) for cash will be a losing proposition. The EU banks will demand that the euros be sterilized, to receive ECB debt in exchange at an acceptable interest rate…

Where do we stand?

Everyone expects Spainto request a bailout and accept the conditions that would allow the ECB to buy their bonds. In the meantime, someone took the time to measure the impact of the ECB backstops over the past year and came up with a number: EUR9BN in capital gains. On Sep. 20th, the European Banks research team from Barclays published a note titled “Liability management-understanding the rationale”. Barclays estimates that in their liability management transactions on EUR200BN of unsecured debt, European Banks have gained EUR9BN, from lower interest expenses. This of course, came courtesy of the Fed first (remember the EURUSD swaps put in place at the end of 2011?) and the ECB later, with 3-year long-term refinancing operations. The chart below (source: Bloomberg) shows the iShares MSCI Europe Financial Sector Index Fund (ticker: EUFN). The rally that began at the end of July with the speculation on the future actions of the ECB has peaked, awaiting further news.

 If we are correct with this conclusion, removing (i.e. buying) the assets backstopped by the ECB (i.e. sovereign debt) from the banks in the secondary market via the OMT (Outright Monetary Transactions), will be expensive to the banks. Why? Because these banks, which after so much misery, end up finding out that the assets they were holding are no longer in risk of default and provide a nice interest, will now have to hand these assets over to the ECB. It would be ok to do this every once in a while. However, the fiscal deficits of the EU countries do not happen every once in a while, but every minute and they keep on growing! Should the ECB seek to make the OMT sustainable as the fiscal deficits of the Euro zone periphery continue, the banks will have to be appropriately compensated. The risk remains then, that at a future, much later date, the ECB faces a net interest loss (between the interest it receives for their sovereign debt holdings and the one it pays to the banks). Under this scenario, the only alternative left will be to monetize that deficit all the way to hyperinflation. But in the meantime, let’s  move to…


-Conclusion No.2: The ECB backstop will set a floor to yields

This is what we wrote: “…As the ECB backstops short-term sovereign debt, two results will emerge in the sovereign risk space: First, the market will discover the implicit yield cap and through rational expectations, that yield cap –having been validated by the ECB- will become the floor for sovereign risk within the Euro zone. The key assumption here is that primary fiscal deficits persist across the Euro zone…”

Where do we stand?

It is too early to say anything, as the ECB has not purchased anything yet and the potential secession ofCataloniaand recent protests have delayed (if we are correct) the establishment of a floor.


-Conclusion No.3: The ECB backstop will first push rates within the Euro zone to a convergence (periphery will have lower rates, core will see higher rates). And secondly, will force US rates to converge to the Euro zone rate, if the Euro zone survives the first convergence.

This is what we wrote: “…within that maturity range selected by the ECB for its secondary market purchases (up to three years), the market will arbitrage between the rates of core Europe and its periphery, converging into a single Euro zone yield target….” and “…If the () trend proves true, there would be no reason to believe that the short-term US sovereign yield should keep as low as it is vs. the equivalent EU sovereign yield. For all practical purposes, in the segment of up-to-3 years, the European Central Bank would set the value of the world’s risk-free rate! The big assumption here is of course, that the first trend, above, holds true. Only then, the arbitrage between the US sovereign yield and the EU sovereign yield could be triggered…

Where do we stand?

Again, with the political struggle between the periphery and coreEuropeand (within the periphery) between the people and their appointed leaders, this convergence has been temporarily interrupted

The charts below (source: Bloomberg) show the convergence that started at the end of July, in 2-yr rates (but can also be observed in 10-yrs, not shown here). In the second chart, we show theUS30-yr yield, which suggests that a bearish trend is building (i.e. higher yields), consistent with our conclusion. Time will decide….


All this would indicate that the key to what’s coming next is simply political, which brings us back to one of the first letters of the year, titled “An analytic framework for 2012”, where we precisely showed the tragic (and spiraling) circularity of enhanced deficits, adjustments programs and coercion by the EU council, backstopped by the actions of the ECB. We reproduce a chart from that letter, below.

As the problem spirals, the actions of the ECB must strengthen: If at the beginning of the year, 3-yr lines of secured lending bought time, by September, “conditional” but unlimited bond purchases were now required. A few months from now, that conditionality will surely be merely a simple protocol. In every turn of this circularity, as unemployment, prices and fiscal deficits grow, so does social unrest. Social unrest therefore is the determinant in this overdetermined system.


To those familiar with Algebra, we suggest that the Ponzi scheme we live in is actually an overdetermined system, because there is no solution that will simultaneously cover all the financial and non-financial imbalances of practically any currency zone on the planet. Precisely this limitation is the driver of the many growing confrontations we see: In the Middle East, in the South China Sea, in Europe and soon too, in North America. That these tensions further develop into full-fledged war is not a tail risk. The tail risk is indeed the reverse: The tail risk is that these confrontations do not further develop into wars, given the overdetermination of the system!


Some final comments on hyperinflation

We have noticed of late that there’s a debate on whether or not the US dollar zone will end in hyperinflation and whether or not the world can again embrace the gold standard. We will not discuss the latter today. With the regards to the former, we think it is still early to talk about hyperinflation. We don’t know when it will take place. All we can guarantee is that there are certain conditions necessary to see inflation spike up and morph into hyperinflation, and such conditions have not crystallized yet. However, there is a high risk at this stage in the game that they do, and we briefly examined that risk for the Euro zone, on September 10th.

Money has two purposes: to store value and to transact. There is however another use of money, which is a derivative of the storage-of-value use. The use of money to repay debt.

Those who demand money to repay debts do not do so to store value or to transact. But as long as there are debts outstanding, there will be a demand for currency to repay that credit. This means that, in order to see such demand diminish, we need to see defaults first, which will along eliminate credit extended in fiat, debased currency. As this process unfolds, the banking system goes bankrupt, is nationalized, and credit is directed towards and centrally managed by the government. This may easily takes years, but it is taking place in the Euro zone right now. The repo market and futures markets die along and central banks end up becoming counterparties in cross currency and interest rate swaps. Once this stage is reached, the private sector is out of the system and fiat money is only demanded to transact. Here’s when the velocity of circulation of money starts to rise exponentially.

As these successive steps are passed, slowly, central banks suffer structural changes in their balance sheets. For instance, let’s take the example of Argentina. At one point, after many devaluations of the peso, the central bank by 1982 had become the main USD swap counterparty for corporate credit. However, to avoid a wave of bankruptcies after the June 1982 devaluation (after the Falklands War), it refinanced USD denominated debt at a 23% lower exchange rate, and in the process sold FX insurance at a cost (for the corporations entering the transaction) of 5%/month, when the inflation rate was 7.9%/month. This was going to be a huge burden that accelerated the deficit of the central bank, which of course was monetized (refer here), unleashing the first high inflation of 1985.

The parallel with the situation in the Euro zone is self-evident: If the ECB starts buying sovereign bonds as fiscal deficits continue, the recent transitory appreciation of the Euro (to $1.3150 was mainly driven by short covering and the capital gains in financials, mentioned above) is not sustainable. In the long run, the intervention of the ECB would only devalue the Euro, creating a currency mismatch for those companies  in the Euro zone that issued USD denominated debt. Thanks to the FX swaps by the Fed and the crowding out of the ECB in favour printing Euros for government debt, these companies are more numerous than they would have been. Therefore, the ingredient for an hyperinflationary process is already present, but we’re not quite there yet…

In the end, by the time the use of fiat money is reduced to its transactional role, central banks run huge deficits, called quasi-fiscal. They have backstopped government debt, money markets, repo markets, future markets and derivatives markets. The interest they pay on their liabilities to sterilize their actions always ends being higher than the one they receive for their assets. And it makes perfect sense: Otherwise, nobody would have asked these central banks to be their backstop! An additional source of fuel for this fire is the so called Olivera effect (after Julio H. Olivera). This is another ingredient to turn a mild inflationary process into hyperinflation. This effect refers to the fact that when inflation reaches a relevant number, it becomes profitable for taxpayers to delay their tax filings, which reduces the tax burden. Governments are thus forced print more money to cover the loss in real revenue they suffer.

The fact that we are still in the early chapters of the story just narrated does not allow us to state that hyperinflation is only a tail risk. The tail risk is (again) the reverse: That all the steps central banks took since 2008 won’t lead to spiraling quasi-fiscal deficits.

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
Deathrips's picture

Wheelbarrows for sale....get em while they're cheap.

Silver Bitchezzz!!!!

jeff montanye's picture

while i'm in general agreement with the thrust of your comment, i feel obliged to respond to the post.  

my math is more than a little weak but my first thought on reading this was "most of what the fed has done since '09 has been an attempt to remove a constraint (liquidity) which is, in fact, not a real constraint on the (insolvent) financial sector".  i believe i learned it from my betters: 

Newsboy's picture

That time of history is coming up again.

History isn't a market.

History moves in waves of growth and collapse, and the whole planet is now in a global wave of stagnation.

That's the Wil-E-Coyote moment.

Look down, now!

Radical Marijuana's picture

Yes! One of the astonishing side-effects of controlling the world through triumphant frauds is that the "real" world more and more takes on the appearance of a cartoon. The amplified success of frauds, backed by violence, getting bigger and bigger, and being spread around more and more, makes the "real" world look like a loony tunes episode.

Every action that enables the collective fraudulence to increase, and wraps up more people into those insane risks, due to living on the basis of believing in huge lies, drives social "reality" to get farther and farther away from the laws of nature. Of course, that is NOT actually happening. There is NO "real" magic, only bigger and better illusions. But nevertheless, everyone gets wrapped up in this spiral of illusions built on faith based money, which refuses to admit that it is actually a murder based money.

So, I totally agree that there must come some Wil-E-Coyote moments, where we look down, and "realize" there was nothing there ... or rather, perhaps, that all the missiles and rockets, and so on, have flipped around to be headed back at us!

The "real" world is like a cartoon because privatized fiat money is a crazy cult, that was forced to become our state religion. People were forced to accept runaway frauds, as the basis of the rest of the decisions they made regarding how to live their lives. Wil-E-Coyotes, in Europe, and the USA, have been kicking the can on down the road, punting field goals, and pumping their fists, claiming that they have SCORED, every time they found a way to wrap up more debt, into bigger packages, carried by more people ...

The money system, as our state religion, is more full of glaring absurdities than a loony tunes cartoon ... and yet, for now, "reality" has been held at bay. The established systems have created a quadrillion units of gambling debts, like there were 10 more planet Earths, and that is being backed up by enough weapons to destroy more than 10 planet Earths. ... YET, somehow, the FACT that there is only ONE planet Earth has been able to be disregarded ... and so, indeed, Wil-E-Coyote has already run off the cliff, but, somehow, at this moment, still able to not quite look down ...

I am not sure what being overdetermined means when crazy psychology messes with physics so much, but maybe that is what happens when Wil-E-Coyote finally does look down, and realizes that there IS only one thing that can happen next?

Speaking of a "Fiscal Cliff" Wil-E-Coyote runs off, here is another excellent little video from McGrath:


Cliff Dive to Economic Suicide

vote_libertarian_party's picture

So what you are saying AAPL?

Atomizer's picture

Yes, go long on Apple. You can easily map your financial future. /sarc


Hitler Finds Out About Apple's new iOS6 Maps


Google analytics may also lead you to water before sending off to the cliff. Garbage in, garbage out. [hammers on my keyboard to help the algorithm define information]

‚¹ªŒŒ™¬‰???€??æ   s?un? ??o ??n?

FreedomGuy's picture

This is the core problem of central planning and government controlled economies and currencies. Afree economy is constantly and everywhere rebalancing just like a rainforest at a million points is reacting to all situtations. Governments come in and decide they favor one or two plants and destroy everything else. They make undeliverable promise. The solution is always more control and more government which makes it worse. i think there is no way to avoid some sort of economic collapse or reset at this point.


Bunga Bunga's picture

Volcker says QE does not work, no inflation.

CPL's picture

Square peg meet round hole.  


They'll try everything in their power to avoid collapsing the entire system.  Lie, cheat, steal, murder.

Debugas's picture

and he is right - as long as major defaults have not happened

XtraBullish's picture

Notice: I have been LONG ONLY since March 2009 - I am now FLAT and I am LOOKING to get SHORT.


The AG lawsuit against JPM has altered the playing field.

XtraBullish's picture

If Obama trashes the market makers, they have zero bid power. No bid = no market.


Way to go Barrack Hussein. Strong work.

XtraBullish's picture


A Lunatic's picture

This is how I found out I had dyslexia...........

Dr Benway's picture

Beautiful. Best case scenario is global war.

Radical Marijuana's picture


This article was bloody optimistic.

The "Ponzi scheme we live in" ... is the whole of Neolithic civilization! Having a saner debate of any of the chronic political problems inherent in the nature of life is practically impossible because the people who were the most successful in dealing with those problems were the people who were the best at lying about them!  That is the real history of militarisms, and therefore, why we are so totally fucked up!

It is practically impossible to have a rational discussion about human ecology or industrial ecology with anybody, since the REAL SYSTEMS were made and maintained by the people who were the best at lying about what they were doing!

This article trots out the grossly superficial notions about what money is, that are the generally accepted ones:

Money has two purposes: to store value and to transact. There is however another use of money, which is a derivative of the storage-of-value use. The use of money to repay debt.

Money is based on murder. ALL human reality was always organized systems of lies, operating organized robberies. That is the only view that is consistent with the rest of an advanced scientific world view.

I do not mean the mainstream orthodoxy regarding science, which is mostly just another captured bullshit factory, controlled by its funding, and therefore, in a vicious spiral of triumphant scientific frauds. I mean a science which is worthy of that name.

Payment of debts depends upon have the power to force people to pay. The debt controls depend on the death controls. All transactions take place inside of that context. Those who take for granted that there is some rule of law, which makes money able to store value and facilitate transactions, are simply sliding along on the surface, without critical thinking!

Since money IS based on murder, and our system became a runaway fiat money fraud, of astronomical proportions, which will probably end by collapsing into chaos, and mass murders. The ONLY way to prevent that is to do it better, first, and constantly. The central concepts of human ecology (and industrial ecology too) are the same as found throughout natural ecologies!

AFTER one already has a system where there can be reproduction, then there are automatically a set of innate problems which come along with that system. It is a package deal, that life automatically MUST come with its own chronic problems, and that those problems MUST be resolved somehow.

Given that there IS LIFE, then the death controls are necessarily the central concepts. (Of course, no life, no production, no problems. There has to be life for the limits to life to become a problem.) In our complicated civilization, the murder systems mattered most. Thus, the history of militarism, as the supreme ideology dominating and controlling everything else. Thereafter, the money system depends on that murder system.

Therefore, our PONZI SCHEME (which is pretty well the whole of Neolithic civlization's social pyramid system) have developed expedient solutions to chronic political problems. The paradoxes of militarism are as old at the first book on the Art of War, namely, success in war is based on deceits, and spies are the most important soldiers Therefore, as I stated above, our society is ruled over by the Fraud Kings. Those who were the best at lying about what they were doing became the most wealthy and powerful people. The real money systems depend on the real murder systems. The REAL economy MUST be perceived as organized systems of lies, engaged in organized robberies. The real human ecology and industrial ecology MUST be doing that too!

However, by and large, as I wrote above, it is practically impossible to have a saner debate about what our death controls should be. Therefore, there is no realistic hope of ever having any saner debates about our debt controls.

As long as our society continues to be dominated by those who are the best at dishonesty, and they have practically no effective opposition, that is more realistic, instead of more idealistic, in various goofy ways, then we are doomed to back up our money system with a murder system that is a runaway psychotic insanity ... which IS the real world today, of global electronic fiat money frauds, backed up with the threat of weapons of mass destruction.

ONLY better murder systems can resolve these real problems better. However, that truth is practically impossible to have any rational social debates about, since those who ARE operating those systems were required to become the best at lying about that!!!

Welcome to the world where awesome progress in physics and biology, etc., has NOTHING to compare that to in political science, because those who dominate political sciences were the best at lying about what politics was really doing. Only radical paradigm shifts in militarism, to understand the original purposes and imperative reasons WHY there were death controls, and thus, then achieving those purposes in better ways, are satisfactory solutions, which then would also have their expression through the money systems.  BUT, BUT, BUT, good luck with that series of political miracles, eh! 

The paradoxes in the money system are the same as the paradoxes in the murder system. That is WHY someone can read an article like this, and then post their correct comment: "Beautiful. Best case scenario is global war."

falak pema's picture

to wage a War you need an enemy; the only true enemy that Ponzi Pax Americana has today, is itself.

The runaway ponzi prison construct is now a world phenomenon; except for the 0.1%.

We have a mad "Madoffed", two headed couple as king financier from his FED/WH cell. 

Who will he aim his missiles against? 


Radical Marijuana's picture

... only true enemy that Ponzi Pax Americana has today, is itself ...


The vast majority of human beings, and certainly younger Americans, are totally FUCKED unless they go through a Second American Revolution to make their CITIZENSHIP count, and take back control of the money system, and so forth ...

Too bad that too many are way too stupid for that to be practically possible. Instead, it looks like a horribly insane grinding down process, that will hit the metal at some point, after all the softer bits are filed down to nothing.

Here is recent TED TALK, stating what has been obviously coming for many decades, but is picking up speed exponentially:

Andrew McAfee: Are droids taking our jobs?

The answer is OBVIOUSLY YES!

It is going to get more and more impossible for Americans to compete with third world peasants and robots! Unless the American people radically change the way that they think about their money system and economy, then, bit by bit, it is guaranteed that those who own the machines will own everything, and those who do not will have no chance to do anything. This splitting apart is getting worse and worse, faster and faster. The better the technology gets, the more it is actually used to make a tiny group richer, and everyone else poorer. We are already approaching the point where the "economy" is only about the rich people, and everything revolves around them. The masses of poorer people will be marginalized to nothing ... They will never be able to compete with the advancing technology, and/or third world peasants. 

There are never going to be any real jobs available for them!


So the view that we have met the enemy and he is us is more true now than ever before!  Everything that I said above in my comment is only going to get more intense!

An inhuman money system will destroy all human values. The runaway fascist plutocracy will eventually destroy itself, since, eventually, even those who own the machines could be replaced by machines too!

We are making the worst science fiction nightmares come true!  I wish I believed that the vast majority of people were not already too stupid and ignorant! However, the global privatized Ponzi scheme is simply Neolithic civilization on steroids, transforming into a monster, that will NOT be human, or care about humans, unless human beings make that so.

At present, we have a runaway insanity of an economic system which is based on triumphant frauds, which enables itself to become more and more psychotic.  Unfortunately, the path we are on is the for real world to be much, much worse than any of the art forms that have portrayed the science fiction nightmares in the past!

The abstractions of financial numbers, which are runaway frauds, which have been able to divorce themselves from the violence that got them going, and kept them going, are all being amplified to astronomical sizes.

It is too bad that Americans no longer are remotely close to being brave enough to face these facts, and deal more directly with them. Instead, we are being entertained to death, while the real world is being destroyed, and even the richest human beings will be too ... although they may be the last ones to understand that, since they are inside of the most protected environments.

(The TED TALK I linked to above is an example of a higher quality manifestation of being "entertained to death!" I find that almost all the TED TALKS are put on very intelligent people, that otherwise are mainstream morons. They would NOT be giving a TED TALK unless that was the case. The optimistic conclusions in that TALK are theoretically possible, but those are NOT what is happening in the real world. Of course, the relevant kinds of more radical truths that are most necessary, will NOT be presented as entertainment, with big corporate sponsors! Nor is there anymore than a Fringe Cubed audience out there now to listen to such a presentation, as far as I can tell at the present time!)

An insane money system develops out of human insanity to begin with, but that has now been automated, and is happening faster all the time. The imperatives for a deeper and more profound intellectual and political revolution keep on building ... However, as far as I can tell, there is no reasonable hope that enough Americans will be able to stop the runaway frauds happening, and after it happens to them, it will not be possible to prevent that from happening to everyone else in the world too, later.

polo007's picture

One hiccup of liquidity, where bond buyers pull back from lending the U.S. cash for nothing, and these bonds would be turned into dead president cash.

This freshly minted cash would then flee into hard assets, and off goes a new asset bubble.

But where will this cash go? Euros? Yen?

In fact, the cash has nowhere to go… it has to be sucked up by liquid assets. Stocks.

Equities in huge multinationals are a currency hedge as well as a good inflation hedge. Big stocks have plenty of transparency and a very long trading record.

So investors keen to position themselves to survive “bond-ageddon” should realise the place to look is the giant market cap goliaths–ones paying dividends.

Here are some to put in your portfolio if you think the dam of cash will break.

Kellogg, Exxon, Wal-Mart, Time Warner, Dow Chemical

What a boring list. However, boring will be very attractive when bond prices start to melt.

The timing is, of course, very tricky. These impossible situations can drag on and on long past a point you would feel it was possible for them to continue. The sign to watch for is when the Fed starts to take new corporate debt onto its balance sheet.

Then the final episode of the great unwind will have begun. Monetising corporate debt is the last throw of the reflationary dice and will signpost one last, desperate attempt to keep the old system alive.

Yet even when it does, the sun will come up in the morning and life will go on as if nothing is happening, such is the chronic way the world changes.

Peter Pan's picture

All I know is that the letter of the law and the laws of mathematics are progressively been ignored and disbanded in the blind pursuit of strategies that are either illegal or manifestly dead ended.

orangegeek's picture

Europe is getting squeezed both from within and outside.


Within, smaller countries played endless shell games and refuse to curb spending.


Outside, Europe is out of rope and is looking to beg for cash from anywhere it can - how's the UN global tax coming along?


The world will be a much more peaceful place after Europe collapses financially.

falak pema's picture

the world will be a much more peaceful place once PAx Americana, Financial Ponzi and US$ collapse; there fixed it.

You are caddying for the wrong team. 

Superb article on a runaway fiat world now feeling the brakes of hyperinflationary winds and eddy current whirl pools. Despotism and statism...we are in gridlock. 

autonomos's picture

It seems to me there is another statu quo: recession, unemployement and 1984 like slaves